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Speech held by Dr A H E M Wellink, President of De Nederlandsche Bank, at the launch of the Netherlands Society of Investment Professionals on 6 October 1999. | Mr Wellink speaks about trends in the European banking industry and in banking supervision Speech held by Dr A H E M Wellink, President of De Nederlandsche Bank, at the launch of the Netherlands Society of Investment Professionals on 6 October 1999. * I. * * Introduction Ladies and gentlemen, It was with great pleasure that I accepted the invitation to deliver a speech on banking supervision at this official launch of the Netherlands Society of Investment Professionals. On this occasion, I would like to give you a broad picture of the major trends in the European banking industry. After having discussed the key driving forces for change, I shall present the strategic responses of banks to these forces. I will then describe the reactions of banking supervisors to these changes. At the end of my speech, I shall share my views on the future of banking with you. You will understand that it is impossible for me to tackle all relevant issues due to time constraints. II. Forces for change in European banking The European banking landscape is generally expected to undergo drastic changes over the next few years. Perhaps the most fundamental force for change in the financial sector has been the evolution of technology, particularly computing and telecommunications. Technological innovations affect banking capacity by changing production costs. They also spur disintermediation, increase competition by lowering entry and exit barriers, help the internationalisation process, and so on. Technological developments have shaped banking business both internally and externally. Internally by means of the reconstruction of banks’ internal organisation and production processes and externally by spurring product innovation and establishing new distribution channels. The fruits of developments in information technology are, of course, available to non-banks as well as banks. Another driving force behind structural changes in the European banking sector is undoubtedly the introduction of the euro. It is assumed that the euro capital markets will be deeper, more transparent and more liquid than the previously existing national capital markets. This could make it cheaper for large corporations to raise money directly in these markets than to borrow from banks. The privatisation of banks is another force for change. It is also argued that the deregulation of the financial sector will further erode the obstacles that deny new providers of financial products access to the market. Demographic factors are also shaping the European banking industry. The widely held view thus appears to be that European banks are heading for turbulent times. The driving forces just mentioned will lead to intensified competition not only among banks but also between banks and other, new financial intermediaries. This is generally expected to increase the need for a restructuring of the banking sector. The general tenor seems to be that banks are specialised in an economic activity that can, to a growing extent, be performed by non-specialist players. If so, the demand for bank loans will decline and the structure of the balance sheets of banks will alter. This envisaged disintermediation and securitisation is expected to pose a threat to relationship banking, which still occupies a prominent position in the banking industry. It even raises the question of the continued viability of banks. It should, however, be realised that any shrinkage of the banking industry as a result of market forces is not by definition cause for concern. That would be different if the decline of the banking industry were due to excessive regulation. Excessive regulation would prevent banks from operating more efficiently and from offering new products. This in turn would allow other or new providers of financial services, which are subject to less stringent regulation, to push banks out of the market. Such a situation would, of course, be highly undesirable. III. Strategic responses of banks As you may have guessed by now, I myself do not believe in the gloomy scenarios. The structural trends I have just identified have obviously prompted banks to reconsider their activities and their distribution channels. In the following, I will emphasise that the driving forces have not only posed threats but have also offered banks new opportunities. Consolidation in the European banking industry The driving factors mentioned before have changed the perceptions with respect to the efficiencies to be achieved through consolidation in the banking industry. Indeed, the number of mergers and acquisitions has increased considerably since the mid-1980s. Mergers and acquisitions are, in turn, partly responsible for the reduction in capacity and the slight increase in concentration in the EU banking industry over the past decade. So far, the recent wave of consolidation has developed mainly within national industries. Cross-border mergers or acquisitions still seem to be the exception, although things have started to change. Looking at simple capacity indicators like the number of banks or branches per inhabitant, it can be expected that consolidation will continue in the French, German, and Italian banking sectors in particular. It is questionable, though, whether this process will follow the same pattern as, for example, in the Netherlands or Sweden, because the share of publicly owned banks has always been much larger in France, Germany and Italy. It is also unlikely that the expected consolidation process will ultimately lead to concentrated banking sectors such as that in the Netherlands. Indeed, the domestic markets in France, Germany and Italy are bigger and, consequently, offer room for a greater number of viable banks. It will also become increasingly difficult to interpret national concentration ratios in the euro area. Conglomeration A second manifestation of the forces for change is conglomeration in the financial sector. Largely due to the deregulation of previously segmented financial markets, different types of financial institutions have entered each other’s territory over the past decade. A familiar example of this is the provision of typically traditional banking products like mortgages by pension funds and insurance companies. In parallel with this development, banks, securities institutions, and insurance companies have merged into financial conglomerates. In the Netherlands, 10 out of the 15 largest banks are part of a financial conglomerate, which makes our country the undisputed leader in this field. The recent acquisition of the Nationale Investeringsbank by the PGGM and ABP pension funds is the first major partnership involving institutional investors and commercial banks. New products, markets and distribution channels The driving forces identified earlier also have major implications for the type of business conducted by banks, and the way that business is conducted. The information technology and the deregulation of the financial services sector have enabled banks to develop an entire range of new, complex financial products and new distribution channels. Technological innovations have recently been instrumental in the creation of various derivative products – including credit derivatives – and the application of credit scoring techniques to consumer finance, credit cards and mortgages. It has also become possible to unbundle the various risks implicit in any single financial instrument – for example market risk, credit risk and liquidity risk – and to trade these risks separately. As for disintermediation and securitisation, it is true that securities markets have become increasingly important in providing funding to businesses. However, banks are closely involved in the issue of securities by large corporations and institutions. Investment banks possess the expertise necessary to manage issues successfully, to attract potential investors, to maintain a securities market, and to hedge or underwrite possible risks. As regards the trade in shares, bonds, and derivatives, banks increasingly focus their activities on executing customers’ orders, speculate on market developments, and engage in proprietary trading. Activities of this kind generate commission income for the banks. So, how much truth is there in the pessimistic view that the position of banks in the financial intermediation process is being gradually eroded? Indeed, one could say that the banks’ role in supplying credit has been steadily declining, as evidenced by their falling share in total financial debt. The decreasing reliance on bank loans seems to be most pronounced among large firms with credit ratings, which can resort to public capital markets to meet their funding needs. By accessing the public capital markets, these firms can bypass the usual screening by banks to some extent. However, I think that this view on banks’ disintermediation must be nuanced and put into perspective. Bank loans, savings accounts, and deposits continue to grow when expressed in terms of national income. Therefore, I am sure banks will continue to play an important role in solving asymmetric information problems in the financial markets. Some businesses can rely only on bank loans because they are unable or unwilling to reveal their financial position to the outside world. If insufficient information is disclosed, rating agencies are unable to form an accurate opinion of the financial position of a particular company and the attendant risks. Such companies are thus only able to obtain external funds in the form of bank loans after screening and monitoring by banks. Recent international experience has shown that, particularly during periods of economic stress, banks perform a critical function in providing large corporations, too, with liquidity. In other words, large firms also need to and want to maintain relationships with banks. Besides, conclusions with respect to the position of banks in the financial system which are based solely on balance sheet activities are misleading. In recent years, banks have developed an extensive range of off-balance sheet operations. By offering instruments like financial derivatives, banks have been able to tap new sources of income. If one ignores these activities, one may wrongfully conclude that banks are a dying breed. For Dutch banks, the credit equivalents of off-balance activities already amount to between 15 and 20% of their on-balance sheet operations. Even taking balance sheet and off-balance sheet operations together does not present an accurate picture of the true position of banks in the economic system. Banks are, for example, also closely involved in setting up, managing and marketing investment funds. In most EU countries, more than 80% of all investment funds are controlled by banks. In the Netherlands, half of all investment funds are associated with banks. Banks have thus been successful in internalising at least part of the supposed disintermediation on their liabilities side, which indicates their capacity to adapt to altered market conditions. Developments in information technology also offer potentially important commercial uses in the retail distribution channels. In the development of, and participation in these new distribution channels, banks are leading the way. Through alliances with supermarket chains, banks in some EU countries are already marketing simple banking products in-store. Banks are closely involved in the development of e-commerce, too, and have established a sound position in remote banking. IV. Developments in banking supervision As indicated earlier, the driving forces have enabled banks to venture into many new areas. Many banks have seized the opportunity to diversify their activities, both geographically and in terms of their product mix. This obviously increases the burden on regulation and supervision. Bank supervision has always focused on the assessment of the quality of a bank’s balance sheet at some point in time, and on whether it complied with capital requirements and restrictions on portfolio composition. This approach, however, has become less adequate in a world where banks are active players in international capital markets and can, because of potential trading losses, be driven into financial problems extremely rapidly. Thus, the emphasis in banking supervision has shifted toward risk control and market discipline. Take, for example, disclosure requirements to improve transparency as well as reliance on internal risk models that are more flexible than capital requirements. The process of mergers and acquisitions in banking mentioned earlier raises supervisory questions with respect to concentration and market power. It is difficult, however, to draw conclusions about the competitive nature of banking markets on the basis of concentration ratios. The reason is that the figures for the banking industry as a whole can mask sharply different degrees of concentration in specific segments of the market. In wholesale markets, competition may be fiercer and a critical mass may be required which exceeds that appropriate for national markets. In the retail markets, on the other hand, banks still operate in fairly fragmented national markets. It is also true that for a proper evaluation of the relationship between concentration and competition, the volume of intermediation activities by non-banks in specific segments of the retail markets should be taken into consideration. The high concentration index for the banking industry must be interpreted differently if other financial institutions also have a significant market share. As you know, non-banks also perform an important function in the intermediation process in the Netherlands. Another supervisory issue related to mergers and acquisitions, internationalisation and conglomeration in the financial sector is systemic stability. Here, a distinction should be made between the national and international dimension. Nationally, the issue of systemic stability is particularly relevant for small countries where very large banks or financial conglomerates have emerged. In the Netherlands, systemic supervision, aimed at safeguarding overall financial stability, is the domain of the Nederlandsche Bank, especially where banks and payment systems are concerned. Internationally, the trends just sketched stress the increasing importance of coordination and cooperation between national supervisory authorities and further harmonisation of regulatory rules. These elements are effected by various sector-specific international groupings of regulators and supervisors, such as the Basel Committee on Banking Supervision, the Joint Forum on Financial Conglomerates, the Financial Stability Forum, and the Banking Supervision Committee of the European Central Bank. Given the responsibility of national central banks for fostering financial stability in the eurosystem, this Banking Supervision Committee could, in principle, develop as a forum for strengthening the multilateral mode of supervisory cooperation within EMU. Yet another supervisory issue is raised by the increasingly blurred distinction between different types of financial institutions and the growing importance of financial conglomerates. These developments have recently led to the establishment of a Council of Financial Supervisors in the Netherlands. This Council consists of Board members of the Securities Board, the Insurance Board and the Nederlandsche Bank. I consider the establishment of the Council as an accurate and logical reaction to the structural developments in the financial services industry. It seals the long-standing close and harmonious relationships between the Dutch financial supervisors. The Council of Financial Supervisors will not execute supervisory functions itself, but leaves that to its constituents. It deals with regulatory issues that go across boundaries of specific financial sectors. The first issue concerns the supervision of financial sector integrity. The second field of operation deals with the supervision of financial conglomerates. The third subject is related to customer protection, focusing on adequate product information. In this respect, the Nederlandsche Bank has recently established a Consumer Protection unit. This unit deals with the supply of information to consumers on the supervisory role of the Nederlandsche Bank. The unit will also stimulate the supply of information by institutions under supervision regarding their products, and will inform consumers on the possible procedures and competent authorities to settle disputes. V. Concluding remarks Let me now briefly summarise the key insights emerging from my speech. Banks now conduct a much wider range of business than simply taking in deposits and making loans, which is their traditional financial intermediation business, and have become financial services firms. In many countries off-balance sheet income of banks now exceeds income earned from their traditional activities. Moreover, profound changes in the distribution channels for banking products and in bank-customer relationships can be observed. The driving forces identified in this speech may have put the industry under pressure but, more importantly, they have also created new opportunities. One is left with the undeniable impression that the regulation of banks has not prevented them from developing new activities and entering into new markets. In this respect, it may be noted that banking supervision and regulation are naturally frequently re-assessed in light of new developments. The recent suggestions for adaptations in the regulatory framework for banks by the Basel Committee on Banking Supervision mirror the genuine intention and proactive attitude of supervisors to ensure sound market conditions in the financial services industry, and to safeguard the stability of the global financial system. Having said all this, I cannot but finish with an optimistic observation. The banking industry has shown ingenuity in coping with many challenges. This is mirrored in the diversification of its activities. By continuously aiming at a high level of ethics and professionalism within the Dutch investment community, the Netherlands Society of Investment Professionals will certainly contribute to the health and integrity of the financial sector in general, and the banking industry in particular. | netherlands bank | 1,999 | 10 |
Speech given by Professor A Schilder, Executive Director of the Nederlandsche Bank, in the context of the Second European Social Week held in Bad Honnef, Germany, on 7 April 2000. | Arnold Schilder: The boundaries of the Civil Society? The example offered by financial supervision Speech given by Professor A Schilder, Executive Director of the Nederlandsche Bank, in the context of the Second European Social Week held in Bad Honnef, Germany, on 7 April 2000. * * * Introduction The main theme of this Second European Social Week is the establishment of a Civil Society in Europe. This Week is intended to generate initiatives which could contribute towards this goal. At the same time, we need to ask ourselves where the boundaries of a Civil Society lie. Put differently, does the model for the Civil Society meet the requirements of the European Society that we envisage? I am sure that you have no need of an explanation of the concept of a Civil Society. Put briefly, a Civil Society is a society built on a large measure of self-control. If you favour a Civil Society you expect individuals to engage in responsible behaviour. In our societies, freedom is a great good. But freedom goes hand in hand with responsibility. One man’s freedom may be another’s lack of it. That is why freedom is curtailed by standards and values. At the end of the day, it is these standards and values that protect our freedom. These days we are increasingly asking ourselves to what extent individuals are capable of taking responsibility for their actions. This question arises from our growing interest in moral values. There is an increasing call for control and supervision of compliance with standards. Why? Well, we are living in highly democratized times, where the need for transparency and openness is growing daily. This is not least because of the development of a wide variety of new media, such as the Internet. Whether this call for more supervision and control spells the end of the Civil Society is something I will be going into later. Let me first say something about the boundaries of the Civil Society. Why do we need to see to it that individuals shoulder their responsibilities? I shall illustrate my point by taking a look at supervision as it is exercised on the financial sector. Financial supervision in summary Before discussing the boundaries of the Civil Society, I would like to provide you with a brief overview of financial supervision. The emphasis will be on how that supervision is organised in the Netherlands. However, keep in mind that the issues confronting the Dutch financial system are no different from those in other European countries or other parts of the world. In this context, the fact that supervision is organised differently from one country to the next is irrelevant. Supervision on the Dutch financial sector is segmented. The supervision on banks (credit institutions), investment institutions and exchange offices has been delegated to the Nederlandsche Bank. The Bank is also responsible for the stability of the financial system as a whole. Insurance companies are supervised by the Dutch Insurance Supervision Board, while the Dutch Securities Board supervises the stock exchange, securities firms and securities business in general. Regulatory issues which involve all three supervisory authorities are dealt with by the Council of Financial Regulators, without detracting from their individual responsibilities. This model is receiving increasing attention internationally. It forms a good alternative to the supervisory model whereby all regulators are united in a single agency. The supervision of the Dutch financial sector is laid down in a number of statutory instruments. The statutory objectives of banking supervision in particular may be summarised as follows: safeguarding a stable financial system, protecting creditors and, within the near future, maintaining the integrity of the financial sector, objectives which I will be looking at extensively later on. Let us now return to the Civil Society: what are key issues here? There are three, which I will be discussing in detail. First, externalities, i.e. the benefit for and cost to society of individual action. Second, reprehensible behaviour on the part of individuals. Third, the need to protect the interests of weaker groups in society. In each case, I will be drawing parallels with supervision of the financial sector and pointing out what lessons could be drawn from this for the Civil Society. Key issues of Civil Society: externalities A Civil Society is no free-for-all; it is a society of individuals engaging in responsible behaviour. As the Chairman of the Van Ede Foundation, Mr Leeuwens, put it very aptly not long ago: acting responsibly is acting appropriately on the common ground between self-interest and the greater good. This is not a novel idea, and has always held its place in economic science, as Mr Leeuwens so rightly pointed out. Adam Smith was a fervent advocate of free enterprise. He argued that when individuals are free to choose how to use scarce goods and capital, the resources available to an economy are put to their best use. Adam Smith was not thinking in terms of mere self-interest. He spoke of an invisible hand, providing guidance to the market mechanism. He too assumed that, individuals are guided by the common good consciously or unconsciously. The question arises whether this invisible hand always works properly. Most individuals base their behaviour on a cost/benefit analysis of their own. Even an individual who tries to take the general interest into account has no inkling of the true costs and benefits of his decisions for society as a whole. In addition, individuals often base their decisions on less rational considerations as well. Take, for instance, investor behaviour, such as the herd instinct on the stock exchanges. This can be explained by the theory of cognitive dissonance: investors filter information to justify earlier investment decisions. Economic textbooks often cite environmental pollution as an example of an area where the invisible hand does not work as it should. Industrialists undoubtedly take the consequences of their production process for the environment into account. Nevertheless, they are incapable of making an optimum assessment of the costs of pollution for society. In cases such as this, we need to seek ways of internalising the externalities into the market mechanism. One way of dealing with this problem is to impose statutory requirements on the release of pollutants and to set up an agency which checks compliance with these requirements. A Civil Society will also have externalities to deal with. Even if the participants in a Civil Society behave responsibly, the outcome of their actions may not be optimal to society. To what extent do externalities figure in the functioning of the financial sector? A good example is the Nederlandsche Bank’s responsibility for the stability of the financial system. Through their behaviour, financial institutions may jeopardize their own continuity. Take, for instance, a bank which exposes itself to considerable risk by granting vast, high-risk loans. If the borrower defaults on these loans, the bank could founder. That in itself would be a disaster, but the ultimate outcome could be worse still. If the bank in question has borrowed heavily from another bank, the latter may also find itself in trouble. This is known as the domino effect. In order to prevent such situations from arising, the legislator has set up a banking supervisory authority. The first task entrusted to this supervisor was to watch over the continuity of banks. This is where prudential supervision came in. It made it possible for regulators to issue rules and guidelines for the way banks manage their balance sheets. The best known internationally-agreed - rule is the Basel Capital Accord. It compels banks to maintain a buffer of own funds, of at least 8% of all loans outstanding. Should a bank fail, something that cannot be wholly precluded by supervision, the supervisory authorities can resort to other ways and means to keep it going. In the early-1990s, the Swedish government made vast amounts of funds available to the Swedish banking system when a major financial crisis threatened to paralyse the entire financial sector there. If and when a central bank will actually act as lender of last resort is known only to that central bank. This is to prevent banks from engaging in “moral hazard” behaviour. If banks knew under what conditions liquidity support is given to the banking system, they might anticipate such action, rather than shoulder their own responsibility for the continuity of their business. This brings us back to the Civil Society. Even though there may be an authority which supervises the functioning of the financial sector, at the end of the day it is up to banks themselves to bear responsibility at the very least for their own continuity. Supervisors do not act for bankers. In other words, rules and standards - and the establishment of an agency which ensures compliance - may help to internalise externalities in the Civil Society; ultimately, the participants of the Civil Society must shoulder their own responsibilities. Key elements of the Civil Society: reprehensible behaviour The second constraint on the Civil Society is reprehensible behaviour on the part of individual participants in respect of certain standards and values. Those who advocate a Civil Society assume that everyone is more or less concerned with the common good. Everyone operates on the common ground between self-interest and the greater good. There are, however, always people who have only their own best interests at heart, and who have no qualms about sacrificing others in the process. This is considered reprehensible behaviour. In this sphere, too, there is a need for an agency to demarcate the boundaries between acceptable and unacceptable behaviour, as well as to ensure that these boundaries are not transgressed. Reprehensible behaviour is completely out of the question in the financial sector. Individuals entrust their money to financial institutions. Abuse of that trust will damage the reputation of the bank in question, and with it possibly its continuity. That is why financial supervisors are paying increasing attention to the integrity of financial institutions. This brings us to an area of great activity. In the past, supervisors focussed notably on the prudential aspects of banks’ operations. Over the years, however, their attention has shifted to the integrity aspects of banking. First of all, it turned out that reprehensible behaviour can also threaten the continued existence of a financial institution. Secondly, the requirements to be met by the integrity of the financial sector have been sharpened over the years. Insider trading, never questioned several decades ago, is now considered totally unacceptable in most countries. The Nederlandsche Bank has also come to pay increasing attention to financial integrity. In July 1997, the Bank decided to set up an integrity unit. The unit offers specialised support in the sphere of regular integrity supervision. It also takes part in policymaking in this field. Financial integrity has since come to figure prominently on the Dutch political agenda. As things now stand, integrity supervision is becoming a separate, statutory aim of Dutch banking supervision. In anticipation of this development, an integrity audit has been drawn up under the auspices of the integrity unit. This is in fact a computerised methodology that allows supervisors to assess banks systematically in terms of integrity. Back to the Civil Society again. Tackling reprehensible behaviour does not mean distrusting every participant in the Civil Society in advance. That is in any case not how financial supervisors see their task. Financial institutions, and certainly the overwhelming majority of banks, are not out to engage in reprehensible behaviour. After all, if they did, they could be jeopardising their continuity. However, there is always the chance that an individual employed at an institution cannot resist the temptation to put his own interests above those of others. Supervisors must therefore be on the lookout at all times. However, if distrust were to get the upper hand, the open relationship between the supervisor and the bank would be undermined. The Civil Society, too, cannot function on the basis of distrust. The measure of trust among people determines the measure of cohesion within society. Key elements of the Civil Society: protecting the weak Let us take a look at the third element of the Civil Society. The participants of the Civil Society are basically assumed to be equal. They allegedly have the same information at their disposal and are considered capable of looking after their own interests. In practice, however, that is not always the case. Society also encompasses weaker groups, which are insufficiently able to defend their interests in a Civil Society. There are several solutions to this problem. Notably in a well-functioning Civil Society, the obvious thing would be for vulnerable groups of individuals to organise themselves. If this option proves ineffective, they should be able to resort to an agency which looks after their interests for them. From the point of view of the financial system, the weaker party is clearly discernible, viz. consumers, the individual customers of a financial institution. Their interests are protected by supervision in several ways, in the Netherlands, too. To begin with, the Dutch Act on the Supervision of the Credit System explicitly seeks to protect banks’ creditors. Not only do the supervisory authorities watch over the continuity of financial institutions with a view to overall financial stability, they also seek to protect those who have entrusted their money to banks. In the event of a bank failure, its creditors can resort to a deposit guarantee scheme, which ensures that their deposits are guaranteed - subject to certain conditions - to an amount of EUR 20,000. Supervisors furthermore seek to ensure that financial institutions provide their customers with proper information. The supervisory authorities do not intermediate between banks and their customers, on the contrary. They - increasingly - require banks to provide consumers with adequate information. Consumers must have sufficient information at their disposal to make a well-founded choice. In the Netherlands, a package of minimum information requirements is currently being drawn up. Last year, the Nederlandsche Bank set up a consumer affairs unit. The unit’s staff contribute to the rules being drawn up with regard to the information being supplied to consumers. They also answer questions put by consumers about financial services, and inform consumers on what to do when they have concrete complaints about a financial institution. In this respect, the Netherlands is in the vanguard in Continental Europe. In the United States and the United Kingdom, consumer interests figure even more prominently in supervision. The conclusion is therefore that even in a Civil Society, it may be necessary to protect the interests of vulnerable groups by formulating standards and values. Is the Civil Society infeasible? So much for key elements of the Civil Society. Does this mean that the Civil Society is infeasible? Far from it. As I noted earlier, the proponents of the Civil Society are well aware of the bounds of societal responsibility. The Civil Society has nothing to do with unbridled liberalism. On the contrary, the protagonists of the Civil Society are continuously seeking to improve and supplement its model. This serves to internalise the constraints which I outlined earlier. In the Netherlands, supervision is, on the one hand, enforced by a statutory framework, providing for rules and obligations for financial institutions and sanctions for non-compliance. On the other, it was set up in a “partnership” with the financial sector. The financial system helped to shape supervision as we know it. In other words, the currently much-acclaimed Dutch polder model concerns not just the cooperation between government and social partners, but in a sense also the supervision exercised on the financial sector, with all parties involved acknowledging that proper supervision serves a common purpose. Obviously institutions have commercial goals, but they are also aware that the public’s confidence in the financial system is conditional upon sound supervision. An open relationship has consequently grown up between the Bank and the institutions subject to its supervision. Yet the Bank maintains a sufficient distance vis-àvis the institutions, to safeguard objectivity and the authority to act when and where necessary. It is this mix of cooperation, efficacy and forceful action which makes the supervision exercised by the Bank so potent. I would like to point out that a partnership does not equal self-regulation where the supervision of the financial sector is concerned. The experience gained by the financial sector with self-regulation has not always been positive. Though widely sustained by the sector, financial supervision also clearly stands above it. As the Civil Society will not be able to function properly without impartial supervisory bodies, it will need to delegate part of its competencies and responsibilities to them. Conclusion I am nearing the end of my address. I am all for striving for a Civil Society in Europe. It means, however, that we need to analyse the obstacles that we find on our way to that goal. The model of the Civil Society is up against several constraints. First, the externalities of the behaviour evinced by those taking part in the Civil Society. Second, possible reprehensible behaviour by individuals - to the detriment of others. Third, the tendency to lose sight of the interests of weaker groups in society. I have attempted to show that the limitations that the Civil Society is up against also constrain the financial sector; there the remedy has been found in the establishment of a supervisory authority which sets standards and ensures compliance. Ideally, financial supervision is a partnership between the supervisory authority and the financial sector. At the same time, the supervisor should stand above the sector, and be capable of intervening forcefully and effectively. What does all this mean for the Civil Society? Though the constraints on the Civil Society can be remedied in part by society itself, some form of supervision is ultimately indispensable. The best illustration I can think of is street violence. Violence cannot be curbed by simply putting more police on the street. Maintaining standards within society calls for the active participation of all. A good example is the neighbourhood watch. On the other hand, it would be unacceptable if people were to take the law into their own hands, or if safety on the street were to become only their own responsibility. An impartial supervisory authority - in this case the police and other instruments of the constitutional state - may not be the ultimate remedy. It certainly is an indispensable tool in ensuring a well-functioning society. Finally, how does the Civil society achieve a state of supervision which is effective? This should develop through public debate as well as initiatives from participants. Recently in the Netherlands we noted some cases of so-called meaningless violence: youngsters killed by mindless people for no reason. This raised storms of protest, demonstrations, silent procession. Now we see this developing into a mix of officially backed arrangements and joint private efforts to fight violence and the lack of solidarity. That is the right balance between organized supervision and self-regulation. So, there is no excuse for awaiting others’ actions. That is why this conference may prove meaningful. | netherlands bank | 2,000 | 4 |
Speech by Mr A H E M Wellink, President of De Nederlandsche Bank, at the press conference, held in Amsterdam on 17 May 2000. | Dr A H E M Wellink: Introduction to the press conference on the 1999 Annual Report Speech by Mr A H E M Wellink, President of De Nederlandsche Bank, at the press conference, held in Amsterdam on 17 May 2000. * * * The world economy is in good shape. In 1999 GDP growth came out at 3%, exceeding expectations. Yet, this overall pattern masks a number of risks and uncertainties. The motor driving the exceptional US economic performance - at the same time the motor driving the world economy - is in danger of becoming overheated. Southeast Asia recorded a rapid recovery from the financial crisis, but the Japanese performance remains weak. The first half of 2000, however, holds out better prospects. In Europe, too, economic performance is improving. In 1999 GDP growth reached 2.3%. Though seemingly low compared to the 3% growth rate of the world economy, it should be noted that European growth accelerated considerably in the course of 1999. For the current year, a robust growth rate of 3-3.5% is expected. Thus, prospects for Europe are bright, definitely so if the structural reform policies are continued and the renewal of the economy, so evident in the United States, progresses further in Europe as well. There are no grounds to suppose that the ICT train will bypass Europe, provided, of course, that we see to it that we are well prepared. Despite the movements in the euro’s external value, Europe may pride itself on a successful first year of monetary union. First and foremost, prospects for price stability in the euro area remain favourable, thanks not least to the success of the ECB: whoever would have thought two or three years ago that the launch of the euro would be as smooth as it has proved to be? In addition, Europe’s vulnerability to external shocks, such as the Asia crisis, has undeniably diminished as a consequence of monetary union. Good, better, best: in the Netherlands, we may meanwhile be doing too well. The Dutch economy is experiencing its most prolonged cyclical upturn in fifty years’ time, due in part to the consumer spending impulse emanating from higher asset prices. For 1999 this impulse may be roughly estimated at NLG 10 billion (1.25% of GDP). In a sense, the situation in our country is comparable with that in the United States. We have now reached a point where caution is called for. In order to prevent the economy from overheating, it is first of all required that, apart from those already decided on, no further fiscal impulses should be provided; phrased differently, higher-than-expected revenues are to be reflected in lower public debt levels. Second, moderate wage movements are to be ensured. Even then, the new tax system for 2001 will boost average purchasing power by 4% or even more, representing a powerful stimulus for consumption. Many commentators view the new millennium as the start of a “new economy”. ICT developments will undoubtedly have a major impact on world economic performance; still, there is no indication whatever suggesting that economic laws have become fundamentally different. For this reason, and in order to be able to benefit to the full from the renewing economy, we must continue the structural reform policies (further improving the operation of the labour market, especially on the supply side, and of a number of product markets). More in general, policies must remain geared towards the achievement of well-balanced global macro-economic conditions (low inflation, more equilibrated balance-of-payments positions). We may well count our blessings, but should not close our eyes to reality. | netherlands bank | 2,000 | 5 |
Opening address by Dr A H E M Wellink, President of the Nederlandsche Bank, at the CEPR/European Summer Institute conference, held in Amsterdam, on 15 September 2000. | A H E M Wellink: Heterogeneity in Europe and the role of monetary policy Opening address by Dr A H E M Wellink, President of the Nederlandsche Bank, at the CEPR/European Summer Institute conference, held in Amsterdam, on 15 September 2000. * * * Introduction It is a pleasure to be here to give the opening address to this conference and to welcome you to Amsterdam. After only a couple of years, this annual conference has established a reputation for stimulating discussion on economic policy issues in Europe. This year’s programme looks set to further enhance your reputation. Issues of heterogeneity were the subject of much debate and analysis in the run-up to the introduction of the euro. The debate has continued since then, too, and this conference will no doubt provide fresh insights into the issue. Enlargement is also on the conference agenda. Obviously enlargement will have implications for current EU members, as well as for accession countries. Further, there are links between enlargement and heterogeneity. This afternoon I would like to talk a little about heterogeneity in the euro area, and its implications for policymakers. I would also like to look forward and discuss these issues in the context of EU and EMU enlargement. Heterogeneity First, some thoughts about heterogeneity. We are used to thinking about heterogeneity mainly in terms of nation states. We focus on differences between countries. Of course, it is not only when discussing economic policies that we think about national differences. We also highlight differences in other areas – the Netherlands was a mass of colour from supporters of different countries earlier this summer during the European soccer championships. And, the Sydney Olympics provide an opportunity to celebrate national achievement, as well as individual sporting excellence. Traditionally, monetary policy has also been conducted on a national basis, although European monetary policy did become more coordinated in the run-up to the introduction of the euro. Other economic policies have generally continued to be set on a national basis, although EU membership does impose some degree of consistency. Heterogeneity also occurs on other dimensions, such as between sectors of the economy. I will return to that point in a minute, but first want to make a couple of comments about country differences. There have been many studies in recent years focussing on differences between euro area countries. And, while a few studies find evidence to the contrary, there appears to be a general consensus that business cycles have converged to some extent over the past decade or two. As a central banker, I am naturally interested in inflation differentials, and these are certainly lower now than they were 10 or 20 years ago. For example, inflation rates among current euro area members ranged from 21% in Italy to 5% in Germany in the last quarter of 1980. By the second quarter of this year the range was only 3½ percentage points. Naturally, divergences do remain, and these reflect a number of factors. Some divergence is due to a process of convergence as countries catch up to euro area averages, the well-known Balassa-Samuelson effect. This effect explains how productivity growth during a catch-up process can result in higher inflation without undermining competitiveness. Country-specific policies, including fiscal policy and regulation, also result in divergences. Finally, countries have different industrial or sectoral concentrations. Differences in the economic performance of various sectors will therefore be reflected in cross-country divergences. These factors are not going to disappear immediately, but may diminish as price and income levels converge and through continued deepening of the internal market. However, we cannot be sure how rapidly they will diminish, nor can we be certain what level of divergence will be normal in the long run. In addition, the process of convergence will not necessarily be continuous. For example, inflation differentials have widened a little over the last year or two, although they remain much smaller than they were a decade ago. For small areas within a monetary union, a common monetary policy does have some specific implications. Small countries have little influence on the euro area inflation rate, which is a weighted average of national inflation rates. If inflation rates in those small countries diverge from the euro area average, that has relatively little impact on the overall monetary policy stance for the euro area. Consequently, it is possible for smaller countries to temporarily have growth rates and inflation rates that differ from those that would result from a national monetary policy aimed at maintaining price stability at the country level. Large countries could also be in this position. If inflation is well above the euro area average in one country, but below it in another, monetary policy may not contribute to narrowing the divergences. Where such divergences are not the result of catching-up processes, national economic cycles could potentially become more pronounced. Some euro area countries are arguably in this position now, or heading towards it. The Netherlands is one of those countries. Of course, such a deviation can also occur in the other direction, with inflation and output growth rates remaining lower for longer than would occur with a national monetary policy. This can lead to long-lasting social and economic costs if there are factors inhibiting a smooth adjustment process. I will return to this issue shortly. As I mentioned earlier, heterogeneity occurs across several dimensions. In addition to country differences, there are also differences in economic performance between sectors in the economy. As the internal market continues to deepen, there may be fewer regulatory differences between countries and the Stability and Growth Pact constrains national fiscal policy. It seems likely that cross-country divergences will increasingly reflect exposures that countries have to various sectors. Thinking about heterogeneity at a sectoral level might therefore be more insightful for the euro area than focussing solely on cross-country comparisons. Consider trends in inflation. The Eurosystem has defined price stability as a positive inflation rate below 2% over the medium term. The definition recognises the fact that at times inflation may temporarily move outside that target range. That is currently occurring as a result of higher oil prices which are a kind of sectoral shock. The weak exchange rate is also contributing to higher prices. The most recent HICP inflation rate shows that euro area consumer prices increased by 2.4% in the year to July. Almost half of that increase is due to higher energy prices. Naturally, cross-country inflation differences remain, and are relevant. However, these cross-country differences are themselves affected by higher oil prices, reflecting the fact that energy intensity and energy taxation vary between countries. In the current circumstances, analysing relative price trends can help in assessing whether inflation is confined to specific sectors, or whether it is leading to more generalised inflation. Implications for policy So we have heterogeneity across several dimensions. What does that mean for policy, and why should policy makers be concerned about divergences? Let me focus on price divergences. In a market economy, relative prices play an important role. And, relative prices include not only the prices of different goods and services within a country, but also the prices of the same goods and services in different countries. These relative price changes provide the signals to ensure that changes in preferences or technology flow through to changes in resource allocation. In theory, therefore, relative price movements are welfare enhancing and not something that we should be concerned about. In practice, the world is not so simple and markets are not perfectly competitive. Relative price movements do not always occur freely, and adjustments to changes in preferences or technology can be costly. Monetary policy cannot and should not influence relative prices within the euro area to offset divergences between sectors or countries. Those relative prices are determined by real factors. Instead, the best contribution that monetary policy can make to society’s welfare is to stabilise the general euro area price level. That reduces the noise in relative price changes, and therefore improves the workings of the price mechanism. Nonetheless, central bankers do monitor divergences. Why do we monitor divergences if there is nothing we can do about them? First, our knowledge of the monetary transmission mechanism is incomplete. Information about the various parts of the economy, including divergences, adds to our knowledge of the economy as a whole. We are particularly conscious of this in the euro area where we are still in the process of developing and enhancing indicators for the euro area as a whole. The second reason for our interest is that regional or sectoral differences in economic performance can provide early signals of area-wide developments, as US experience has shown. If monetary policy cannot and should not react to divergences, what about other policy areas? As I mentioned earlier, allowing relative price changes to occur is often the best approach, so that resources are allocated to their most effective uses. Accordingly, structural reforms that allow the relative price mechanism to operate are generally sensible. And, hearing central bankers call for structural reforms is nothing new! My colleagues and I on the ECB Governing Council have been regularly calling for further structural reform. For example, labour market reform that stimulates the movement of labour around the euro area is likely to reduce euro area unemployment overall, as well as reducing disparity in prices, wages and unemployment rates between regions. Central bankers in other countries make similar points. Another approach would be to use fiscal policy to try and dampen national divergences. However, given the planning and implementation lags, it is not easy to use fiscal policy in a counter-cyclical manner. In addition, the main objective of fiscal policy is not normally to reduce cross-country or cross-sector divergences. Even though fiscal policy is normally formulated within a multi-year framework, elements of discretion remain. Any discretion should be used to reduce, rather than increase, cross-country divergences in inflation. Fiscal policy should also be in a sustainable position so that automatic stabilisers can operate fully. At times it may even be appropriate for fiscal policy to seek to offset divergences. It is certainly the case that there is little to be gained from discretionary pro-cyclical policies. Rather, economic cycles could become more pronounced, resulting in costly adjustment taking place in downturns. The point I made earlier about small countries is relevant here. Euro area monetary policy is not significantly influenced by the inflation rate of a small country. It is therefore important for small countries to have the flexibility in other policy areas to offset inflation. Of course, large countries would also gain if they undertook structural reform and avoided pro-cyclical fiscal policy. And there could be times when it is appropriate for large countries to use national policies to offset divergences. I would merely make the point that the costs of not being flexible might be greater for small countries in the event of a downturn. Monetary policy after enlargement I would also like to briefly discuss how these issues apply to enlargement. First, the points made regarding small countries currently in the euro area apply with even greater force to accession countries. Given the relative size of accession countries, monetary policy for the enlarged euro area will be little influenced by their inflation rates. Accession countries are in general less converged in real terms than the initial EMU members were when monetary union began. This is true when measured on the basis of GDP per capita, and when adjustments are made for differences in purchasing power. Real convergence may therefore take a considerable period of time. Ongoing convergence, EU membership, and eventually adoption of the euro, could all result in economic shocks that mean monetary policy requirements in an accession country differ from those in the euro area as a whole. Given these factors, the extent of the difference in monetary policy requirements could be greater or more protracted than is the case for small countries currently in EMU. To minimise the economic and social impact of divergences, it is important that accession countries have flexible economies, sound financial systems, a solid fiscal position, and a well-developed institutional framework. Arguably, accession will therefore have greater consequences for countries now than was the case previously, in the sense that they are less converged in real and institutional terms than initial EMU members. A cautious approach to the adoption of the euro therefore appears appropriate, as premature adoption could prove costly. Second, monetary policy within the EMU will continue to focus on area-wide conditions. Obviously, that area will be larger following enlargement. One of the important issues for us will be to ensure that the indicators we use in our monetary policy deliberations are based on developments across the enlarged area. Our data requirements will expand accordingly. We will also need to learn how the monetary policy transmission mechanism works across the new area. I expect that the national central banks from the accession countries will have an important role to play here in helping us understand the workings of the enlarged euro area. Conclusion Despite having given some warnings about the consequences of divergences, I would like to conclude on an optimistic note. Yes there are differences within the euro area. But the differences do not create problems for euro area monetary policy. The overall gains from membership certainly outweigh the costs. I am confident the same will apply for accession countries. What the divergences do teach us is that other policies must play their part if we are to maximise the gains from a common monetary policy. That is particularly important for small countries. Thank you for your attention. I would like to repeat my welcome to you, and wish you well for the remainder of the conference. I am sure that it will be both stimulating and fruitful. | netherlands bank | 2,000 | 9 |
Speech by Mr A. Schilder, Executive Director of De Nederlandsche Bank N.V., at the Take Off Conference 'Information Battle: Consequences of the New Economy on Economic and Business Life', University of Maastricht, 14 February 2001 | Arnold Schilder: Banking in the new economy: a supervisory perspective Speech by Mr A. Schilder, Executive Director of De Nederlandsche Bank N.V., at the Take Off Conference ‘Information Battle: Consequences of the New Economy on Economic and Business Life’, University of Maastricht, 14 February 2001. * * * Introduction The new economy affects the almost two-hundred-year-old Nederlandsche Bank in many ways. Today, I will focus on the implications of the new economy for banks and for banking supervision. The subject therefore is: e-banking supervision. Electronic banking First, what is e-banking? E-banking is the provision of banking services by means of electronic data transfer between participants. The information is transferred via a network, which may be a computer network such as the Internet, or a telecommunications network. Rabobank’s Random Access Banking is an example of e-banking. By that, customers can make payments, deposit savings, and make investments over the Internet or by telephone. In addition, when people shop in a Dutch cybermall, such as Davista (www.davista.nl), Random Access Banking mostly offers the possibility to pay using Rabo Direct. This last application could be described as using your PIN code over the Internet. Another recent example of e-banking is Wellowell, owned by ING. This is an on-line marketplace. Customers can compare insurance offers and banking products from various providers here, and close the deal there and then. Examples are a car insurance or a savings account. In this way, ING offers its own products, as well as those of its competitors. What does the advent of electronic media mean for banks? I would like to mention three consequences. One is that the Internet makes the market more transparent. Consumers can compare products and services from different providers more easily, and shop around for the best offers. This is particularly the case for standard products like consumer credit, where price is the key factor determining the customers’ selection. In addition, the costs of switching suppliers are lower in the case of electronic banking. Combined with the increased comparability of products, this could reduce customer loyalty. This in turn means fiercer competition for banks. A second consequence of the new information and communication technologies is that the organisational structure of banks will be affected. Banks have a very integrated value chain, horizontally as well as vertically. This means that all elements of their service are provided by the same organisation. Examples are account management, product development and infrastructure. The Internet puts pressure on this integrated organisational structure. An important aspect of Internet technology is that its development requires very high initial investment, but that the marginal costs of use are low. This raises the possibility that new, specialised suppliers are able to carry out certain specific activities more efficiently than the banks themselves. On the one hand, this situation offers the banks the option to outsource some of their operations to others, thus achieving cost reductions. On the other hand, it could bring unwanted pressure on parts of the banks’ value chain, and ultimately lead to deconstruction of the chain itself. A practical consequence of this trend is that banks are developing into network organisations by way of alliances and cooperation with both financial and nonfinancial institutions. For example the cooperation between ABN AMRO and KPN in relation to the launch of the ‘Money Planet’ Internet site. A third consequence is that new suppliers can enter the market more easily. In the virtual world, barriers to entry are significantly lower. There is no longer a need for an extensive branch office network, for example. Lower entry barriers mean more suppliers in the market, which intensifies competition. These suppliers may take different forms. They may be existing banks originating from other countries. These banks can use the Internet to bring about a rapid internationalisation of their activities. Various institutions have already set up electronic subsidiaries, which offer banking services on an international scale under a new brand name or under the name of the parent bank. Examples include the Bank of Scotland’s electronic subsidiary Eubos, which offers mortgages on the Internet in this country, or ING Direct, ING’s electronic offshoot, which is active in Canada and elsewhere. New suppliers can also be pure electronic banks, or institutions from the non-banking sector. Pure electronic banks are not linked to an existing physical bank. Although they do not have the high fixed costs of a branch network, they do have to invest heavily in building up their reputation. It is interesting to note that the current market share held by such banks is still very small. The principal reasons for this are probably the lack of confidence resulting from the lack of a physical presence and the high cost of marketing the brand name. Newcomers from the non-banking sectors can be existing non-financial institutions that offer a limited range of financial services through electronic channels. Volkswagen in Germany is one example. They offer consumer credit. Also companies which specialize in payment systems are part of the non-banking category. Right now I am talking, they offer you the possibility to make payments over your mobile telephone. This sevice is already available in the United States. Other non-banking institutions include consumer comparison sites like Wellowell, portals and personal agents. The implications of e-banking for supervision So far I have described some consequences of electronic media for the banking system. But what are the implications for banking supervision? Let me discuss some recent activities undertaken by supervisors. First, the Nederlandsche Bank supervises the banking system in accordance with the Dutch Credit Systems Supervision Act. The Policy Regulations for the Media (Beleidsregels Media) were formulated to indicate how this Act should be applied where financial services are offered via electronic media. Briefly put, these Regulations state that it makes no difference whether banking services are provided via traditional channels such as branch offices, or over the Internet. In both cases the institution concerned is required to hold a banking license. For example, an institution established in the Netherlands which provides banking services over the Internet comes under the supervision of DNB. However, a provider which is established abroad but via the Internet is active in the Dutch market is also subject to DNB supervision. Several indicators play a part in deciding whether activities are considered to be directed at the Dutch market, like the use of the Dutch language, contact points in the Netherlands, and the addressees of the media used. The existing regulatory legislation is therefore adequate for proper banking supervision, also with the advent of e-banking. E-banking has however made the regulator’s task more complicated. How do we check that all providers that are active over the Internet in the Dutch market do indeed comply with regulatory legislation? This brings me to a recent DNB initiative. Second, in combination with its fellow regulators the Dutch Insurance Board and the Securities Board of the Netherlands, the DNB has entered into a co-operative agreement with the Dutch National Police Agency (Korps Landelijke Politiediensten, or KLPD) and the Dutch Economic Investigation Service (Economische Controle Dienst, or ECD). We are working together on developing new tracking methods. The objective is that those whose actions on the Internet are in breach of the regulatory legislation can be traced. A third initiative is the introduction of the internet officer. The digital detective, or cybercop, is already a familiar phenomenon in police circles. From the beginning, the use of cybercops has induced investigation authorities to develop techniques to discover the identity of those who are in breach of the law. The regulators want to use this technology in their supervision of the financial sector. The DNB now has one internet officer, which like the digital detectives is engaged in tracing financial offenders. So far, several indications of offences on the internet have been found. For example institutions that offer banking services over the internet without having a banking license. Also some so-called ‘study investment associations’ (studiebeleggingsclubs) were in breach of the regulatory legislation. These investment funds, founded by students, operated over the internet without a license of DNB. A fourth initiative to protect consumers against unauthorised banking services is the introduction of so-called hyperlinks. This possibility is currently being investigated. Every financial services provider using e-commerce would be required to place a hyperlink on its website referring to the relevant regulator. By clicking on this hyperlink, consumers would access a list of providers licensed by the regulator, and could easily see whether a provider is on the list, and therefore is trustworthy. Another possibility being considered is a regulator’s ‘black list’, which would be a special page on the regulator’s website listing financial services providers that are operating without a license and therefore not trustworthy. So we work together with fellow regulators, the police and investigation services. However, the Bank has a separate unit concerned with the supervision of banks and information technology within its Supervision department. The fact is that e-banking involves several specific operational risks. One operational risk mainly relates to the security of systems and transactions, including data confidentiality and authentication of the parties involved. Another operational risk refers to the continuous availability of the Internet as a medium for financial transactions. This availability is prone to serious hazards, such as computer viruses and hackers. Think for example of the Homebanking application of ABNAMRO, that was subject to an attack of hackers in September last year. Such an incident may damage the reputation of the internet as a means of payment. It is therefore very important for banks to ensure the safety of e-banking. The regulators at our IT- unit monitor whether this is sufficiently done. To that end, they have conversations with the banks to gain insight in the controls, the legal implications and particularly the security of e-banking. Furthermore, they retrieve documentation, such as the banks’ risk analysis, an independent EDP audit report and the results of a penetration test. This test is a legal attempt to hack, conducted by an external organisation. As well as the national initiatives I just mentioned, there are international activities under way in the e-banking area. A good example of this is the work of the Electronic Banking Group, or EBG, which is a working group of the so-called Basel Committee of Banking Supervision. This group is engaged in formulating international guidance and principles regarding e-banking. The EBG recently published its principles for risk management in electronic banking, which also include issues relating to consumer protection. One example is a principle that concerns appropriate disclosures for e-banking services. This principle states that banking organisations should provide on their websites some core information in order to assist customers in making informed choices. Examples of such disclosed information could include contact details for the supervisory authority responsible for the supervision of the bank’s head office as well as details of access to national compensation or insurance schemes. The risk management principles for e-banking are currently presented to the banking sector for consultation. It is expected that the final version will be presented to the Basel Committee next month. Around April, the principles will be published at the website of the BIS (www.bis.org). Beside the publications at our own website (www.dnb.nl), such as this speech, you also find a link to the site of the BIS. Besides the work of the Basel Committee that applies specifically to the banking sector, there is more general legislation in the form of EU directives. These affect e-banking as well. For example the Directive on electronic commerce, which requires providers of electronic services to make information on prices and conditions accessible for consumers. Another relevant directive for e-banking is that on the remote provision of financial services. This states for example that consumers have the right to recall an agreement if a supplier did not provide them with the terms of delivery, like prices, before entering into a transaction. Conclusion To summarize: e-banking is a phenomenon which affects both banks and regulators. I hope I have made clear that this subject has the regulators’ full attention, both nationally and internationally. As well as participating in international discussions on e-banking, the Bank has undertaken various initiatives to include e-banking in its supervisory policy. This does not mean that we can afford to be complacent. Developments are proceeding rapidly, and the DNB is closely monitoring developments to ensure a timely response. In various ways we keep up our know-how on an continuous basis. By means of courses and self-study, for example. But also by benchmarking through third parties, as it is relevant to review one’s own organization from time to time. Finally, a very important way for keeping up our know-how is by recruiting new staff. So if the supervision of e-banking has aroused your interest, DNB is probably something for you. | netherlands bank | 2,001 | 2 |
Speech by Dr Nout Wellink, President of the Nederlandsche Bank, at the European Institute in Washington DC, 30 April 2001. | Nout Wellink: Prospects for a unified Europe Speech by Dr Nout Wellink, President of the Nederlandsche Bank, at the European Institute in Washington DC, 30 April 2001. * * * Introduction The European Institute has asked me to focus on the topic of economic diversity in Europe. It is a key issue, and I am glad to share with you some of my ideas on it. At the end of my speech, I will allow myself to take a broader view and consider the longer-term prospects for Europe. But first, I will discuss a more down-to-earth issue of immediate relevance to us all: the prospects for economic growth in Europe. The key question is: With declining US growth, will Europe be the white knight that rescues the world economy from slowing? Growth prospects for Europe The European economy is on solid ground. Real GDP growth in the euro area amounted to 3.4% in 2000, which is the highest growth rate of the past ten years; at the same time, the ECB remains successful in maintaining inflation at low and stable levels; employment growth has been higher than in the US for each of the last three years; and finally, high fiscal deficits have been eradicated, and are a thing of the past. So, the background is encouraging. In at least two respects, the euro area economy is currently less vulnerable than the US: First, Europe has a positive rate of personal savings, serving as a buffer against unexpected contingencies, such as a sharp decline in equity prices. With a negative personal savings rate, as in the US these days, shocks in equity prices may have relatively large effects on consumer expenditure and, hence, economic activity. This is all the more so, as shares are more widely held in the US. In 1999, the average American family’s equity ownership was worth 174% of its disposable income, roughly twice the German figure. Second, and connected with the first observation, the current account position is stronger in Europe than in the US. The US current account has reached a record deficit of 4% of GDP. This reflects the fact that business investment in the US has become more and more dependent on foreign sources of finance. As a consequence, a change in international investor confidence away from the US is likely to aggravate a significant slowdown in economic activity, and thereby to lead to a downward spiral in the external value of the dollar. We don’t see this right now, but it has happened before. This is not to deny that the current US slowdown will affect Europe. The familiar truism that Europe catches a cold when the US sneezes still applies. Although direct trade links are limited, other channels are more important. In today’s global economy, disturbances on US financial markets impact significantly on their European counterparts. A decline in US economic prospects will also undermine European producer and consumer confidence. But even if the uncertainties concerning the European economy materialize, domestic economic conditions in the euro area seem to be more robust than in the US. In 2001, euro area GDP is expected to grow more or less in line with potential, and faster than the US economy. Nevertheless, since imports of goods and services count only for about 16% of GDP in the euro area, it would be misguided to think that Europe could be the one-and-only power engine for the world economy. A buoyant global economy requires healthy growth in both Europe and the US. Economic diversity in the euro area So far, I have discussed the euro area as an economic entity. I will now talk about the euro area as a collection of 12 separate EU countries. Recall that the UK, Sweden and Denmark are EU member states not participating in monetary union for the time being. Taken on their own, these 12 euro area countries were small in comparison to the US. But with the establishment of monetary union, these countries have integrated important aspects of their economies into a single euro area economy. In many respects, the euro area and the US are comparable. For instance, the euro area has a population of 300 million people; the US has 270 million people. The share of the euro area in world GDP is 16%, which is slightly less than the US share of 22%. On the other hand, the share of euro area exports in world exports is 19%, whereas the US share is 15%. In spite of monetary union, economic diversity across the euro area has not disappeared completely. Growth differentials between countries have been more or less stable over the last decade; inflation rates have converged in the run-up to monetary union, but have diverged somewhat since. Divergences in Europe attract much more public attention than do regional differences in the US. This is striking, since in fact economic differences across the US do not vary greatly from those across Europe. Admittedly, the dominating position of large member states in Europe is unprecedented in the US. Germany counts for 32% of euro area GDP, France for 22%. Taken together, California, New York and Texas count only for a modest 28% of US GDP. But on the other hand, GDP in our smallest euro area member state, Luxembourg, is roughly the same as the share of small states like Vermont, South Dakota or Maine. Consider another example. In Europe, the Finnish economy is heavily dependent on only one sector, telecom. I am sure, the Nokia trademark rings a bell here, too. But take Texas: it is heavily dependent on the oil industry. Such differences in economic structure can cause differences in cyclical patterns among regions, both in Europe and in the US. These differences also explain differences in exposure between regions to economic shocks, a phenomenon well known in the US. Maybe economic divergences in Europe attract much more public attention than in the US because the euro area has a very short history. Or maybe divergences in Europe catch the eye due to the fact that we are used to thinking about economic divergences in terms of sovereign countries. Probably, both answers contain elements of truth. But there is an additional reason why regional divergences in the US do not attract much attention. Regional differences in the US tend to cancel each other out in the medium term. It is common for a US state to have inflation and economic growth above the federal average in a particular year, and to have inflation and growth rates below average few years later. With only two years after the establishment of monetary union, we do not know whether this will also be the usual pattern in the euro area. US states do not diverge persistently from federal trends. That is due to economic mechanisms that restore equilibrium. A very important mechanism is labor market flexibility. If there are lay-offs in one part of the US, people tend to move to other, more buoyant regions. Every year, more than 2% of the American population moves to another state to find a job. A further mechanism that contributes to restoring equilibrium in the US is income transfers by the federal government. To be honest, similar redistribution mechanisms to absorb shocks on an interregional basis are less developed in Europe. Labor mobility is limited across Europe, and even within countries. Fiscal transfers between countries would be politically difficult to implement and they lack public support. In addition, the current European Commission budget is very small in comparison to the US federal budget, and certainly too small for significant fiscal transfers. Instead, our system relies much more on the intertemporal absorption of shocks within individual countries. This works through automatic stabilizers in national budgets, which are large in comparison with US state budgets. According to the so-called Stability and Growth pact, member states should have fiscal surpluses in boom years in order to allow for possible deficits during economic downturns. They must also keep deficits below 3% of GDP; over the cycle, budgets of member states are required to be in equilibrium or in surplus. In the European context, the Stability pact is a much better mechanism for smoothing divergences than income transfers between countries would be. As regards monetary policy in the context of economic diversity, an important consequence of monetary union is that varying national monetary policies and national exchange rates can no longer cause divergent business cycles or inflation differentials. Until the early 1990s, interest differentials and, more importantly, exchange rate disturbances often caused economic divergence. In the run-up to monetary union during the second half of the 1990s, more uniformity emerged. In 1999 a single monetary policy was established that took away these potential causes of regional divergences. From 1999 onwards, the ECB has aimed at low and stable inflation in the euro area as a whole. The single monetary policy is not in a position to influence the dispersion of inflation rates across the euro area. However, the ECB is aware of inflation and growth differentials. Large economic divergence could undermine public support for the single monetary policy of the newly created ECB, as divergences make a ‘one-size-fits-all’ monetary policy less appropriate for certain parts of the area. Again, like in the US, a second reason for our interest in regional divergences is that they can provide early signals of area-wide developments. In this respect, there is no major difference between the ECB and the Fed. The Fed reports regularly on US regional developments in its Beige Book. The fundamental difference between the euro area and the US concerns market flexibility and economic stability. The European model has benefits associated with greater economic stability for economic agents than in the more dynamic US economy. Recall, for example, the more generous European social safety net. However, doing it the European way comes at a price in terms of less flexibility. For instance, the American model is more adapted to integrating new technologies. The major challenge for Europe is to increase market flexibility without risking the benefits of its current system. European economic structures are improving. On 1 January 1993, Europe created a single market. Only six years later, the common monetary policy was put in place. Budgetary discipline has improved considerably over these years. More recently, Europe has abolished most barriers to competition in the telecommunication and energy sector. Reforms are under way on a broad front. For example, at the Stockholm summit of EU heads of government last month, new steps were announced to make Europe more competitive and knowledge-based. Several initiatives relate to removing obstacles to the mobility of workers between European countries. The most practical step forward was the agreement on proposals prepared under the chairmanship of Alexandre Lamfalussy aimed at taking away the last hurdles to a fully integrated European capital market. Subject to the energetic implementation of structural reforms, especially those in the field of labor markets and social security, Europe will be able to benefit more from new technologies, and trend economic growth will increase. Many countries in Europe show encouraging signs that progress on structural issues is under way. Take France for example. Flexible work schedules have recently been introduced on a broad scale. The government has reduced the state’s stake in banking, air transport and telecoms. France has also made a first step in lowering the fiscal burden with a one percentage point reduction in VAT last year. There are also developments that point to another direction, for example recent government plans to double redundancy pay by employers. But, on the whole, France has moved from a vicious cycle of higher unemployment and welfare charges to a virtuous growth cycle. Enlargement and closer cooperation across Europe Taking a broader view across Europe, one can say that the coming EU enlargement to Eastern Europe bolsters prospects for structural reforms. Currently, negotiations are under way with 12 accession countries. Imagine how different the EU will look when they have joined. The EU will then consist of 27 countries; its population will increase by 30%, though GDP will increase by only 5%. It is difficult to imagine that enlargement to the East would occur without reforms leading to lower agricultural subsidies, fewer transfers from so-called cohesion funds and more efficient social security systems. The more so as our policies, in contrast to US policies towards their Latin American backyard, are aimed at full integration of accession countries in the EU. However, the new states that we want to welcome to the ranks of the EU must realize they have to bear the main burden of adjustment. Their first step is to enter the EU. In this context, they have to adopt European legislation, to implement EU environmental standards etcetera. When they subsequently prepare for joining monetary union, the accession countries will have to continue the adjustment process in order to successfully converge towards the standards of the euro area. This could take several years after EU entry. However, the potential for structural reform and, therefore, for additional growth is immense. Apart from enlargement, closer cooperation in several policy areas is another major theme within the EU. In this respect, monetary union works as a catalyst for more cooperation on economic policies. For instance, tax structures are moving closer together across the euro area. Another sign in this field concerns the euro area Council of ministers of finance. They have an unprecedented power to fine member states with excessive budget deficits. This Council can also make recommendations to member states with economic policies that are inconsistent with broad policy guidelines. They made such a recommendation recently to Ireland. It is understandable that within the EU, euro area member states want to cooperate more closely. For example, the euro area ministers of finance have intensified their cooperation in the so-called euro group. With closer European cooperation on monetary and economic issues, it is natural that cooperation on other policies will increase too. However, there is no ultimate goal for closer political integration. Some dream about the United States of Europe, but Europe will not be ready for this within the foreseeable future. Others think of a United Europe of States. Anyhow, there is a growing understanding among European political leaders that Europe cannot develop faster than the people want. As I see it, from time to time this can mean that there is a pause at the current level of integration. But there is no moving backward. As it stands, we have to be realistic and focus on issues that have to be resolved at relatively short notice. The main issue now is how to deal with enlargement to Eastern Europe in terms of decision-making processes. If we want to have both enlargement and closer cooperation on particular issues, there is a need for pioneering groups of member states that move closer together on these issues. That is unavoidable; whether you refer to these groups as ‘centers of gravity’, ‘avantgardes’ or in the best tradition of Eurocrat-speak ‘member states of a multi-tiered Europe with variable geometry, in concentric circles with a hard core’. Last year’s Nice summit has cleared the ground for this flexible approach. Concluding remarks Let me conclude. European economic growth prospects are favorable. Euro area economic diversity is a fact of life, but not very different from the US situation. Admittedly, the European economy has considerable progress to make in structural reform. But the improvements so far are genuine and are likely to last. Closer European cooperation on economic and political issues is under way. If I may quote the American economist Lester Thurow from his 1992 bestseller Head to Head: ‘future historians will record that the 21st century belonged to the House of Europe’. End of quote. In this environment, a common European culture is emerging. As of January 1, 2002, euro notes and coins will give European citizens a concrete sign of their common identity. Nonetheless, some cultural differences will remain, just as in the US. Joe-six-pack as the average American is only virtual reality. I am sure that someone from New Jersey is very different from someone from Texas. Also in Europe, we will keep national traditions. I was born Dutch. Now I feel European, but a Dutch European. I am proud of that. | netherlands bank | 2,001 | 5 |
Address by Dr A H E M Wellink, President of the Nederlandsche Bank, on the occasion of the Russia?Netherlands Economic Forum at The Hague on 29 October 2001. | A H E M Wellink: The role of the Nederlandsche Bank Address by Dr A H E M Wellink, President of the Nederlandsche Bank, on the occasion of the Russia-Netherlands Economic Forum at The Hague on 29 October 2001. * * * Introduction It is with great pleasure that I’ve accepted the invitation to deliver a brief address this morning, not least, of course, because this Forum has been organised in co-operation with our colleagues of the Bank of Russia. At the request of the organising committee, I shall dwell briefly on the main tasks of the central bank of our country, the Nederlandsche Bank, as well as on the relations with the European Central Bank. Some of you probably also attended the previous conference, held in Amsterdam in May 2000, which had ‘Transition to the Market Economy: Actual Problems in Financial and Banking Sectors’ for a theme. One of the items highlighted on that occasion was financial stability. Who could have suspected at the time that a mere eighteen months later, on the eleventh of September, an act of unprecedented brutality would put the international financial system under threat? 11 September: also an attack on financial stability On Tuesday the eleventh of September, it was soon brought home that the system of (international) payments was running the risk of becoming seriously unsettled. It was not at all certain either at that point whether the financial markets would continue to function properly. Fortunately, despite some minor hitches, payment systems could be kept operational. Even so, the American financial markets did not open again until the seventeenth of September. Since that day, the FED, the ECB and several other central banks have cut their interest rates. All in all, the monetary authorities have managed to ward off the acute threat to the financial system by a wide range of monetary measures. Their actions were swift and well co-ordinated. Presently, the authorities are seeking to cut off terrorist groups from their financing sources by tracking and freezing their bank balances. It may be clear that this is a comprehensive operation for the international banking system. In our country, the scope of the supervisory legislation will be extended to include trust offices and special financial institutions. The existing legislation, such as that governing the disclosure of unusual transactions, will be adjusted as well. These measures all serve to safeguard the integrity of the financial system. I firmly believe that the currency markets would have grown quite restless if it hadn’t been for the euro or the ECB. And the policy measures taken by the European central banks in response would have been far more difficult to implement than without the ECB as contact for consultations and coordination. This s a tangible example of the benefits brought by a single European currency and single central bank. Distribution of tasks between the Nederlandsche Bank and the ECB I already mentioned it briefly a moment ago: payment systems, financial markets, interest rate cuts and bank balances. These are all terms that refer to the Nederlandsche Bank’s three key tasks: contributing to and implementing the monetary policy, exercising prudential supervision and promoting the smooth operation of payment systems. By ensuring an adequate performance of these tasks, the Nederlandsche Bank controls the stability of the Dutch financial system. Financial stability in turn is difficult to achieve without properly functioning central banks. If we had a blazon, which we don’t, it would probably read "Guardian of financial stability". The fact that stability is among our chief objectives manifests itself in the following highly coherent areas of activities, which I will briefly explain: - contributing to and implementing the European monetary policy - promoting the smooth operation of the payments system - exercising supervision on banks, collective investment schemes and foreign exchange offices. As you know, on 1 January 1999, the responsibility for the monetary policy of the member states participating in the Economic and Monetary Union, or EMU, was transferred to the Eurosystem. The Eurosystem comprises the ECB and the central banks of the euro area. So, instead of an unshared, national responsibility, monetary policy has become a shared, supranational task. The objective has not changed, though: maintaining price stability. The most important decision-making body within the Eurosystem is the Governing Council of the ECB. It is made up of the Executive Board of the ECB and the twelve central bank governors of the participating countries. The members of this council operate in a private capacity, and are there to promote European interests. National motives may not come into play in the Council’s decision-making process, which proceeds from the "one man, one vote" principle. To prepare for the meetings, the governors can however draw on their own organisations’ expertise, which, after all, is extensive. Together with the contribution of the ECB organisation, this makes for a multifaceted approach to issues. The decentralised set-up of EMU was chosen deliberately and is laid down in the EU Treaty. It implies that the implementation of the monetary policy is practically fully delegated to the national central banks. Consequently, instead of to the ECB, the commercial banks in the Netherlands must turn to the Nederlandsche Bank for liquidity, and hold the statutory cash reserves on an account with the Nederlandsche Bank. Besides the implementation of monetary policy, the national banks are also entrusted with the management of the ECB reserves. So, we do not just manage our own gold en foreign exchange reserve assets, but also a part of the gold holdings in Frankfurt. Another example of the decentralised approach: should the Eurosystem decide to intervene in the foreign exchange markets, the dealing rooms of the national banks will also assist in the practical execution of the measures involved. The second key task consists in promoting the smooth operation of payments. This task is assigned to us under the Bank Act and in our capacity as participant in the ESCB. For the settlement of transactions to be efficient, it is essential to have a payments system that is reliable. Everybody should be able to rest assured that the banknotes and coins they receive are genuine. This, of course, applies to guilders and euro alike. The Nederlandsche Bank orders the banknotes from Johan Enschedé in Haarlem, manages the supplies, sees to the distribution, checks whether incoming banknotes are soiled or false etc. The responsibility for the minting and issuing of the coins rests with the Minister of Finance. The coins are minted by the Koninklijke Nederlandse Munt at Utrecht, but, just as the banknotes, distributed by the Nederlandsche Bank. The Nederlandsche Bank not only deals with cash payments, but also with non-cash, or funds, transfers. Funds transfers must be settled smoothly and at a reasonable fee. Under my chairmanship, a working committee composed of senior officers who are currently conducting a survey of the fees involved by payments and of the payments infrastructure. On the basis of the final report, which will probably appear in February 2002, the Nederlandsche Bank will make recommendations towards enhancing the efficiency and the competitive and innovative power of the Dutch payments system. The Nederlandsche Bank will also contribute to the efficiency of payments by ensuring that the payments systems and securities transaction systems are secure and reliable. This task is called "oversight". And, last but not least, we come to supervision. As the supervisory task is purely a responsibility of the national authorities, the introduction of EMU has hardly had consequences for this task. However, the financial world and, consequently, supervision are really in a state of flux. Think, for example, of the ongoing process of concentration and internationalisation. Also the dividing lines between the various kinds of institution are fading as financial conglomerates are formed. The products and services offered by these conglomerates are growing increasingly complex. In view of the attendant risks and uncertainties, today’s consumers must be better and more extensively informed than they used to be in the past. The developments I just sketched call for a new supervisory approach in the Netherlands. Recently, the three supervisory authorities, the Securities Board of the Netherlands, the Pensions and Insurance Supervisory Authority of the Netherlands and the Nederlandsche Bank, submitted a proposal to the Minister of Finance regarding an adjustment of the current supervisory practice to the changed circumstances. To be precise, they proposed that supervision should be split up into behavioural supervision and prudential supervision. In the situation as envisaged, the Securities Board of the Netherlands was to deal with behavioural supervision, including customer protection, while prudential supervision would be the domain of the Nederlandsche Bank and the Pensions and Insurance Supervisory Authority of the Netherlands. In addition, the Nederlandsche Bank would continue to be responsible for the supervision of the system, meaning that it would continue to promote the stability of the financial system. Why national supervisors? The question regularly arises whether we should not be working towards a single European prudential supervisor. One important argument in favour of national supervision is that national supervisors maintain close relations with individual institutions and financial markets in their countries. They are better placed to interpret information and identify and deal with problems swiftly and effectively than a single supranational supervisor would be. This helps the decision-making process. Of course, the ongoing internationalisation of the financial sector does have implications for supervision. That is why supervisors are continuously consulting on an international level about harmonisation of the rules and a level playing field. Besides, the Nederlandsche Bank has exchanged so-termed memoranda of understanding with supervisors in a number of countries. Synergy benefits The three key tasks of the Nederlandsche Bank, which I just discussed, do not stand alone, but interact. In each of the areas of activities, the Nederlandsche Bank has a key role. I’m aware that this isn’t the case in all countries. In my view, however, the "Dutch" model has evident advantages, especially given the high degree of concentration of our banking system. In our country, banking supervision, monetary policy and payments are literally accommodated under one roof. I consider this essential, because of the common ground between the three areas and the synergy benefits for the information supply. The benefits brought by the combination of the said task areas are manifest not only in good times, but also in bad times. In the event of a crisis, adequate and rapid action based on the latest information is imperative. The way in which the key tasks are organised at the Nederlandsche Bank enhances the quality of the decision-making process. This was once more made clear by the tragic event in the United States. A final word Central banks play a pivotal role in bringing about financial stability. There can be no stability without confidence. Confidence in the value and authenticity of money; confidence, also, in the solvency and integrity of the financial institutions to which we entrust our money; confidence in the adequate operation of the financial infrastructure; and, confidence in the independence and expertise of the monetary and supervisory authorities. Confidence is not gained overnight, but takes time to grow because, to be trusted, the guardian of stability requires a track record. The Bank of Russia is a young central bank. It was founded in 1990 and, just like the ECB, is still in the middle of building up such as track record. I am convinced that the mutual contacts and exchange of ideas during this Forum will contribute to this process. | netherlands bank | 2,001 | 10 |
Speech by Dr A H E M Wellink, President of the Nederlandsche Bank, at a symposium of the Banque de France on 'New Technologies and Monetary Policy', Paris, 30 November 2001. | A H E M Wellink: The impact of new technologies on the implementation of monetary policy Speech by Dr A H E M Wellink, President of the Nederlandsche Bank, at a symposium of the Banque de France on “New Technologies and Monetary Policy”, Paris, 30 November 2001. * * * When thinking about new technologies, Information and Communications Technology (ICT) is probably the first thing that comes up in most people’s mind. And, there are those who see an acceleration in the diffusion of ICT as being equivalent to the concept of the ‘New Economy’. For the purposes of this conference, I would prefer to take a wider perspective, in which the new economy is seen as the interaction of several mutually reinforcing factors. These include advances in ICT, financial innovation and liberalisation, the globalisation of trade, improved functioning of markets and enhanced macroeconomic management. The interplay of these factors has the potential to raise the speed limits of the economy. That is, the new economy can operate at higher growth rates than in the past without generating additional inflation. Therefore, both the initial hype surrounding the new economy with some pronouncing the demise of the business cycle, as well as the elimination of the new economy all together in response to current economic circumstances, seem to be misguided. The jury is still out on the question whether we can detect a new economy in Europe. Without wanting to prejudge the outcome, I would argue that there is no intrinsic economic reason to expect the new economy not to materialise. So, assuming that it will take root, indeed what does this new economy imply for the monetary policymaker? I have a couple of general observations to make. First, the new economy influences the transmission of monetary impulses through the economy. It can be argued that in the new economy it will take less time for a monetary policy impulse to have an impact on inflation and output, while the impact of a given impulse will be smaller. Since there is a separate panel discussion devoted to this topic, I will leave it at that and move on to the second observation. That is, policy makers do not bring about the new economy. It is the result of private sector behaviour, driven by innovative entrepeneurship or, more fashionably, ‘creative destruction’. Policy in general can only be conducive to the new economy. In a market-based economy, private sector decisions are guided by the allocative role played by the price mechanism, which performs best in an environment of price stability. Hence, the monetary policy objective of price stability, which served us well in the old economy, will help foster a new economic environment. It is no coincidence, therefore, that the champion of the new economy, the United States, achieved its greatest advances in an era of low inflation. A third issue, crucial for monetary policymakers, is the question of how to react to the new economy. Let me simplify matters by conceptualising the new economy as a shock to productivity. The economic consequences of this shock will be felt in the long run as well as in the adjustment towards the new steady state of the economy. Let me start with the long run.The new equilibrium is characterised by structurally higher growth rates of productivity, implying higher profitability of investments. In order to attract the capital needed to finance these investments, and achieve macro-economic equilibrium, a higher interest rate is needed. The central bank must take this upward movement of interest rates into account when formulating monetary policy. Before this new equilibrium is achieved, the economy goes through a complex adjustment process. Analytically, this adjustment not only involves an outward shift of the aggregate supply curve, which by itself implies lower inflation and higher growth. It could also elicit a stimulus to aggregate demand, for example due to wealth effects. The latter would imply higher inflation and higher growth. So, it depends on the circumstances and on the stage of transition from the old steady state to the new one, how monetary policy should react. It is important to note that the monetary strategy of the Eurosystem was devised in order to conduct monetary policy in a particularly uncertain economic environment. The monetary strategy is well-suited, therefore, to cope with uncertainties, including the uncertainty surrounding the effects of the new economy. As such, the definition of price stability does not need to be altered and the two-pillar structure will continue to serve us well. There could, however, be a need to re-assess the information content of individual variables within each pillar. Let me try to illustrate this. Advances in and the spread of ICT can lead to new forms of money, i.e. electronic means of payment. Anticipating this, electronic money balances held by euro area residents have already been included in the definition of euro area monetary aggregates. However, the new economy could change the information content of the monetary aggregates. For example, electronic money could increase the velocity of money, because people will be able to economise on their money holdings, only accessing money when they need to spend it. Also, structurally higher productivity growth will eventually lead to higher trend growth in the euro area. In due time, both effects could independently elicit an adjustment of the reference value for M3. This issue is covered by the yearly review of the reference value for M3 by the ECB Governing Council. Under the first pillar, valuable information is also distilled from the counterparts of broad money, such as credit variables. The development of new financial instruments could change the information content of these variables. For example, securitisation places bank assets outside bank balance sheets, which could complicate the observation by the central bank of credit flows. In the second pillar, the new economy could widen the range of useful indicators, i.e. because wealth effects gain in importance. The information content of other indicators must be re-evaluated in order to take into account a possible increase in the speed limits of the economy. The new economy could, for example, lead to a downward adjustment of the NAIRU – the non-accelerating inflation rate of unemployment. At the same time, variables that measure the current economic situation could become more important, as these will be the first to reveal that the new economy has landed in Europe. Let me conclude with three key points. First, the new economy could have, and in my view will have, important implications for monetary transmission. Second, the implications of the new economy for the conduct of monetary policy are not clear-cut. Especially not in the transitional period to the new economy. What is clear, however, is that price stability will remain at the heart of central banking. Third, the ECB monetary policy strategy is well-suited to take the uncertainties surrounding the new economy into account in policy-making. There is no reason to amend the two-pillar structure on account of the new economy. Within and between both pillars, the assessment of all incoming information is and will continue to be evaluated. This exemplifies the art of monetary policymaking, both in the ‘old’ and in the ‘new’ economy. | netherlands bank | 2,001 | 11 |
Speech by Dr A Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, for the Dutch Business Round Table, Zürich, 12 March 2002 | A Wellink: The Euro, a major challenge and catalyst for Europe Speech by Dr A Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, for the Dutch Business Round Table, Zürich, 12 March 2002. * * * Introduction It was in here in Zürich over 55 years ago that Winston Churchill held his famous speech on the future of Europe. He depicted a United States of Europe that would put an end to centuries of conflicts and bring prosperity to its peoples. Indeed, since then we have come a long way in actually fulfilling his grand vision, although without Switzerland - the nation he addressed - playing an active role. Of course, there are many reasons - mostly of a historical -political nature - why Switzerland chose to stay outside the process of European integration. In this respect, I certainly do not want to pass judgement. Nevertheless, you find yourselves surrounded by an ever closer union of Member States that has also introduced a single currency. In this light, I would like to elaborate on the introduction of the Euro and it´s consequences for the European Union - taking into account, where possible - the position of this country. First, I shall briefly touch on the actual changeover to the Euro at the beginning of this year. Then I shall go into the merits that monetary union already brought over the last few years. Finally, I will give my vision on future challenges and dynamics of the Euro. Changeover Ten years after the Treaty of Maastricht, the Euro finally found its way into the pockets of 300 million Europeans. This unprecedented process - comprising the distribution of 239,000 tonnes of coins and 2 million kilometres of notes - was an outstanding logistical success. Moreover, doom scenarios predicting mass forgery, robberies and threats to public security proved wrong. Of course, a clear, central scenario and tight planning, especially within the European System of Central Banks, provided a firm foundation, but the operation remained highly dependent on local players; transporters, retailers, bankers, administrators, law-enforcers. In fact, there were also a number of Swiss companies (Lanqart (paper), OVD Kinegram) involved in developing and producing the high quality Euro notes. The efforts of these local players and the sheer public enthusiasm for the Euro were central to the success of the changeover. Indeed, through the sale of so-called eurokits, people on average had already 14 eurocoins in their pocket before 1 January. This “euro-eagerness” explains that by the first week, already 75% of cash payments were in Euro. In the Netherlands, this 75% level was already reached on the second day, and after one week, the changeover was virtually completed. As such, it was not without pride that I proclaimed my country European champion - though that could not entirely wash down the bitter aftertaste of missing this year´s World Championship soccer. In hindsight, people felt well-informed about the Euro and found the Euro introduction in no way the drama that some had predicted. Finally, on 28 January, the Dutch Guilder was the first of the former euroland currencies that in practice lost its legal tender status. To ease the minds of Dutch Roundtable members present, Guilders can under certain conditions - still be exchanged for Euros at my central bank; coins until 2007 and banknotes even until 2032. One tiny spot on the otherwise shiny, new currency is the anecdotal reporting of price changes associated with the changeover. There is, however, little evidence of any significant effect on aggregate inflation figures in the Euro area. According to the European statistical office, Eurostat, the effect is likely to fall within the range of 0.0% to 0.16%. On a country-by-country basis, the possibility to round up prices would, of course, be linked to the conversion rate of the national currency. For example, calculating back from Euros to German Marks is much easier than from Euros to Dutch Guilders. In addition, the cyclical position of the economy would influence the direction in which rounding may have occurred. For the Netherlands, our research suggests that there might have been a slight upward effect on the price level of 0,2% to 0,4%. Overall, competition and peer pressure from consumer organisations would clearly limit room for manoeuvre. Moreover, possible one-off effects will be more than compensated by increased price transparency over the years to come. The merits of the Euro so far This brings me to the reasons why the Netherlands decided to give up its beloved currency. Foremost, the Euro is a political project in which the Dutch could not afford to stay out. Integration in a supranational context protects the interests of smaller European players. In economic terms, the Euro increases macro-economic stability and cross-border price transparency. It reduces transaction costs by eliminating exchange rate risks. Moreover, the Euro is a catalyst for further economic reform and integration. In this respect, the economist Andrew Rose recently published an interesting article on common currency arrangements. Using cross-country panel data, he shows that countries with the same currency, trade substantially more than those with different currencies. Interestingly, the impact of a common currency is also larger than of a fixed exchange rate regime, which reduces volatility but retains separate monies. In this light, the Euro is the icing on the internal market cake by broadening and deepening its scale. But, as always, the proof of this cake is in the eating. Indeed, the three years of the Euro´s virtual existence confirm the Dutch political and economic motives. Though some tend to be misled by its exchange rate, the Euro has proven to be rock solid with low inflation and, with it, a credible European Central Bank. Now, with hard currency in hand, the public will become more aware of the fact that a Euro is a Euro, and that the internal stability of the Euro counts. Stable price developments and a low level of long-term interest rates provide a firm basis for growth. In addition, the Euro ended once and for all the uncontrolled spending dynamics of the past. Indeed, the EU is unique in having set itself a standard for sound government finances through the Stability and Growth Pact. In this light, you probably all heard about the early warning that the European Commission recommended for Germany and Portugal. As a consequence, both countries strongly re-committed themselves to budgetary consolidation and the close to balance rule of the Pact. The outcome clearly reflects the respect of all countries involved for the Pact, and underlines the credibility of the macro-economic policy framework in general. Thus, the Euro has offered a stable environment both to governments and business. Finally, the Euro has already made a spectacular impact on financial markets in Europe. These have become broader and deeper, with a sharp rise in both the volume of capital issues and the spread of credit quality. Compared to 1998, total international bond issuance in Euros have more than doubled, and now compares well with the level of dollar-bonds. The sharp rise in the corporate bond market has increased financing possibilities and enhances merger & acquisition activities in Europe. Switzerland and the Euro Being closed in by Euro-territory, the Swiss can also reap the Euro fruits, all be it partly, in terms of bigger investment and borrowing opportunities in the Euro-market. In addition, the trading environment has improved with more price transparency in comparing potential trading partners and less exchange rate risks. On the downside, potential exchange rate volatility remains, as you have experienced between the Frank and the Euro. Given that business services and tourism are central to the Swiss economy, there is no doubt that Euro coins and notes will increasingly pop up cross border. Indeed, large retailers appear to accept Euros and a large number of cash dispensers in major cities and at the border produce Euro notes. I heard that in this city even ticket machines for car parks are made “euro-fähig”. Some point to a possible parallel use of the Euro in economies surrounding the Euro area. In fact, it was the British that first introduced the notion of a parallel currency back in the early seventies, and again during negotiations at Maastricht. As an alternative to monetary union, they wanted the intangible European Currency Unit to compete with the national money. Should the European currency prove stable and successful, it would by the laws of nature become the sole legal tender. Along these lines, Helmut Kohl argued recently that Switzerland would adopt the Euro in 2010 at the latest. However, I think that mature countries such as the UK, Sweden or Switzerland, are not likely to take on the Euro as national currency without further political integration with the EU. In other words, they will have to be part of - and committed to - Economic and Monetary Union. Here, we can draw a parallel with, for example, the limited role of the US dollar in Canada - despite the relative economic weight of the US and strong trading relations in the context of the North American Free Trade Area. Future challenges and dynamics of the Euro It appears, I am already looking into a crystal ball, so let me move on to the future challenges and dynamics of the Euro for Europe. The dynamics of the Euro clearly lie with the expectations and pressures of markets and the public opinion at large. A good example is the recent agreement in the EU that the costs of cross border bank transfers should be substantially reduced. In a similar vein, economic agents simply do not accept that cross border security transactions are more expensive than within the US. Therefore, the European Parliament recently accepted the report, prepared under chairmanship of Baron Lamfalussy, that foresees in speeding-up decision-making on the elimination of barriers in the European security market. This plan is part of an ambitious EU programme to create a truly integrated financial market by 2005. This political spin-off is not limited to the EU alone. For example, the European Commission has recently opened discussions with Switzerland, and other third countries, on banking secrecy and the fiscal treatment of savings. I understand that on the Swiss side, this sensitive dossier has been linked to other fields of negotiations such as Schengen and European immigration policy. It goes to show that even in third countries the impact of the Euro surpasses the economic domain. Clearly, the Euro enables the “E” of EMU to reach the critical mass necessary for progress in many policy areas. In that sense, a further deepening of financial markets will enhance labour mobility, for example through the portability of pensions and social security entitlements across borders. More importantly, there are signs that labour market flexibility has been improving. Thus, the European labour force tends to absorb cyclical fluctuations more effectively. In a similar vein, wage negotiations appear to adjust faster to changing economic conditions, while inflation expectations have decreased. This change in behaviour is a reflection of the fact that in the Euro-countries exchange rate flexibility is no longer available to neutralise structural deficiencies. The extent of success is determined by one, major factor - European policy makers must recognise the Euro dynamics and live up to the expectations of long-term integration. Here lies the central challenge that follows from the introduction of the Euro: Politicians have to deliver. In that sense, the European Council, that convenes in four days´ time in Barcelona, will have to put its political weight behind the liberalisation of the energy market and the deadlines of the Financial Services Action Plan. Moreover, the Council should be committed to - for example - the speedy adoption of the European take-over and patent directives, both of which have been on the table for decades. Conclusion Let me conclude. A representative of the Deutsche Bank recently said that ´there has been a lot of positive Euro speak in the last couple of years, but nothing that has led to better growth´. I disagree; the virtual Euro has brought macro-economic stability and increased dynamics in the internal market, the financial market in particular. Moreover, the changeover to the tangible Euro has been a major success thanks to the great acceptance and enthusiasm around Europe for the common currency. The historical and political importance of the Euro for “an ever closer union among the peoples of Europe” (preamble Treaty of Rome) is without any doubt. However, I agree that one needs to put the money where the mouth is. The benefits of the Euro can only be reaped to the full if its dynamics are acknowledged. In this respect, the Euro is a catalyst for more growth and employment, while it is a challenge for European policy makers to shape the right climate. In a way, the Swiss also face this challenge - the more, now that the EU is on the brink of a sizeable enlargement. Following Winston Churchill´s address here half a century ago, the time might come when sensitive questions on sovereignty and neutrality no longer tilt the balance against playing an active role in Europe. In fact, an historic breaking point might have been reached with the recent, public majority support for membership of the United Nations. Should Switzerland ever decide to take part in European integration, I am convinced that you will embrace the Euro as warmly as the Dutch did on 1 January. | netherlands bank | 2,002 | 3 |
Address by Dr A H E M Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, at the Nederlands Genootschap voor Internationale Zaken, Utrecht, 13 March 2002. | A H E M Wellink: EU expansion and EMU Address by Dr A H E M Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, at the Nederlands Genootschap voor Internationale Zaken, Utrecht, 13 March 2002. * * * Introduction "We Europeans must create the basis for a broader and deeper community among peoples long divided by bloody conflicts and lay the foundations for institutions which will give direction to a destiny henceforward shared". These lofty words, formulated over fifty years ago, can be found in the preamble to the Treaty establishing the European Coal and Steel Community. Although they may strike you as slightly passé, the underlying thought has lost none of its poignancy. • To begin with, we sense a moral and historical duty to unite a long-divided continent in these words. For the first time, countries from Central and Eastern Europe will be joining the European Union, as from 2004. • Secondly, the Preamble states that Europe should have sufficient institutional power and cohesion to give direction to a shared destiny. As you know, the European Convention which has just started is dealing with this issue; I understand that Dick Benschop will be here next week to elaborate. • Finally, the text speaks not just of a duty to form a close-knit and strong Europe, but also of the right of every European to share in the fruits of such an undertaking. We are aware that the tensions between these three principles have grown, as evidenced by renewed power politics at the national level and growing discrepancies between large and smaller Member States. The economic heterogeneity within the EU will only be augmented by the accession of new Member States. It is this very heterogeneity which is exacerbating the discussion on rights and duties and the need for cohesion within the Union. It is with these consideration in mind that I will be discussing the economic background to the expansion of the EU, with a special focus on Economic and Monetary Union. The central theme in my address will be the specific challenges to economic policy which the accession countries will be facing over the next few years. Given these challenges, the accession countries should, in my view, adopt a gradual approach towards the euro; they should first be properly embedded in the existing process of economic policy coordination. Situation with regard to expansion Today, twelve countries are negotiating accession to the EU: the Visegrad countries in Central Europe, the Baltic states and three Balkan countries: Bulgaria, Rumania and Slovenia. These countries must all pass what is known as the Copenhagen test. This test was drawn up by the European Council in Copenhagen in 1993, and consists of three criteria: • To begin with accession countries must have political and democratic institutions along western lines before they can even enter into negotiations. That is why Turkey, the thirteenth accession country, finds itself in an exceptional position. • Secondly, the potential Member States must subscribe to the objectives of European integration. This means, among other things, that they must adopt and implement all European legislation and rules, in other words the Acquis Communautaire. Exceptions, such as those made in the past for the British and the Danes with regard to participation in EMU, will not be allowed. • Finally, the Copenhagen criteria also encompass an economic test: the accession countries must have a functioning market economy and be capable of coping with market forces within the EU. In my opinion, this means they must be able to create a stable macro-economic climate, where market operators and consumers can take decisions and develop initiatives in a predictable and reliable environment. This presupposes powerful institutions and supervisory authorities, a full-fledged physical and human infrastructure and a developed financial sector. It also means that economic sectors must be sufficiently competitive to be able to operate within the single market. An indicator of such competitiveness is provided by trade relations with the European Union. Over the past ten years, these relations have tightened considerably. The geographical reorientation and the abolition of trade barriers since 1990 have contributed to an increase in the trade volume between the accession countries and the EU. Today about 67% of these countries’ exports go to EU Member States. It is worth noting that trade between the same sectors has also grown materially. There can be no doubt that this is largely the result of vast foreign investment in these countries. The adoption of European rules may, however, impair the competitiveness of, for instance, the agricultural and industrial industries. In its latest evaluation, of November 2001, the Commission concluded that all accession countries except Rumania and Bulgaria have a functioning market economy. Of these countries, the Baltic states, Hungary, Poland, Slovakia, Slovenia and the Czech Republic are considered capable of holding their own within the single market, provided they continue to reform. Malta and Cyprus already fully meet the economic criterion. Subsequent to this Commission report, the European Council of Laeken indicated in December that eight to ten countries will be joining the EU as from 2004. The chances of a big bang scenario, with all accession countries except Bulgaria and Rumania joining at the same time, has thus gained in probability. Politically, this would be the preferred route, eliminating tensions between countries joining soon or at a later stage and facilitating the ratification process of individual accession treaties. On the other hand, a big bang scenario should not conceal the persisting – and sometimes substantial – structural differences between accession countries. There is a correlation between potential problems in the economic structure and the stage of transition reached. The consequent specific policy challenges will continue to demand attention even after accession, and notably when participation in the Monetary Union is considered. Policy challenges for accession countries on the road to convergence Let me begin by pointing out that over the past ten years the countries in Central and Eastern Europe have engaged in a highly successful catching-up exercise. Painful reforms were enacted, often attended by rampant unemployment. The necessary institutions, such as central banks, were built up from scratch. At the same time, the transition process from a centrally planned to a market economy usually proved more laborious than expected. The economic downturn was such that only a few countries have managed to regain the GDP level recorded before 1990. The growth potential may exceed the average in the European Union, but so far the margin has been slim. For instance, the Czech central bank puts the potential growth rate of the Czech economy at 2-3% per annum. Income differentials vis-à-vis the European Union will consequently persist for some time to come. In fact the policy challenges of the accession countries lie in furthering structural reforms aimed at raising the growth potential. Economically, structural and real convergence towards the EU interact. It is a lengthy process, involving such measures as introducing free enterprise and corporate governance, as well as setting up social security systems and fighting abuse and corruption. In this context, the Commission recently announced an action plan intended to boost the institutional capabilities of the accession countries. Looking at my own field, I see that banking supervision will need to be stepped up. In general, the financial sector is not developing in line with the economy as a whole, and plays no more than a limited role in the financing of local enterprises. The capitalisation rate of banks and share/bond markets in Poland and Hungary is less than a third that in the EU. Financial intermediation must clearly be stimulated if economic development and growth are to be boosted. In parallel, supervisory powers will have to be strengthened further. Finally, several accession countries face specific sectoral problems. Here the restructuring of heavy industry in Poland and Slovakia comes to mind, as do the depreciation of bad debts in Slovakia and the Czech Republic and the transformation of the vast and unproductive agricultural sectors in Poland and the Baltic states. The transition to a modern economy will clearly be attended by further economic and hence social friction. All in all, it seems to me that these structural problems are taken into account in the Copenhagen test, but that the ultimate test is a general and political one. Copenhagen is consequently no guarantee for a high measure of structural convergence towards the current EU Member States. This need not pose problems so long as the structural and administrative challenges are really acknowledged in an expanded Union, an issue I will deal with in greater detail later. As noted, the prospective Member States face a major challenge in that they need to boost their prosperity, in other words, achieve real convergence with the current EU. The differences in prosperity between the accession countries and the EU are exceptionally large. Per capita income in Poland is less than 20% of that in the EU. By comparison, per capita income in Portugal, the poorest EU Member State, comes out at over 50% of that in the EU. Slovenia is currently the only accession country where this level is roughly achieved. In order to equal the average of the poorest three EU Member States, Portugal, Greece and Spain, Poland would have to record average annual growth percentages of around eleven percent. Such real convergence poses several specifical challenges for economic policy. I shall try to explain this without going into too much theory. • First of all, achieving the necessary high growth rate goes hand in hand with rising prices. In other words: the process of convergence makes inflation go up. This upward pressure can be partly offset through appreciation of the exchange rate. Generally speaking, a flexible exchange rate regime can alleviate the pressure on the economy generated by transition and catching up, for instance, when capital inflows are considerable. Under such circumstances, flexible regimes give less rise to speculative attacks on the currency. • In addition, fast-growing transition countries are generally vulnerable to asymmetrical shocks (affecting only the country concerned). The Baltic states, for instance, were seriously affected by the Russian crisis of 1998. Another case in point is the Czech banking crisis of the mid-1990s, which ultimately resulted in a foreign exchange crisis. • Maybe we should see the achievement of EU membership as a shock in its own right. After all, the considerable administrative and financial burden of adopting and complying with the Acquis Communautaire and of the confrontation with competition in the single market constitute a major change to economic functioning. This calls for a flexible policy. Given these specific challenges to policy posed by transition and convergence, it is worth noting that those accession countries which have made the most progress, such as Hungary, the Czech Republic and Poland, have switched to more flexible exchange rate regimes in recent years. This allows them to exercise greater influence on real appreciation and strong capital inflows, to reduce potential speculative attacks on the currency and to partially absorb shocks. Policy challenges and participation in EMU What is the relationship between the challenges posed by structural and real convergence and participation in Economic and Monetary Union? As you may know, countries acceding to the European Union may begin to consider changing over to the euro after two years. The question arises whether under the given circumstances early introduction of the euro is always advisable. It must be remembered that the instrument of exchange rate flexibility is no longer available to countries which have joined the monetary union. There is furthermore a considerable chance that a new Member State eager to change over to the euro quickly may find the euro area-wide monetary conditions incompatible with its specific circumstances. On the one hand, an accession country which has been successful in its efforts to catch up will temporarily face structurally higher inflation levels. On the other, such a country’s economic weight is too insignificant to affect the ECB’s monetary policy. In such a situation, negative real interest rates, overheating of the economy and erratic economic cycles may occur, making very heavy demands on macroeconomic management and the flexibility of the economy, notably the labour market. This brings us back to structural convergence and the requirements and implementation of the Copenhagen test. New Member States in the European process of policy coordination Given these structural and real challenges to policy, it would seem advisable to continue to comply with the essence of the Copenhagen test following accession to the EU. This would give the accession process the necessary flexibility if a big bang scenario were actually enacted, so that transition periods might be considered for specific parts of the Acquis Communautaire. In fact, such an approach would also allay the fears voiced by the Scientific Council for Government Policy regarding potential erosion of the single market. Their central concern is that new Member States should not only incorporate all 90,000 pages of the Acquis Communautaire in their national legislation, but actually implement them. [As a matter of fact, the European Union is already paying the necessary attention to transition- and catch-up-related policy challenges in the financial and economic field. Both the European Council of Ministers of Finance and the Eurosystem have entered into active consultations with the accession countries to discuss diverse issues such as the monetary policy strategy, financial stability and fiscal policy. During these consultations, the EU addresses not just the challenges inherent in joining the Union, but also the manner in which successful convergence can be continued after accession.] A major element in this surveillance is exchange rate poliy. Sooner or later the new Member States will take part in the European exchange rate mechanism, ERM II. The Treaty provides for a minimum participation period of two years before changeover to the euro can be considered. It cannot be sufficiently stressed that apart from this requirement, participation in the mechanism can offer the necessary stability and flexibility for a successful convergence process. The ERM offers stability in the form of a central parity anchor against the euro, and flexibility in the shape of ample fluctuation margins and the option of central parity adjustments. Participation in ERM II should therefore not be perceived as an obligatory hurdle on the road to the euro, as some policymakers in Central and Eastern Europe unfortunately do. [Actually, the financial and economic dialogue with the accession countries could be incorporated into the regular process of European policy coordination and surveillance, with special emphasis on the monitoring of transition periods, specific challenges to policy and administrative capacity. Changeover to the euro will eventually follow, when a sufficient degree of structural convergence can guarantee the desired price stability in an environment marked by an irrevocably fixed exchange rate and a centralised monetary policy.] Conclusion Having set out the specific policy challenges facing the accession countries consequent on accession, transition and convergence, I am coming to the end of this address. Obviously these challenges will continue to present themselves in some way or another to newly joined Member States. In this context, I warned against premature changeover to the euro. The surrender of exchange rate flexibility and the euro area-wide orientation of monetary policy may not be compatible with the challenges posed by structural and real convergence. It is important that these challenges (continue to) be explicitly acknowledged in the regular process of European policy coordination. This will guarantee the successful economic integration of new Member States into the Union. Expanding the EU is a duty which ensues from the essence of the European integration process. At the same time, both the cohesion of Europe and the rights which European citizens derive from Europe must be guaranteed. In this light, it is imperative, and in the interests of all, that new Member States succeed in catching up economically. The current participants, on their part, bear the responsibility of preparing the Union for expansion. Permit me, in this context, to issue a warning before the Genootschap’s next discussion, on the institutional powers of a heterogeneous Europe. There can be no doubt that European interests are Dutch interests. This means that we must reform the single agricultural policy and structural policy in Europe before the EU expands any further. Moreover, it would only be natural if a new European regional policy were to address only the poorest regions in an extended Union. Dutch interests are best served by a strong role for the European Commission and the European Parliament, especially in an extended, more heterogeneous Union. I would therefore like to warn against a French form of intergovernmental centralisation – a gouvernement economique. If such a power policy-based authority were established, the position of the Netherlands could become bogged down in the trade-off between the interests of large Member States, with the Netherlands receiving financial compensations on the periphery. And the greater the number of countries joining the Union, the larger the periphery. | netherlands bank | 2,002 | 3 |
Opening remarks by Mr Nout Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, at the conference on the occasion of the 50th anniversary of the Dutch Act on the Supervision of Credit Systems, Amsterdam, 24 April 2002 | Nout Wellink: 50th anniversary of the Dutch Act on the Supervision of Credit Systems Opening remarks by Mr Nout Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, at the conference on the occasion of the 50th anniversary of the Dutch Act on the Supervision of Credit Systems, Amsterdam, 24 April 2002. * * * It is a great privilege to welcome you here in Amsterdam at the conference ‘Banking Supervision at the Crossroads’. This conference has been organised to celebrate the adoption of the Act on the Supervision of the Credit System in the Netherlands 50 years ago. That was when banking supervision in our country was first formalised. It replaced a system of voluntary arrangements between De Nederlandsche Bank and the private banks. In my opening remarks today, I will look back at the past half century, that has taken us from informal gentlemen’s agreements to the phenomenal complexity of Basel II. We still aim for agreement and most of the time try to behave like gentlemen, but the world has become a different place. And it will continue to change rapidly! The question we are faced with is how supervisory practices should respond and in particular - and that is the theme of the conference - to what extent they should converge. I am very happy that we have a number of prominent speakers that are willing to shed light on this important question. First of all, I must inform the audience that due to unforeseen obligations in Parliament, Minister Gerrit Zalm will unfortunately not be able to join us this afternoon. However we are happy that in his place Mr Kees van Dijkhuizen is willing to deliver the keynote speech this afternoon. As the highest civil servant at the Ministry of Finance, Mr. van Dijkhuizen takes a keen interest in financial supervision in this country. We furthermore are very honoured to have in our midst Mr William McDonough, President of the Federal Reserve Bank of New York and chairman and of the Basel Committee on Banking Supervision, Mr Jochen Sanio, Chairman of the new Federal Office for the Supervision of Financial Services in Germany and Mr Tom de Swaan, Chief Financial Officer of ABN AMRO. As mentioned, the Dutch Act on the Supervision of Credit Systems formalised the supervisory task of De Nederlandsche Bank. It was a response to the major changes in the financial and economic environment that took place between the two World Wars. The banking crises of the nineteen twenties, the Glass Steagall Act in the United States, the growing role of the banking sector in the economy: they all made it clear that a sound functioning of the banking system was too important to be arranged informally. In this respect it is noteworthy that supervision on the insurance sector was formalised even further back in time and exists almost 80 years now. But, of course, in the decades that have passed since then the financial environment has kept on changing, and with it the challenges that supervisors face. Two trends have been particularly prominent in the past decades. The first is the enormous increase in cross-border activities made possible by the liberalisation of capital markets. The second is the blurring of the borderlines between banking, insurance and securities activities. These fundamental developments are the driving force behind the increasing need for convergence of supervisory practices across borders and sectors. Let me illustrate by looking at our experiences in the Netherlands. The international dimension of our major financial institutions has increased dramatically. As a result, in some cases nowadays more than half of assets and profits are related to activities in foreign countries. There are no signs that the internationalisation of the financial industry will slow down, rather on the contrary. In a world where national financial systems and institutions are increasingly dependent upon one another, it is obviously crucial for financial stability that high and comparable supervisory standards are maintained everywhere. This has long been recognised in the field of banking regulation. Indeed, it was reflected in the establishment and the work of the Basel Committee, as well as in the work of the European committees in this field. In this context I would like to express my great respect for the leadership shown by Bill McDonough in steering the ship ‘Basel II’ through stormy seas to a save haven. This difficult task could not be in better hands than those of a former US Navy officer! Importantly, as part of Basel II, there is wide recognition that besides having convergence in regulation, it is equally important that supervisory practices (the implementation of the rules!) converge. The creation of the Accord Implementation Group by the Basel Committee, and the work being done by the Groupe de Contact in Europe reflect this understanding. It is important to keep in mind that the importance of cross-border convergence is not confined to the banking industry. It equally applies to other parts of the financial sector, such as insurance. This brings me to the other main trend that I mentioned, i.e., the blurring of the borderlines between banking, insurance and securities activities. Here too, the development in this country is a case in point. We have been frontrunners when it comes to financial conglomerates or bank assurance, institutions that combine banking, insurance and securities activities. As is well known, the Netherlands houses a couple of world’s major internationally active financial institutions. Most of the major Dutch banks currently combine banking, insurance and securities activities. The emergence of these conglomerates was made possible by the lifting, in 1990, of the prohibition on combining banking and insurance activities in one financial institution. As the importance of cross sectoral financial activity increases, so does the need of the supervisory response. The main challenge in this field is to achieve a consistent approach in the supervision at the group level as well as at the level of the entities within the conglomerate. Consistency does not imply that the approaches should be identical. It should be interpreted as avoiding the potential for regulatory arbitrage as well as regulatory overlap. Again, we try to take the lead in the way we organise supervision in the Netherlands. Co-operation between bank and insurance supervisors dates back to the early nineties and has performed well. Nevertheless in anticipation of a continuation of the trend that I have described, we have come to the conclusion that a cross sectoral approach to supervision is the right way forward. In this approach we make a clear distinction between prudential and conduct of business supervision. It assigns the responsibility for these inherently different objectives to separate authorities. This is not to say that this is the only way to address this challenge. It depends on the specific characteristics of the financial sector in a country which design is best suited. In our case, for instance, we have a highly concentrated financial sector with institutions that are, almost by definition, systemically relevant. As a consequence we considered it essential to link prudential banking supervision with the central bank and its other functions such as oversight of the payment system and providing lender of last resort facilities. But as I said, circumstances and the solutions chosen will vary from country to country. This is fine, as long as the approaches have at least one thing in common: they should be designed with the aim of ensuring consistency. Consistency not only in regulation, but also in supervisory practice. This is an important precondition for achieving a level playing field for the international financial industry. Let me add, as a final observation, that in achieving this goal, there is an important complementary role to be played by market discipline. Meaningful disclosure by financial institutions is a potentially powerful tool in furthering the cause of a level playing field between countries and across institutions. Ladies and gentlemen, let me conclude. Looking back in history, we are a far cry now from where we were fifty years ago, when our predecessors introduced formal banking supervision in the Netherlands. Looking forward into the future, I am pretty sure that our successors will not be celebrating the centenary of the Act on the Supervision of Credit Systems, or even the centenary of insurance supervision 20 years from now. We will have entered a cross sectoral world long before then! And as to the topic they will be discussing, that could well depend on the turning we take on the crossroads that we are at now. Thank you for your attention. I wish you all an interesting and entertaining conference. | netherlands bank | 2,002 | 4 |
Address held by Professor Arnold Schilder, Executive Director of the Netherlands Bank and Chairman of the Basel Committee's Accounting Task Force, on the occasion of the opening of the new premises of the Bank of the Netherlands Antilles, Curacao, 8 May 2002. | Arnold Schilder: Corporate governance, accounting and auditing post-Enron issues Address held by Professor Arnold Schilder, Executive Director of the Netherlands Bank and Chairman of the Basel Committee's Accounting Task Force, on the occasion of the opening of the new premises of the Bank of the Netherlands Antilles, Curacao, 8 May 2002. * * * Ladies and gentlemen, Let me start by congratulating the Bank of the Netherlands Antilles with the opening of their new premises. Governor Tromp, on behalf of the Dutch central bank, I bring you the best wishes of Governor Wellink and my other fellow Directors. Also, in my capacity as Board member of the Dutch Pensions and Insurance Supervisory Board (PVK), I bring you their best wishes as well! So a positive start, and one would expect this week’s program to be orchestrated in the same way. However, Governor Tromp invited me to speak about more troublesome issues such as accounting and auditing after Enron. I hesitated for a while, suggesting that we keep it a bit more general. But when preparing this speech, I realised he was right. We can no longer speak about accounting and auditing without mentioning Enron. I address this issue from the perspectives ensuing from my mixed background. For 26 years I was involved in public accounting at one of the Big Four firms. (You will agree that we can no longer speak about the Big Five, sadly enough). In 1994 I finished my PhD on the subject of auditor independence. In 1995 I visited Curacao as the President of the Dutch Institute of Public Accountants Royal NIVRA. And then, in 1998 I was invited to join the Dutch central bank as the Executive Director of Supervision, succeeding Tom de Swaan. As a consequence I became a member of the Basel Committee of Banking Supervision, and in 1999 I was asked to chair the Basel Committee’s Accounting Task Force. You will notice this mix of accounting, auditing, regulation and supervision in my address. Enron has seriously shaken our confidence. This is a grave matter, because it means confidence has weakened in rules and regulations, in supervisory authorities and in the functioning of the financial system in general. Therefore, I will first discuss key issues regarding Enron. From there we will proceed to confidence and trust, accounting and ethics. I will then review some challenges to the auditing profession. Finally, I will draw some conclusions. My one-line conclusion will be that the ethos of public service needs to be restored and that this is a matter which concerns people from many more walks of life than just auditors. Enron has shocked our confidence. That conclusion is obvious from so many comments, articles, and even worse, the spate of sceptical jokes about auditors. Such as: if you want to win an Olympic medal, just put some auditors on the jury. But it is actually about much more than auditors. The biggest shock is that no warnings were issued – and yet it happened. So the reputation of directors is at stake. The Enron executives are subject to public enquiries – but many other directors outside Enron suddenly face greater scepticism about their assurances. The slightest unclarity about financial statements may cause considerable confusion. Because it is no longer taken for granted that they can be trusted. Then the auditors, already mentioned. Are they still to be relied upon? In whose interests are they working: their paying clients? Their own interest in large fees? Is their integrity still intact? But the doubts do not stop here. Rating agencies: why did they not warn in time? How good are they? Can we still believe in their quality? And then analysts: important messengers to investors. Are they just telling stories to please the firm’s important clients? Are they focused on their bonuses only? And the investment bankers, what is the value of their advice? Do they apply professional judgement or are they simply out to conclude the next deal? And so on. Confidence is shocked – in virtually every participant in the financial reporting cycle. Nevertheless, one keeps wondering about the pervasiveness, the magnitude of this event. Inquiries are going on, also on the more technical issues. However, these as such were not new. Special purpose vehicles, derivative instruments, consolidation principles: they are examples of technically complex issues. But also in this field there is a pervasive accounting literature, and each accounting firm, rating agency or bank has specialists at hand. Of course, there is much to learn and to develop. Was it just the magnitude of the fraud then? Secret documents, side-contracts, lying to the auditors maybe? But think of large scandals like Maxwell, BCCI, Barings. Did they bring similar shocks or consequences? To me it seems that the most unique element in Enron was the shredding of documents by Arthur Andersen and, subsequently, the handling of the resulting publicity. The gradual confession of that professional and ethical crime really caused the earthquake. Because it was a blow to the very heart of the ethics that underlie our financial reporting system. So a public sense of great urgency resulted. For example, the Financial Stability Forum, which comprises finance ministers, central bank governors and regulators, discussed the Enron-case at length at its March meeting in Hong Kong. Let me briefly explain the ethics of the financial reporting model that are at stake. In business we have shareholders on the one hand, and firms led by directors on the other. Shareholders are dependent on the accounts given to them by the directors. But the latter know more about their business than the shareholders. This is called information asymmetry. To bridge this gap, directors use accounting as an intermediating language between them and the shareholders. But this language is difficult to understand and can be manipulated. So the shareholders called for independent interpreters. The shareholders require these interpreters to check the language used, and then to convey to them the real messages they need to know. The shareholders are entitled to ask this, as they are the principals of the directors who are using their money. Now multiply these shareholders into many kinds of stakeholders, including employees, taxpayers, bondholders, agencies. One can easily see that you need a lot of interpreters. By interpreting correctly, they help to establish fiduciary relationships between all these principals and their many agents. That is, building trust in the economic relationships that are the basis for our conduct of business. Now what kind of ethics would one require from these interpreters? Well, the least that one expects from the interpreters is that they are unbiased, impartial translators of what they hear. If they make a mistake now and then, are tired or simply miss something, OK. But it would not be acceptable if they made up their own stories, or are deliberately involved in playing games with their audience. They would be thrown out immediately. These key ethics are well known in the auditing profession. Let me read you several quotes from a magnificent book about the history of 75 years Arthur Andersen, called “A Vision of Grandeur” (1988). The young Arthur Andersen and his partners believed strongly in key statements like: “Think straight/talk straight.” And: “Rigid standards of honesty and integrity.” And: “Accounting principles can and should only be accepted if they present most fairly and most honestly the financial facts.” For the experts among you: a clear-cut example of principle-based accounting, including a true and fair override principle! These are the ethics that made Arthur Andersen such a strong global firm. So, what the firm shredded were not documents – it was their basic ethics. Arthur Andersen destroyed the trust it had earned in 90 years’ time. What can society do in response other than withdrawing the license to operate? This is what happened to Arthur Andersen. But what does it tell the auditing profession in general? What challenges does it pose? First, the profession has to fully understand what caused the shock. So far I am not sure whether that is already the case. The other Big Four have been keen to pick up the victims from the global AA firm. But what is the response to the broad concerns in society as a whole? Or, how can one stop the scepticism? As Bryan Carsberg and John Kay wrote (Financial Times, April 2, 2002): “It is to restore the ethos of public service and public obligation that has been eroded as accounting has moved from liberal profession to competitive business.” That, I believe, is the action program. In March 2002, the International Federation of Accountants (IFAC) announced a comprehensive “project on restoring the credibility of financial statements in the global marketplace”. IFAC said: “The project will address worldwide problems, issues, and best practices in the areas of financial and business reporting, corporate governance, and auditor. It will be developed by a task force comprised of members representing IFAC, audit committees, boards of directors, the investment community, and financial management.” Well, it is to be hoped that IFAC will be able to do more than just ‘address’ this – the project needs clear deliverables that help to restore confidence and trust. In this context, the profession should prepare to have a more effective crisis management plan than Arthur Andersen was able to demonstrate. Much can be learned for example from the food and health industries. They have learned their lessons. If a problem occurs, the reaction is no longer to minimize the issue and to hide behind vague excuses or to accuse other parties involved. Instead, full transparency is given about the issue and the risks involved for the public. At the same time, a comprehensive action plan is announced to fully take away the risks or their consequences, to compensate for damages and to explain how in the future such an event will not occur again. Another important issue is public regulation and oversight. It is all right to make maximum use of sound self-regulation. But the auditing profession should realize that self-regulation alone does not suffice. Like for example financial services, accounting and auditing services are of great importance to society. It is all right that such services are offered on a commercial basis in competition. But as a counterbalance, strong independent oversight has to be established. Various initiatives are discussed in this context. It is important not to compromise but to make such oversight independent and powerful. Licensing, examining audit practices and disciplinary measures are some of the crucial elements to be incorporated here. Let me mention several other important issues that may help to restore confidence and trust. In the accounting area, we have to remember what I quoted from young Arthur Andersen: accounting principles and their implementation in daily practice have to aim at presenting a true and fair view of what was and is. This general principle has to override detailed rules and interpretations if necessary. It is not easy, it can be subjective and judgemental, it may lack comparability in the details – but in the end it is the only thing that matters. This of course is not something that is relevant to auditors only. It matters to all people involved in the reporting cycle. So it is a matter of education, of awareness and of discipline. Regarding auditing, let me highlight a few important issues. Partner rotation should be made mandatory. At least for so-termed public interest companies, e.g. listed ones, or financial sector firms. Personally, I believe it should be applied more widely as it is a healthy discipline. Peer reviews have to be strong and powerful. As a consequence of public oversight, independent reviewers need to be involved. And adverse results should have adequate response and, where necessary, disciplinary measures transparent to the public. Strong audit committees can be very helpful to monitor both a company’s executive management and its internal and external auditors. They need to comprise independent non-executive directors only and to report to the full board. They are also the appropriate body to monitor the extent to which the audit firm performs consultancy engagements for the audit client, and to set principles and limits for such practice. Finally audit firms have to be much more transparent. At least they should be as transparent and accountable as financial sector firms. I refer to what will be known as Pillar III in the new Basel Capital Accord, that will require substantial transparency from banks. I cannot see why global audit firms should be allowed to be any less accountable than listed companies in the United States or Europe. This includes openness about partners’ income. Ladies and gentlemen, let me conclude. In 1994, I concluded my PhD on auditor independence by stating that, at the end of the day, it all comes down to the ability to withstand pressure. That this is what matters most for the auditor’s reputation of integrity, and that without integrity auditors cannot exist. We have learnt a hard lesson from Enron in that not only auditors (or auditing firms) can be threatened in their existence. We are all on call. There is a need to restore the ethos of public service, whether we are auditors, bankers, analysts, regulators or executives. In fact it matters to all players in the broad area of corporate governance. We all have a license from society to operate, as long as we adhere to essential ethics of public responsibility. Thank you. | netherlands bank | 2,002 | 5 |
Speech by Mr Nout Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, at the Institut International d¿Etudes Bancaires, Amsterdam, 17 May 2002. | Nout Wellink: Monetary unions in Europe and the US - just how different are they? Speech by Mr Nout Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, at the Institut International d’Etudes Bancaires, Amsterdam, 17 May 2002. * * * Introduction First of all, thank you for the invitation to speak to you today. Now that we have a monetary union, there has been discussion about the role of national central banks in the euro area, including some questions about their ongoing relevance. Clearly you regard us as relevant or you would not have invited me to speak! It will come as no surprise that I also think that national central banks are relevant, and will continue to be so. Today I would like to briefly compare monetary policy in the euro area and in the US. Of course there are differences between the two areas, but there are also important similarities. This comparison can help us understand the reasons behind our differences and may provide some useful insights into the institutional implications for euro area monetary policy in the future. I will structure my remarks around three themes: the policy goals of the two monetary unions, their organisation, and the monetary policy decision-making process in each system. Goals and philosophy Let me begin by comparing the goals or mandates of the Eurosystem and the Federal Reserve System. Here in Europe the primary focus of monetary policy is to maintain price stability. In contrast, the Fed has multiple objectives for monetary policy. Their goals are to achieve maximum employment, stable prices and moderate long-term interest rates. An important explanation for our different mandates can be found by looking at our economic histories. In Europe, monetary union is the most recent step in an ongoing process of political and economic integration. The hyperinflation experienced in the first half of last century in some European countries, in particular in Germany, has played an important role in ensuring that European monetary policy is focussed on price stability. Our experiences in Europe contrast with those in the US. A key US event that commentators frequently refer to is the Great Depression. Monetary policy is often blamed for adding to the severity of the Great Depression in the US. I think that is a reason why employment and interest rate objectives remain in the Fed’s mandate, and why policy makers there react so quickly to signs of slowing economic growth. Under normal circumstances, policy makers on both sides of the Atlantic are likely to take similar decisions. However, around the time that the economic cycle is changing and growth is slowing rapidly, you might see different decisions being taken in Frankfurt and in Washington reflecting our different mandates. In addition to the influence of history, the Eurosystem’s mandate reflects academic insights from the last 20 years or so. This research tends to support the view that monetary policy should only focus on price stability. Other central banks around the world that have reviewed their mandates in recent years have tended to move towards having price stability as their sole objective. Similar proposals have also been made regarding the Fed. If the Fed’s mandate were to change in the future, I expect it to also be in the direction of a more explicit focus on price stability. Organisation of the two monetary unions A second area in which our different histories have played a role is in the way in which the Eurosystem and Fed are organised. While the Fed was created ‘from scratch’ by the Federal government for a single country, the Eurosystem was established when twelve sovereign states voluntarily gave up their monetary autonomy. This is reflected in the fact that the Eurosystem is some ways more decentralised than the Fed. Greater decentralisation is consistent with the EU-wide principle of subsidiarity, under which decisions are taken at the country or regional level where possible. This greater degree of decentralisation is apparent in areas such as monetary policy decision-making and operation, banking supervision and statistics. However, the Fed can also be considered decentralised in other areas. In fact, when you exclude staff working on tasks unrelated to the monetary union, both systems have roughly the same number of employees. Clearly, this does not tell us much about the potential for efficiency gains, except that it is around the same in both systems. The European monetary union is made up of sovereign countries. That means that it is not politically or publicly acceptable to carry out all central banking tasks at the ECB. Our preference for subsidiarity also implies that there are limits to potential efficiency gains within the system. The pace of further centralisation is linked to the speed of further political integration in Europe. As long as there is no federal European state, I expect that providing an independent view on national and euro area economic developments, within the context of area wide monetary policy, will be a key task for the Dutch central bank. Tasks related to financial stability and banking supervision will also remain part of our core business. In order to carry out these tasks effectively, we have to remain closely connected to the formation of monetary policy. We also have an important role in explaining policy decisions to our citizens. Given the language, cultural and historical differences between countries, we should not underestimate the importance or difficulty of this task and the role of national central banks in carrying it out. These factors help explain the inclusion of national central bank governors in the ECB Governing Council, which brings me to my third theme. Decision-making in the two monetary unions The final area of comparison between the Fed and the Eurosystem I want to make concerns the process of monetary policy decision making. Both areas include representation from regions as well as from the centre. But, it is clear that in this area the US also has a more centralised system than the euro area. Washington-based board members form a majority on the committee that makes US monetary policy decisions. In contrast, the ECB Executive Board members form a minority in the ECB Governing Council. In both monetary unions, all decision makers, whether regional or not, are expected to make their decisions on the basis of prospects for the whole monetary union. This area wide approach is strengthened in Europe by ensuring that Council members are prohibited from taking instructions in their decision making. At the same time, national or European bodies are not allowed to put pressure on Council members. These provisions reinforce the fact that we are in the ECB Council on a personal basis, and not to represent national or other interests. In a few years, the size of the euro area will probably increase significantly. As you will all be aware, European history also lies behind our desire for enlargement. Most accession countries have announced that they want to join the euro area shortly after entry into the EU. Whether they should join the euro area so quickly is a point we could debate another day. Regardless of our views on that issue, the fact remains that we have to be prepared for a substantial enlargement of the Eurosystem in the next five to ten years. Consistent with the provisions in the Nice Treaty, the ECB Council is preparing its proposals on changes to voting procedures to accommodate enlargement. The reason for considering a change is to guard against the perception that our decision making could become inefficient, and that it could potentially be dominated by governors from small countries. In making changes, we must find a solution that retains the supranational character of decision making and does not renationalise monetary policy. This implies that the governors of all the national central banks should continue to be treated equally. At the same time, the Council must represent the Eurosystem as a whole, and be seen to do so - implying that it must not become too centralised. A solution that meets these criteria could involve some form of rotating membership for the governors of the national central banks, so as to limit the number of voting governors. This could be a variation on the Fed system, albeit more decentralised. There, all of the regional presidents participate in the discussions, but not all of them have a vote at any point in time. Finding a solution that meets the criteria I have set out is especially important, given that changes here could set a precedent for other areas of supranational European co-operation Concluding remarks Let me briefly conclude. In my view, differences in mandates between the Fed and the Eurosystem are important in understanding our respective decisions, and this is often forgotten. In addition, comparing the two systems sheds some light on where each institution may head in the future. Regarding our mandates, it seems to me that any changes in this area are likely to be in the direction of the Fed moving closer to where we and other central banks are, rather than the reverse. For organisation and decision making, the future is more difficult to predict. Any changes here need to take account of the political realities of monetary union between sovereign countries. Euro area monetary policy is supranational, so decision making has to be based on the euro area as a whole, and not individual countries. At the same time, the euro area consists of independent countries. That implies that there is a limit to how far the Eurosystem can centralise in advance of any political union. This reality has to be clearly reflected in our decision-making body. I wish you success with the rest of your conference and an enjoyable stay here in Amsterdam. | netherlands bank | 2,002 | 5 |
Introduction by Dr Nout Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, to the paper ¿The Role of National Central Banks within the European System of Central Banks: The Example of De Nederlandsche Bank¿, Oesterreichische Nationalbank Conference ¿Competition of Regions and Integration in EMU¿, Vienna, 13-14 June 2002 | Nout Wellink: The role of national central banks within the European system of central banks- the example of De Nederlandsche Bank Introduction by Dr Nout Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, to the paper ‘The Role of National Central Banks within the European System of Central Banks: The Example of De Nederlandsche Bank’, Oesterreichische Nationalbank Conference ‘Competition of Regions and Integration in EMU’, Vienna, 13-14 June 2002 * * * Introduction I would first like to thank the Oesterreichische Nationalbank for inviting me to this conference and take up the challenge of discussing the role of national central banks in Europe. Clearly, this role underwent a fascinating metamorphosis with the introduction of the single currency. Suddenly, a strong, European dimension was added to these institutions that were traditionally largely confined to national boundaries. Consequently, the national central bank in Europe is of a peculiar sort and has a double identity. On the one hand, it is deeply rooted in national tradition and sovereignty, which reflects specific national tasks and responsibilities. On the other hand, it is part of a system of central banks responsible for a fully supranationalised monetary policy and related, common tasks. Let me now briefly outline my paper on the role of national central banks in Europe. First, I will shortly discuss the general framework of the European System of Central Banks. Subsequently, I will touch on the System tasks and related national responsibilities. Here, I will specifically spend some time on financial stability and supervision. Clearly, this policy area has seen some major developments recently, both on the national and European level. The European System of Central Banks What exactly is the European System of Central Banks? What explains its unique institutional and operational set-up? These are crucial questions in analysing the role of national central banks or, for that matter, understanding monetary union in general. Nevertheless, the questions are seldom asked, let alone answered. Since the Second World War, European integration has been a co-operative effort in which common objectives in principle override the size and power of the individual participants. The European System of Central Banks is a both a product and a reflection of this European Community of Member States. Hence, the fundamental notion underlying the System is a joint and equal responsibility to carry out the tasks assigned by the Treaty. In this set-up, the ECB operates as the legal entity that links the spokes of the system and thus makes the joint responsibility for tasks possible. The Governing Council is the highest decision-making body of the ECB, consisting of executive board members and governors of the national central banks. Apart from the fundamental notion of joint responsibility, two guiding principles of the Treaty determine the operational side of the System. First, subsidiarity prescribes that the responsibilities lie at the lowest possible level. In the context of the European Community, this principle respects national sovereignty and reflects the heterogeneity of its Member States. Second, the Treaty prescribes an efficient allocation of resources. In other words, the System should be effective at the least cost. In practice, there may be trade-offs between the principles of subsidiarity and efficiency, but gross inefficiencies should, of course, be avoided. Tasks of the European System of Central Banks Now, with this basic System framework in mind, let me turn to the actual tasks of the national central bank that follow from the System. In the paper, I cover the tasks of deciding on and executing monetary policy, foreign reserve management, the collection and production of statistics, external relations, and the operational aspects of payment systems and banknotes. Given time constraints, I will limit myself to the conduct of monetary policy. The fundamental notion of joint responsibilities adds value in the sense that it offers checks and balances in the monetary policy process. For example, the participation of NCB-governors increases accountability and the quality of decision-making. Indeed, given their joint responsibility for price stability, all national central banks have not only the right, but also the obligation, to fully prepare their governor in his or her capacity as an ECB-Council member. Although fundamental to the System, the notion of joint responsibility allows for institutional flexibility when it comes to the effectiveness of monetary policy – as this clearly lies at the heart of monetary union. Let me first of all emphasise that the present size (18 members) of the Governing Council has never been a stumbling block for effective, and where necessary, rapid decision-making. Nevertheless, there is the perception that, with further EMU-enlargement, the size of the team could hamper the effectiveness of monetary policy. That is why the Treaty of Nice goes as far as to offer the possibility to restrict the number of votes in the Governing Council on monetary policy. Clearly, on the basis of the fundamental notion on which the System is built, all governors will remain equally involved in future monetary policy decisions. However, they may not all have a vote at the same time. Moreover, the participation of NCB-governors will continue to offer checks and balances and enhance the quality of decision-making. Let me turn to the guiding principle of subsidiarity. Clearly, the principle implies that, to a large extent, the spokes of the System take care of both inputs and outputs. Given the heterogeneity of the euro area, this bottom-up approach to System tasks makes sense. Thus, in dealing with economic, structural, or even linguistic differences and national preferences, the spokes are better positioned in the operation of monetary policy. The same goes for managing payment systems or the collection of statistics – tasks that I will leave aside for the moment. Moreover, governors and their respective central banks bring in specific local knowledge and enhance healthy competition within the System – for example in the area of research. Of course, as explained, we should be conscious of potential trade-offs between subsidiarity and the guiding principle of efficiency. As such, there is no denying that efficiency gains can be achieved in the production and distribution of banknotes. We need to pursue these possibilities. Financial stability and banking supervision – national tasks of NCBs This brings me to the central bank tasks that fall outside the exclusive domain of the European System of Central Banks. For the Dutch central bank, these tasks take up around half of its staff and relate to international financial relations, advising the government, financial stability and banking supervision. Under the subsidiarity principle, these responsibilities lie close to the sovereignty of the nation state. Nevertheless, there are clear links and synergies with the tasks of the European System of Central Banks – which, in fact, is an important reason for national central banks having these tasks. Let me limit myself here to financial stability and supervision – given their importance in recent European discussions. According to the Treaty, the European System of Central Banks as a whole shall contribute to the smooth conduct of policies pursued by competent authorities in the field of prudential supervision and financial stability. The collective responsibility to contribute to these policies follows from the financial stability task of the national central banks. This involvement in financial stability is a natural reflection of other tasks, including monetary policy, payment systems and – to varying extent – banking supervision. Monetary policy relies on financial stability in order to be effective. In addition, in exercising oversight over national payment systems, central banks guard against systemic risks that could be transmitted via these systems. There are therefore clear synergies between financial stability and other tasks. Central to these synergies is the wealth of knowledge on the financial system through the central bank´s active presence in financial markets. Again, the structural differences in financial systems across the euro area mean that the financial stability task is more appropriately located at the national level, although communication and co-ordination across borders are increasingly important. Whereas all national central banks have a financial stability task, not all have direct competence in the field of prudential supervision. The choice to delegate the supervisory task to the central bank is, of course, based on national circumstances and preferences. However, the important synergies between the financial stability and supervisory tasks should not be ignored. I will come back to this issue when I discuss the supervisory arrangements in the Netherlands. In general, it is important to stress that on both a national and European level the national central banks remain involved in discussions on prudential supervision. This is essential for the proper execution of their financial stability task and, as such, enables the System to contribute to the smooth conduct of supervisory policies. Recent developments in Europe regarding supervision Recently, the perception of increased cross sector and cross border financial integration has resulted in demands for enhancing the supervisory structure in Europe. I fully subscribe to the ambitions to speed up the regulatory process of supervision in Europe. Moreover, the convergence of supervisory practices would serve a level playing field in European financial markets. Last year, a European committee under chairmanship of Mr Brouwer – director at the Dutch central bank – made several recommendations on this point. As I explained, the involvement of national central banks will continue to offer welcome expertise in assessing the supervisory needs and challenges of financial integration. Concerning topics directly related to financial stability and systemic risks, the national central banks will be at the frontline of European discussions, together with their counterparts from the ministries of finance. However, I would warn against the suggestion of introducing a single European supervisor. It is a misconception to expect that a top down approach to the design of supervision in Europe would promote financial integration. Clearly, that would simply ignore the structural differences on the national level. Indeed, the practice of EMU has shown that a critical mass in integration is needed before institutional convergence (i.e. the introduction of the Euro) can work as a catalyst. Likewise, I would warn against the suggestion that from a financial stability perspective, the number of supervisors should be consolidated. Here again, the principle of subsidiarity allows for the necessary checks and balances, which would be lost if we had one supervisory giant in Europe. Supervisory reforms in the Netherlands This brings me, as promised, to the supervisory arrangements in the Netherlands. In relative terms, the consolidation and integration of the Dutch financial sector are well-advanced. First, our experience shows that the future challenges to cross border supervision may not be merely European, but rather of a global dimension. Moreover, in the face of horizontal integration, the division of supervisory tasks in the Netherlands has recently been streamlined along functional lines. Thus, the organisational links between the Dutch central bank (as banking supervisor) and the insurance supervisor have been strengthened. This allows for an integrated approach to prudential supervision. On the other hand, issues related to the conduct of business and consumer protection have been concentrated in the Financial Markets Authority. These recent reforms in my country subscribe to the basic principles of effectiveness and subsidiarity I referred to earlier. Thus, there was no case in terms of efficiency or effectiveness to reallocate the supervisory task already assigned to the central bank. Here, the synergies with the task of financial oversight have been acknowledged. Moreover, there is the link to our role as lender of last resort. With the supervisor in-house, a quick and effective assessment can be made of the nature of crises – including whether they involve liquidity or solvency difficulties. Consequently, the central bank has good insights into the risks for the financial system at large. Finally, the necessary checks and balances – in particular regarding supervisory autonomy and accountability – were retained. Conclusion Let me conclude. It is likely that the European System of Central Banks will be continuously evolving in the interplay between hubs and spokes – exploiting efficiency gains to the extent that the principle of subsidiarity allows. However, the federal shape of the System and the firmly rooted national component of central banks reflect the main driver of European integration – the nation state. In short, that implies that, with anything short of political union, the fundamental principle of collective responsibility of the System remains in place. All central banks have to be fully involved if we are to fulfil this collective responsibility. Moreover, the unique structure of the European System of Central Banks and the double identity of its participants add important value. The monetary policy process gains from the individual expertise, knowledge and networks of the national central banks that improve the quality of decision-making and offer checks and balances. The System set-up also enables great synergies with the execution of national central bank tasks. I referred in this respect to the national responsibilities for financial stability, and – in case of the Dutch central bank – the task of supervision. I am convinced that, based on the fundamental notion of collective responsibility and the guiding principles of subsidiarity and efficiency, the System will continue to generate good joint and individual policies, provide proper checks and balances and even enhance the European integration process in general. As such, the national central bank might even contribute to loosening the roots of its very existence - when the nation state would dissolve into political union. But even then, differences of structure, culture and language will remain, and there will be a need for similar, regional bodies to keep monetary union operational. Referring to the theme of this conference, perhaps future generations will then witness the birth of a new entity – the regional central bank. | netherlands bank | 2,002 | 6 |
Lecture by Dr Nout Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, at the 16th annual Tinbergen Lecture organised by the Royal Society for Political Economy (Koninklijke Vereniging voor Staathuishoudkunde), Amsterdam, 18 October 2002. | Nout Wellink: The monetary strategy of the Eurosystem - an assessment Lecture by Dr Nout Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, at the 16th annual Tinbergen Lecture organised by the Royal Society for Political Economy (Koninklijke Vereniging voor Staathuishoudkunde), Amsterdam, 18 October 2002. * * * Introduction The Bank has for some years provided the venue for the Tinbergen Lecture. Apparently, even without the former Palace of Crafts and Industries, this spot at the Frederiksplein has space available for the occasional social activity. The greatest event in this context was the Euro-summit of 1997. And in a symbolic sense, I would be happy to have the Bank move into Wim T. Schippers’ palace of crystal: the glass would exemplify the transparency which must characterise a central bank. This is especially true of its monetary policy, for which our Bank, together with the other central banks in the euro area, bears a common responsibility. Transparency promotes a central bank’s effectiveness and public accountability. In this spirit, I hope to offer some perspective today on the role of a monetary strategy as pursued by central banks in general, and by the Eurosystem in particular. The role of a monetary strategy Essentially, a monetary strategy reflects the way in which a central bank uses its primary instrument, often a short-term interest rate, to realise its objectives. Rather than offering a mechanical decision-making tool, the strategy describes a procedure. It is a guide rather than a cookery book. And monetary strategy not only serves as a guideline for the internal analysis of economic and monetary developments; it also provides a framework for external communications. In the case of the Eurosystem, the short-term interest rate is employed in the pursuit of a single objective. This is the primary objective of a low and stable inflation rate, in other words price stability, in keeping with Professor Tinbergen’s famous dictum that a single instrument cannot be used to pursue diverging objectives. Yet some central banks aim to stabilise real GDP growth or employment, as well as achieving price stability. The American Fed is a case in point. The coexistence of dual objectives and a single instrument may be understood in two ways. First, a central bank may pursue what it perceives as the most favourable combination of inflation and growth stability, without fully realising either. Alternatively, objectives which conflict in the short run may coalesce over time. In ensuring low and stable inflation, a central bank contributes to sustainable and balanced growth in the medium term. Price stability also has a normative side, in that inflation or deflation result in the redistribution of income and wealth without democratic legitimisation. The weaker groups in society are particularly ill-equipped to defend themselves against this. My predecessor, Jelle Zijlstra, dwelled at length on the social dangers of inflation in a 1975 article for the Economist. If inflation is not combated effectively, to quote Zijlstra’s words, then "the principles of private enterprise and of democratic government will not be able to survive". Fortunately, nowhere in Europe is inflation such a threat as it was in the 1970s. Yet the unrest over the inflationary movements caused by the introduction of the euro banknotes and coins shows that even at relatively low rates, inflation is perceived as unjust and hence must be counteracted. Before discussing the stronger and the weaker points of the Eurosystem’s monetary strategy, I would like to make a qualifying remark. Just as many roads lead to Rome, so many strategies lead to price stability. Some academics would have us believe that the macroeconomy can be adequately described by a small number of equations, and they proceed to determine the optimal policy strategy by applying mathematical techniques. I wish things were that simple in practice. Even in 1832, the Prussian military theorist Carl von Clausewitz, in his authoritative work On War, remarked that a military strategy cannot be summarised in a simple rule. On the battle-field unexpected things happen all the time. Similarly, a central banker is confronted on a daily basis by the complexity of the economy and by unexpected events. This is the most important reason why a strategy is used in a procedural way for reaching monetary policy decisions, and is not used as a fixed rule. Monetary objectives and strategies differ less from country to country than is often thought. This is especially true in the current situation of low and more or less stable inflation rates. Policy decisions are sharper in nature during times of monetary crisis, whether amid high inflation, as in the days of Zijlstra’s presidency, or amid deflation, as in Japan today. It is in such times that differences between central banks come to the fore. The unique character of the Eurosystem’s strategy Concerning its decision-making, the Eurosystem’s monetary strategy has clearly been successful. The inflation rate in the euro area since the start of Stage Three of EMU has averaged 2%, precisely the upper limit of price stability. We are at this limit because of a sequence of inflationary shocks. Fortunately for the longer term, expected inflation rates remain low, at somewhat below 2%. The Eurosystem’s strategy is different from that of other central banks. It is made up of a quantitative definition of price stability plus two pillars. Price stability is defined as a year-on-year rise of the harmonised consumer price index of less than 2%. Price stability is to be maintained over the medium term. Deflation is expressly inconsistent with this definition of price stability. Deflation is, particularly in combination with a fall in demand, at least as damaging as inflation. Persistent deflation, in combination with the fact that nominal interest rates cannot be negative, reduces the manoeuvring room for monetary policy. Moreover, deflation increases the real indebtedness of debtors. This definition reflects a desire to secure inflation expectations on a low level without, however, promising greater precision than can be achieved given the uncertainties in economic developments. In practice, we prefer an inflation rate roughly between 1% and 2%. Sometimes arguments are raised in favour of stretching the price stability zone to 3%, as a target rate below 2% is seen as overambitious. These arguments are based on the misconception that a price stability definition implies an inflation targeting goal. Only "inflation targeting" central banks aim monetary policy at a specific inflation target over a specified time horizon. That, therefore, does not hold for the Eurosystem. Under the so-called first pillar, monetary phenomena are analysed, with the main focus on the movement of the broad monetary aggregate, M3. Empirical data indicate that M3 is a good indicator for prices in the longer term. Like so many relations in the economy, however, this one is also beset by uncertainties. For this reason, money growth is measured against a reference value rather than a target rate such as the Bundesbank used to have. The second pillar consists of the analysis of all other information relevant to future price stability. Both pillars are always considered in tandem. Ultimately, monetary policy decisions are made on the basis of a broad assessment of the risks to euro area price stability. These, very briefly, are the lines along which the Governing Council of the ECB reaches monetary policy decisions. Our strategy ensures a high degree of continuity with the German Bundesbank’s monetary policy. This has allowed the Eurosystem to benefit from the reputation of Germany’s central bank. At the same time, the strategy takes account of the fact that monetary authorities are confronted with uncertainty. This is reflected in the broad-based assessment of the risks for price stability, based on both pillars. The uncertainties are greater for the Eurosystem than for other central banks, given the additional uncertainties associated with EMU. The transition to monetary union has changed the behaviour of economic agents, partly because the differences in interest rates that used to exist between the countries of the euro area have almost disappeared. The most striking element in our strategy is the separate pillar for money in a broad sense. Although we call it the first pillar, this does not in itself mean that it is the most important one. The factors which are decisive in determining the prospects for price stability depend entirely on circumstances. Money growth is, at the moment, not the decisive factor. It has for some time clearly exceeded the reference value and the resulting situation of ample liquidity could, over the longer term, lead to upward inflationary pressures. There is currently little danger of this given the present economic weakness. Although the first pillar may not always be the most important one, money remains the logical starting point for our analysis. As a central bank, the Nederlandsche Bank naturally has closer ties to money than to other sources of inflation. To exaggerate slightly: money is our product, so that is what we first focus on. From a more academic viewpoint, a good case may be made for treating money separately. Macroeconomic models for short-term forecasts usually do not assign a specific role to money, although in a monetary economy, every real transaction is offset by a financial one. Viewing real phenomena from a financial angle therefore often provides new insights. Our strategy emphasises the fact that monetary factors are important, though not all-important. In the short run, wage developments and other cost factors are of great significance for inflation. In a sense, therefore, monetary policy in the Eurosystem, like that of the Netherlands in former times, may be characterised as "moderate monetarism". Accordingly, the members of the ECB Governing Council take all indicators into consideration. Our procedure ensures that monetary aspects will be considered separately. Some of us attach more importance than others to monetary indicators. What is so attractive about our strategy is that it leaves room to afford greater or lesser weight to the different indicators. In an economy as complex as that of the euro area, this is a sensible approach. Strategy in practice In practice, making monetary policy is difficult because the economy is continuously exposed to shocks, the effects of which are sometimes not entirely predictable. One might think of sudden changes in the oil price caused by tensions in the Middle East; of failing crops; or of exchange rate fluctuations. In particular, shocks that push up inflation in the short-term while at the same time reducing output, confront a central bank with difficult policy decisions. A strategy offers a guideline for choosing among the available options. In this context, some ECB watchers have urged the Eurosystem to direct its policy towards what they call "underlying inflation" instead of unadjusted inflation. In their view, underlying inflation is something of a cure-all. By assigning a central role to this concept of inflation, the Eurosystem would, as it were, be able to see through the direct impact of a shock on prices. The usual method to arrive at underlying inflation is by disregarding fluctuations of volatile components such as energy and food prices in calculating inflation. I myself reject a monetary policy explicitly centred on underlying inflation. Like other cure-alls, it is a piece of quackery. Rely on it too much, and it can become life-threatening. There is a real danger that a policy centred on an artefact such as underlying inflation would harm the ultimate goal, which is price stability. The public is not interested in underlying inflation, but in the inflation they can see in their purses. For this reason, the European Treaty is also directed towards maintaining price stability, not towards underlying inflation. Another major objection would be that the categorical exclusion of, say, oil price rises from relevant inflation rate is based on flawed reasoning. Without doubt, oil price rises are often to some extent exogenous. Think of a decision by OPEC to raise prices or of rising tensions in the Middle East. To the extent that such a shock is exogenous, there is little reason to worry about more than the knock-on effect on, in particular, wages. But in many cases a rise in oil prices may also reflect increased economic activity. An oil price increase due to a greater demand for oil requires a different monetary policy reaction than a price increase caused by reduced supply. Underlying inflation cannot offer any clarity regarding that difference. So there are both fundamental and statistical reasons why founding a policy on any single underlying measure of inflation would be to court disaster. Although rejecting a central role for underlying inflation, the Eurosystem’s monetary policy still aims to absorb shocks as best it can. External shocks may temporarily push inflation beyond the limits of the price stability zone. This is one of the reasons why our definition of price stability has a medium-term orientation. The other reason is that monetary policy tends to pass through to inflation with a lag averaging some eighteen months. Yet it is very difficult to specify exactly what is meant by the medium term. Lag times vary, and during the time it takes for a policy decision to take effect on inflation, new shocks may occur. Seen in this light, a temporary inflation rate above 2% is not a disaster, and neither is an occasional fall in the price level. But eventually, the Eurosystem will have to deliver the goods, that is, price stability. That is the foundation on which the Governing Council renders account of past policy. The Council makes its decisions jointly. The responsibility for price stability is shared by all members. So far, the Council has never voted over its interest rate policy, which points to a high level of consensus. But this emphatically does not mean that everyone has always agreed on everything, which in itself is a good thing. Consensus only implies that all members of the Council have been able eventually to go along with every interest rate decision. Has consensus slowed down monetary policy decision-making? No, it has not. The reason why is that the Governing Council, although eighteen members strong, is homogeneous in character: members share a preference for price stability. Consensus-building has been strongly supported by the obligation under the Treaty to work towards price stability. Communication If we look at the bare figures, monetary policy has been a success, as I have already noted. Yet, communicating it has not always been straightforward. Several aspects may be distinguished. On each of these aspects, however, progress has been made over time. In the first place, policy decisions have not always been correctly understood by the public. This is not very surprising, since the Eurosystem is a new institution with a new monetary strategy. However, now that it has come into its own, after a few years, this problem has begun to disappear, simply because the public has become more accustomed to our approach. A great help in this respect was the decision to halve the frequency of meetings where monetary policy is discussed to once every month. This has also reduced the extent of speculation over impending interest rate adjustments. In the second place there was – apart from the occasional communication error – too much communication sometimes, especially in the early days. This may sound paradoxical, but what counts is optimum, not maximum, communication. Too many messages do not enhance transparency, especially if they convey what seem to be contradictions. For this reason, the Governing Council has agreed that in the run-up to each monthly meeting, radio silence will be observed about developments with a direct bearing on monetary policy. Thirdly, communication is a complicated matter if one wishes to be as open as the ECB. Although it does not publish minutes of its meetings, the ECB is the only large central bank which holds a press conference directly after every decision, to explain its motives. At the same time, a communiqué is published enumerating the considerations which have led to the decision. Compare this to the sober comments by the Bank when it pursued its independent monetary policy, pegging the guilder to the Deutsche mark. We used to confine ourselves to phrases like: "Domestic and foreign developments considered, the Nederlandsche Bank has decided to lower the interest rate on advances by 0.25% to 5.25%." The question pondered these days is how the Eurosystem’s press releases may provide even more clarity on the considerations leading to interest rate decisions. This has been an ongoing issue. Having said this, it would not be very useful to publish individual members’ views on interest rate policy. A single person may simultaneously harbour considerations in favour of and against a specific decision. Besides, in the European context there would be the risk that views of individual Council members could be linked erroneously to the economic situation in their home country. What ultimately matters is the credibility of the Eurosystem as a whole and publishing the opinions of individual Council members would add little, if anything, to that. To sum up, the monetary strategy of the Eurosystem offers a sound framework for economic and monetary analysis; it has been effective, in my experience, in guiding the monetary decision-making process within the Governing Council of the ECB. The results are favourable, considering current and expected inflation. There have been occasional communication problems, caused in part by the fact that the ECB is such a young institution with a unique monetary strategy. I record with satisfaction that here, too, there is less and less confusion. The strategy will be further refined as we learn from our experiences and from academic insights. The manner in which we achieve the aim of price stability may, if necessary, be adjusted; the aim itself, however, stands carved in stone. Right now, we are well-satisfied with the current strategy. Its flexible character makes it ideally suited to accommodate the accession to EMU of new Member States. The strategy can always be explained more fully, of course. I hope that I have made a contribution in this respect today. | netherlands bank | 2,002 | 10 |
Speech by Professor Arnold Schilder, Executive Director of De Nederlandsche Bank NV, Board Member of the Pensions and Insurance Supervisory Authority of the Netherlands, and Chairman of the Accounting Task Force of the Basel Committee on Banking Supervision, at the congress EYe on Banking, sponsored by Ernst & Young, in Utrecht, 6 November 2002. | Arnold Schilder: Accounting standards, transparency and supervision Speech by Professor Arnold Schilder, Executive Director of De Nederlandsche Bank NV, Board Member of the Pensions and Insurance Supervisory Authority of the Netherlands, and Chairman of the Accounting Task Force of the Basel Committee on Banking Supervision, at the congress EYe on Banking, sponsored by Ernst & Young, in Utrecht, 6 November 2002. * * * Introduction Frequent downward restatements of earnings, and accounting abuses, have deeply shaken public confidence in the reliability of financial reporting. This has contributed to the worldwide downfalls in share prices. In this context, questions arise such as what should be done with accounting standards and whether greater transparency could help to restore public confidence. Also, what role supervisors can play in this respect. I will discuss these issues from both an accounting and a supervisory perspective. First, let me put the erosion of public confidence in financial reporting into its proper perspective. In some countries, particularly the US with Enron, Global Crossing and Worldcom, confidence has waned more than elsewhere. But this was not the only cause of the current malaise on international financial markets. In this respect, the correction of the asset price bubble, the weakening of macro-economic prospects and the threat of war in the Middle-East have been substantial factors as well. Also, incentive structures within firms and in financial markets may have been distorted. Excessive attention to share prices coupled with disregard for long term fundamentals, and exuberant stock option programmes are cases in point. With hindsight, it is fair to say that apart from failures in accounting, there have been shortcomings in disciplining mechanisms, such as in corporate governance, in auditing and in disclosure, as well. Accounting standards What can be done to restore confidence in financial reporting? On a global level, the International Accounting Standards Board (IASB) is working hard to deliver a set of high quality standards as soon as possible. But it is not easy. Why? The first complication is the increasing difficulty of proper measurement. Take, for instance, the growing importance of intangible and non-marketable assets, such as intellectual property rights or goodwill. Another example is the valuation of long-term flows of income or expenditure, such as pension liabilities, which are inherently difficult to predict. In addition, complex instruments for risk transfer and new corporate structures test the limits of existing measurement and valuation techniques. In essence, accounting standards have to be frequently adapted in response to developments in corporate practices and financial markets. These are moving targets! The second issue is the fundamental dilemma in the formulation of accounting standards, namely having to choose between rules-based and principles-based standards, in other words between detailed standards or standards in more general terms. Rules-based standards, like the US Generally Accepted Accounting Principles, in principle may be easier to enforce. However, they increasingly bear the risk of being circumvented, either through financial innovation and engineering, or through what has been euphemistically called ‘aggressive accounting’. Principles-based standards, like the International Accounting Standards, or in the new jargon the International Financial Reporting Standards, may allow for financial innovation more easily. At the same time, they may leave more room for interpretation and thus may be more difficult to enforce. But this issue is not as black-and-white as it seems. On the one hand, there are US attempts to move closer to principles-based accounting. A study on this subject has been mandated by the recent Sarbanes-Oxley Act. Principles-based standards, on the other hand, will most likely retain rule-like components as well, particularly in order to create accounting discipline for complex issues such as financial instruments. This explains, for example, the complaints about the new IAS 39 Exposure Draft being too prescriptive. Moreover, principles-based accounting will not obviate the pressure to make the principles more precise, easier to enforce, and hence, more rule-like. If so, this may give rise to differences between countries and hence raise questions of international coherence. In other words, principles-based accounting creates level playing field issues. A third subject is fair value accounting for the recognition and measurement of financial instruments. Fair value accounting has potential advantages. Essentially, the increased use of market-based information may enhance the transparency and comparability of financial statements. However, fair value accounting may not yet be feasible and reliable ‘across the board’, and may lead to an artificial volatility of financial results. This greater volatility in turn, if not properly explained and understood, may negatively affect public confidence. For these reasons, it seems sensible for the time being to focus on expanded fair value information in the Notes to the Financial Statements. This brings me to a fourth point of interest, the need for risk accounting. Traditionally, accounting has concentrated on the information contained in the balance sheet, income and cash flow statements. Arguably, this is no longer sufficient to determine what risks are being run by firms, particularly firms active in financial markets. Modern financial instruments and techniques, such as derivatives or securitisation, enable them to change their risk profile, sometimes even at very short notice. So more information should be provided about a firm’s risks. That is why banking and insurance regulators encourage disclosures by financial institutions on risk exposures as a means of enhancing market discipline. The IASB is working hard on this as well. Another issue is the context of accounting. International accounting standards mainly deal with financial measurement and disclosure. They do not extensively consider the setting in which financial reporting takes place, such as the firm’s corporate governance or risk management, the role of the audit committees or the internal and external auditors. Auditing standards, however, take a different approach. They first define the conditions to be met by the company environment, before describing what should be audited, and how this should be done. Interestingly, prudential authorities follow the same route. The Basel Committee’s guidelines, the Nederlandsche Bank’s Regulation on Organisation and Control or the Pensions and Insurance Supervisory Authority’s Principles on Internal Control start from the primary responsibility of the management and the directors for sound governance. They then elaborate the requirements to be met by these functions. So the question is whether international accounting standards should deal more comprehensively with the setting for accounting and reporting within the firm and address accounting governance more explicitly. Internal reporting procedures and compliance, an active role of the audit committee, a separation of responsibility for and financial interest in financial reports, for example, are most relevant for sound reporting. Perhaps accounting standard setters should no longer take them for granted. Without an appropriate environment of sound corporate governance and risk management, accounting standards resemble a safe car without a qualified driver! In short, accounting standards need to be adapted to changes in corporate practices and financial markets. Modern standards should be principles-based, take account of sound corporate governance, and be risk-oriented. To get this across, there is a constructive dialogue between accounting standard setters, like IASB, and regulators, such as the Basel Committee on Banking Supervision. Although they have a different scope and different objectives, their interests clearly run parallel in many areas, for example in accounting for loans and proper provisioning practices, or in transparency about risk management. In these fields, the Basel Committee appreciates the dialogue with accounting standard setters and the industry in order to achieve sound and effective reporting. Topical issues are IAS 39/32 and IAS 30. A recent Roundtable in Basel, chaired by BIS General Manager Andrew Crockett, confirmed the need for a coordinated dialogue regarding corporate governance, accounting and auditing, and transparency and oversight. Transparency and disclosure Let us now turn to transparency. Transparency is a prerequisite for effective market discipline. In theory, the rationale for greater transparency is that companies, particularly financial institutions, present information asymmetries to the markets. Simply speaking any company is better informed about its own operations than outsiders are. If the company publishes more information to facilitate the assessment of its assets and liabilities, its strategies and risk profile, markets can function more effectively, at least in theory. Markets contain disciplinary mechanisms, which stimulate sound management and adequate financial performance. For companies which are well-run, well-financed, and transparent, costs of raising capital will tend to decline. The reverse goes for ill-managed firms. More generally, well-run firms, by being transparent, can obtain better terms and conditions in transactions with informed and rationally-behaving market counterparties. In essence, this is market discipline. Market discipline, however, works only if market participants have sufficient information, which enables them to assess companies’ activities and their inherent risks. But more disclosure as such does not necessarily result in greater transparency. On the contrary, rather than just expanding their disclosures, firms should pay attention to the quality of information as well. In short, information disclosure needs to be timely, reliable, relevant and sufficient. Importantly, public disclosure of high quality information contributes to corporate governance. That is to say, the information can be used to hold directors and managers accountable for their decisions and the firm’s performance. Transparency, in other words, serves the accountability of companies to their stakeholders. One aspect of public disclosure which should not be overlooked is the costs involved. Information is not a free good. On the contrary, developing, implementing and maintaining up to standard information systems is costly and takes time. For that reason, accounting standards, should, above all, require relevant information. However, there is a professional risk of an overdose of information, which must be heeded by both standards setters and regulators. Pillar 3 Let me illustrate this by explaining the Basel Committee’s efforts to increase transparency. Market discipline through enhanced public disclosure is one of the main three elements or ‘pillars’ of the new Capital Accord. That also goes for the new European capital adequacy directives. Pillar 3 recognises that market discipline has the potential to reinforce and support minimum capital standards (Pillar 1) and the supervisory review process (Pillar 2). This way, it helps to ensure that banks maintain appropriate levels of capital as a cushion against potential future losses arising from risk exposures. Pillar 3 contains proposals for greater disclosure by banks, pertaining to three broad categories, the so-termed scope of application of the Accord, a bank’s capital adequacy, and its risk exposures and assessments. For essential elements of the new Capital Accord, such as the use of an internal ratings based approach (IRB), disclosures will even be required for supervisory recognition. This means that a supervisor is not supposed to recognize the use by a bank of these techniques, unless the bank has met the disclosure requirements. In this respect, in addition to Pillar 1 with its IRB, Pillar 3 marks the transition to a fundamentally new approach in prudential supervision. As to the content of the information, Pillar 3 aims to provide for a comprehensive set of consistent and comparable disclosures. It should, in other words, establish a common framework for the information to be made available by banks, and that would allow a meaningful comparative analysis by recipients of that information. Comparability is greatly enhanced by the use of the risk weighting methodologies in the context of Pillar 1 as a common yardstick for the purpose of public disclosure. At the same time, however, Pillar 3 should not become overly prescriptive. That is why Pillar 3 attaches great importance to qualitative disclosures. This will allow a specific bank to explain and elaborate the particular characteristics of its operations in plain language. An interesting dimension to the development of the Pillar 3 disclosures is the relationship vis-à-vis the accounting standards, and vis-à-vis listing requirements promulgated by securities regulators. As I have said before, the costs of public disclosures by banks should be limited. Therefore, banks may rely on disclosures under accounting or listing requirements insofar as these are materially equivalent to Pillar 3 requirements. However, such requirements have a broader focus than the third pillar, which aims at banks capital adequacy. Pillar 3, in other words, is a more specific interpretation of the general rules, as a reflection of its more precise objective. Supervisors are therefore keen on the on-going revision of the IASB disclosure standard for banks, IAS 30 and IAS 32. The Basel Committee maintains an ongoing relationship with the IAS 30 Advisory Group in order to achieve consistency between disclosure frameworks. Supervision I now turn to the last topic, supervision. We must not ignore that public disclosure has its limitations and potential drawbacks in certain circumstances, particularly in the financial sector. Modern banks' business is complex and opaque. This means that information asymmetries will be reduced, but not completely removed, even if public disclosure is enhanced. Therefore, it cannot be ruled out that market forces fail to instil sufficient discipline and that banks take excessive risks. When that happens, the market may react too little, too late. Once the risks start to materialize, and the market is aware that the bank’s position is weakened, it may react excessively. Banks may then be subjected to high interest rates or ultimately be excluded from the market, possibly even regardless of their performance. This could spread to other banks and jeopardize the stability of the banking system. Here, prudential supervision complements the picture. Although prudential supervision entails efficiency costs, it has additional advantages for banking stability, as compared to disclosure. Basically, supervisors pay due regard to systemic implications of banking problems, and act accordingly. Supervisors have a public responsibility to maintain systemic stability and to prevent an escalation of an imminent crisis. Such conduct can not be expected from banks' counterparties, who pursue their own, private objectives only. Given their public responsibility, prudential supervisors have a legal right to know about the banks subject to their supervision. They should consequently have an information advantage compared to banks' counterparties. The upshot is that even if banks' transparency is enhanced through greater public disclosure, there will remain a need for a thorough and comprehensive prudential supervision. This explains the three pillars in the new Capital Accord. Interestingly, Pillar 2, the supervisory review process, is an essential complement of the Accord. The application of bank specific risk measurement systems, such as IRB, under Pillar 1 will result in bank specific capital requirements. Inevitably, since banks and their risk measurement systems differ, this will reduce the level playing field. This development, however, is counteracted by Pillar 3, which requires that each bank provides specific disclosures about its risk management and capital measurement. Yet, although there will be greater transparency about banks’ capital requirements, there is a risk of too much subjectivity. For that reason, there is an additional supervisory review of the matter, which is called Pillar 2, as a necessary complement to Pillars 1 and 3. This, incidentally, raises a more general question for accounting standard setters. In the banking sector, figures based on new measurement techiques (Pillar 1) and disclosures (Pillar 3) will be complemented by a supervisory review (Pillar 2). If the application of new accounting standards in the corporate sector were to result in similar intrusions into the level playing field, this could be counteracted partially by greater disclosures. But who will then be supervisor or overseer? Against this background, oversight and enforcement with respect to financial reporting and disclosure must be strengthened. The Dutch government has recently announced its intention to do so. Three elements are worth noting. First, application of eminent and internationally harmonised accounting standards, as Europe moves to adopt IAS by 2005. Second, an adequate check of these financial reports by external auditors. Third, an adequate oversight of compliance with the accounting standards and reporting requirements. The government has proposed that the Netherlands Authority for the Financial Markets (Au-FM) be entrusted with the task of executing this type of oversight, which is essential for the confidence in financial reporting by Dutch listed companies, as well as to the well-functioning of financial markets. The Nederlandsche Bank and the Pensions and Insurance Supervisory Authority will co-operate with the Authority for the Financial Markets, and will oversee prudential areas in financial reporting. Apart from this, there is an issue of oversight on the auditing profession. This will be introduced as well. Also, a brief comment on the US Sarbanes-Oxley Act. Under the Act, the SEC receives new powers, although its role continues to be that of enforcement and oversight. The Act provides for an independent Public Company Accounting Oversight Board, and prescribes audit quality and corporate governance measures. Also, it directs the SEC and other US government agencies to undertake comprehensive reviews of corporate governance, the segregation of audit and non-audit work, and the role and functioning of credit rating agencies. Moreover, the Act strengthens the disclosure requirements for public companies, notably in the areas of off-balance sheet transactions and insider trading. An interesting question, of course, is: how will the Act affect Europe? The debate on the implications of Sarbanes-Oxley for Europe is ongoing. The extent to which the Act will be effective, will also depend on the budget that the Administration intends to provide to the SEC. But what Europeans in any event need to appreciate, is the comprehensiveness of the US approach. The EU in its turn has launched a major effort to improve its members' corporate governance regimes. Also, the EU adopted the regulations which require the use of IAS by EU listed companies in 2005. This deadline will require EU Member States to step up their transition from national to IAS. In addition, the EU supports global convergence through the IAS process on important accounting issues, such as the treatment of financial instruments, performance reporting, consolidation and share-based payments. Furthermore, expanded rules on auditor independence are being drafted. Concluding remarks Let me conclude. The subject of my address, accounting standards, transparency and supervision, is fairly complicated and has many aspects. First, although confidence in financial reporting has waned, this is due to many factors, of which accounting deficiencies are only one, albeit important element. Moreover, these factors are being redressed where possible. Second, accounting standards need to be adapted regularly to new developments in business and finance. This is not easy, given the many innovations being introduced all the time. Not only do accounting standards need adjusting, the broader corporate governance context needs to be addressed as well. Third, greater transparency, through public disclosure and improving market discipline is vital to restoring public confidence. Fourth, although prudential supervisors encourage transparency, this is no panacea. Transparency cannot do without adequate supervision and oversight. Finally, I haven’t said much today about auditing. But if ever there was a need for high quality auditors, it is now. Thank you. | netherlands bank | 2,002 | 11 |
Speech by Dr Nout Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, at the conference ¿Role of Money in Private Law¿ organised by the Marcel Henri Bregstein Foundation, Amsterdam, 1 November 2002. | Nout Wellink: The Bank - a hybrid legal organisation Speech by Dr Nout Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, at the conference “Role of Money in Private Law” organised by the Marcel Henri Bregstein Foundation, Amsterdam, 1 November 2002. * * * Introduction I am very pleased to contribute to this conference centring on the role of money in private law. As you know, the Nederlandsche Bank, or simply the Bank, has traditionally been the guardian of the Dutch monetary system and to this day plays an important role in this regard, not just within the Netherlands, but as of 1 January 1999, within the whole euro area. The legal framework underlying the Bank’s objectives, tasks and activities is less well known, and it is this legal framework that I want to talk about briefly today. The Bank was founded by Decree of King William I on 25 March 1814. The original objective of the Bank was to issue loans to enterprises and private individuals in order to stimulate the economy. In the first half century of its existence, the Bank acted as a pioneer in the field of private banking. In the mid19th century, it was the first bank in the Netherlands with a national network. However, the public nature of the institution gradually became more pronounced. By around the 1930s, it had evolved from a pure circulation bank to a central bank. As guardian of the monetary system, it ensured the smooth operation of the payment system and upheld the purchasing power of the guilder. It also compiled statistics related to the banking system, creating a natural basis for its later task as supervisor. The Bank was nationalised in 1948. All shares came into state hands, and from then on, the Bank solely performed tasks in the public interest. After the Second World War, it also developed as banking supervisor and regulated external financial transactions because of the scarcity of gold and foreign exchange reserves in the Netherlands. The Bank recently underwent a development from an institution with ‘solely’ national objectives and tasks to one which also has European objectives and tasks. Due to historical developments, the Bank has become an interesting, but legally complex, institution. It is subject to various legal regimes, a situation I would like to explain from three angles. Public versus private The first approach concerns the concurrence of public and private rules. On its establishment, the Bank could in many ways be compared to a private financial institution: it was geared to issuing loans to promote trade in the Netherlands. That explains why the Bank had a legal form governed by private law. In the early years, it was moulded as a partnership, comprising shares which the owners had paid for in cash. Later, in 1863, it was changed to a public limited company. Like the commercial banks, the Bank was subject to the rules of the Civil Code. However, the Bank displayed public-law features in some respects and these began to predominate over the years. The first of these was that the central government granted the Bank the patent to act as circulation bank for a certain period. These patents were subsequently extended repeatedly, while no similar patents were granted to other financial institutions. Since its establishment, the Bank has hence enjoyed the exclusive right to issue banknotes. In addition, the Bank looked after central government payments and receipts, and so became the state’s cashier. Another important public-law feature was the fact that the Bank’s powers and tasks had been laid down by law as of 1863. The six earlier versions of the Bank Act 1998 differed in a number of respects from the regime of ordinary company law. Public law overrides private law on these points. The current Bank Act likewise contains some departures from the Civil Code, the most important being: • the Bank’s Governing Board is appointed by Royal Decree for a term of seven years; • the Governing Board members may be suspended or relieved from office only if they no longer fulfil the conditions required for the performance of their duties or if they have been guilty of serious misconduct; • the structure regime laid down in Book 2 of the Dutch Civil Code does not apply to the Bank; • and the Bank is not subject to a number of rules governing annual accounts. It also emerges from the Bank Act 1998 and the Bank’s Articles of Association that all of the Bank’s tasks are governed by public law. One would be justified in asking whether the Bank, in view of its public objectives and tasks, should indeed be incorporated under private law. There are different ways of looking at this issue. On the hand, it could be argued that if activities are carried out as part of a public task, this should not be done in a private-law guise which could make it harder for civilians to recognise state involvement. On the other hand, one could say that in the case of the Bank, in part due to its long history as central bank, there is no room for confusion at all; civilians know that the Bank performs public tasks. In addition, the Bank’s private-law legal form has worked successfully for two centuries partly because it enhances the Bank’s independence from politics, a factor that has gained in importance since the introduction of EMU. Another advantage of the private-law legal form is its flexibility. It is a form which facilitates responses to social developments. Over the years, this private-law mantel has suited the Bank perfectly in changing circumstances and will undoubtedly continue to do so in future. The Nederlandsche Bank is not unique in this respect. The private-law origins of various other central banks can still be traced in their current legal structure. National versus European The second angle is the concurrence of national and European regulations. The Treaty establishing the European Community (the Treaty) provides that, by no later than the date of establishment of the European System of Central Banks (ESCB), every Member State shall make its national legislation compatible with the Treaty and the Statute of the ESCB. This was the reason for enacting the Bank Act 1998. One of the principal changes vis-à-vis the Bank Act 1948 is that in the new Act, the objectives, tasks and activities of the Bank have been made fully compatible with those of the ESCB. Its tasks are not only national but are also European to the extent that they concur with those of the ESCB. The Bank’s European dimension is clearly expressed in section 2(1) of the Bank Act 1998 which provides that in implementation of the Treaty, the Bank’s objective shall be to maintain price stability and that, without prejudice to this objective, the Bank shall support the general economic policies in the European Community. The Bank’s European dimension also emerges in the Bank’s tasks, as laid down in section 3 of the Bank Act 1998, which accurately reflect the tasks of the ESCB, namely to define monetary policy, conduct foreign-exchange operations in the financial markets, to hold and manage the official foreign reserves, to provide for the circulation of banknotes, to promote the smooth operation of payment systems and to contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system. The Bank’s national dimension is shown notably in section 2(4) of the Bank Act 1998 which provides that the Bank shall perform tasks conferred upon it by or pursuant to the law. The tasks subsequently conferred under section 4 of said Act are to exercise supervision on financial institutions, promote the smooth operation of the (national) payment system, collect statistical data and to perform other tasks conferred by Royal Decree. A certain tension can arise between the Bank’s European and national tasks. However, that does not apply to the monetary and exchange rate policy conducted by the ESCB: no national task remains in this area. The Treaty provides that a single monetary and exchange rate policy shall be pursued within the euro area and that this policy shall be determined by the Governing Council of the European Central Bank (ECB). As president of the Nederlandsche Bank, I sit on this Governing Council whose members do not act as representatives of their Member States or their own central bank when taking decisions; they act in accordance with their own judgement and with complete independence. This independence is safeguarded by section 12(4) of the Bank Act 1998 which provides that the Bank’s Governing Board shall acknowledge the President’s capacity as member of both the Governing Council and the General Council of the ECB. In other areas, the division between national and European tasks has been less clearly defined, for example in respect of payment systems. The Bank promotes the smooth operation of payment systems as a national task, but this is also one of its European tasks. At present, national tasks predominate in the area of payments. The ECB has so far made little use of its legislative powers in this regard. Both kinds of tasks, national and European, must fit seamlessly together. Where the national task ends and the European one begins cannot be precisely determined. These limits will undoubtedly be further explored in the coming years and will shift at some points. In the event that national and European tasks conflict with each other, the European task takes precedence. For the System, this principle is expressed in section 14.4 of the Statute of the European System of Central Banks which states that the national central banks of the System may perform functions other than those specified in the Statute unless the Governing Council of the ECB finds, by a majority of two-thirds of the votes cast, that these interfere with the objectives and tasks of the ESCB. In practice, national central banks should follow the principle that where there is doubt, the European functions take precedence. Not just national tasks, but national regulations too can differ from their European equivalents. In principle, a conflict between national and European regulations is prevented by inclusion in the Bank Act 1998 of exceptions to general Dutch law which are specifically based on the Treaty. Nonetheless, some provisions in the Dutch Civil Code might still conflict with the Treaty or the Statute of the European System of Central Banks. The Bank Act 1998 hence contains the provision that where this occurs, the provisions of the Dutch Civil Code shall not apply to the Bank. Public body The third approach to the legal regimes applying to the Bank relates to the fact that the Bank holds public authority. Pursuant to the Bank Act, the Bank exercises public-law powers and is consequently a public body in terms of the General Administrative Law Act. As emerges from the Bank Act, the Bank, in exercising its powers, is not hierarchically subordinate to the Minister of Finance and is hence an independent public body which performs its public tasks at a remove from the minister. The minister need thus be less concerned with details and can concentrate more on the main thrust of policies. However, the minister remains accountable to parliament for the relevant policy areas. He must provide the required conditions, such as sound legislation and an adequate set of instruments to allow a public body to operate efficiently and effectively. As the minister should also monitor the quality of the public body’s performance, he needs the requisite instruments such the right to (aggregated) information, budget approval, receipt of an annual report and annual accounts, the right to appoint and dismiss directors and members of the supervisory organs and to intervene if the public body is neglecting its task. The minister’s instruments must, however, be geared to the specific nature of the relevant public body. This applies particularly to the Bank which, for various reasons, is an exceptional public body. First and foremost because the Bank’s status as public body only covers its Dutch powers under public law and not those powers which it exercises on the basis of European Community law, namely its System tasks. And secondly because the Treaty requires that the Bank, as part of the System, shall function completely independently from political influence. This raises the question whether the minister has enough scope to exercise his responsibility for the Bank’s non-System tasks, including the supervision of financial institutions. The answer is yes, provided that the instruments available to the minister are carefully selected. Moreover, the Bank is an exceptional public body because of the concept ‘supervision at a distance’, meaning that for supervisors of financial institutions, the distance from political influence is an essential point of departure for the independent and expert exercise of supervision. Finally, the Bank is an exceptional public body because it has a private-law legal form (although it is not unique in this). Due to the Bank’s status as an exceptional public body, it has been agreed with the minister that the Bank, as of a date yet to be fixed, shall present an integral budget to the minister for approval, relating solely to its national tasks; the minister will test whether this is budget reasonable. It was further agreed that, as of the same date, the Netherlands Court of Audit would gain access to that part of the Bank engaged in national tasks. As part of the reform of financial sector supervision, it was decided that the Bank, as a supervisory authority, should cooperate more closely with the Pensions and Insurance Supervisory Authority (PVK). This has since led to the cross-appointment of a member of the Bank’s Governing Board and the PVK chairman on each other’s governing organs, as well as the cross-appointment of the chairmen of the Supervisory Boards of the two institutions. The full integration of both institutions is now under consideration. A number of legal issues need to be taken into account, relating to differences in the nature of supervision and the form of ministerial responsibility, and to the fact that the Bank and the PVK have different private-law legal forms, namely a public limited company and a foundation. While these questions are legally complex, they can fortunately be resolved. In conclusion As I have outlined, the Bank is subject to various legal regimes: public and private law, national and European, part public body, part not. Where these areas overlap, conflicts may arise. It has emerged that such situations may be governed by three rules on conflict which can be derived from the Treaty and the Bank Act 1998 and that these rules can serve the Bank as a guideline in performing its tasks. Firstly, that public-law regulations take precedence over those governed by private-law; secondly, that European regulations override national ones; and thirdly that Bank’s status as a public body solely applies to its powers under Dutch public-law and that the Bank’s independent status may not be compromised. I have explained that the Bank does not have an unequivocal legal framework. It is a public limited company, but one which is not subject to the full extent of general law. It is a national and a European institution. And finally, it is a public body, but only insofar as non-System tasks are concerned. The Bank can hence rightly be termed a ‘triplex sui generis’ institution. It plays on several legal chessboards. In performing its tasks, the Bank repeatedly faces the challenge of succeeding in this simultaneous game. | netherlands bank | 2,002 | 11 |
Speech by Dr Nout Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, at the seminar 'Current issues in central banking', on the occasion of the opening of the new office building of the Central Bank of Aru | Nout Wellink: Central banks as guardians of financial stability Speech by Dr Nout Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, at the seminar "Current issues in central banking", on the occasion of the opening of the new office building of the Central Bank of Aruba, Oranjestad, 14 November 2002. * * * It is a great honour for me to deliver a speech on the occasion of the opening of the new office building of the Central Bank of Aruba. This is an important milestone in the short history of this institution. Since its creation in 1986, the relationship between the Central Bank of Aruba and the Nederlandsche Bank has been very close. Those of you who are familiar with the Dutch weather will understand that this relationship is something we especially cherish during this time of the year. But there are many more reasons why our co-operation has always been fruitful, and will remain so in the future. Indeed, although Aruba and the Netherlands have a different history and different traditions, our central banks have much in common. First of all, we both gave up much of our monetary autonomy a long time ago. The Aruban Florin has been pegged to the US dollar since its creation in 1986. Likewise, the Netherlands had pegged its currency to the Deutsche Mark since 1983. This fitted in a longer tradition of stabilising the Dutch guilder vis-à-vis the Deutsche Mark since the demise of the Bretton Woods system in 1971. Eventually, we gave up our own currency in 1999, to become part of the euro. A second common characteristic is that we are both small, open economies with a particular interest in a stable international financial system. While Aruba is an Offshore Financial Center, Dutch banks, insurance companies and pension funds have invested a substantial part of their assets abroad. Finally, a third similarity is that both our central banks have a broad range of activities. We are not only involved in monetary policy, but are also responsible for the prudential supervision of banks and some other parts of the financial sector. In this context, it is important to be open-minded organisations and to adjust to changes in the financial environment. Seemingly, a new trend is that central banks increasingly present maintaining financial stability as their core task. A dozen or so central banks in the industrialised countries have launched a regular Financial Stability Review, and financial stability is often given a more prominent place in their organisation structure. Is this really new, or is it merely an explicit recognition of an activity that central banks have traditionally been involved with, albeit in a less visible manner? Central banks have always been involved in trying to preserve financial stability, for instance through their role as lender of last resort. In addition, a credible monetary policy aimed at price stability encourages confidence in the currency, which is a key element of a sound financial system. I think financial stability is now coming to the fore and is becoming more visible to the general public, mainly as a consequence of two major changes in the external environment of central banks over the past decades. First of all, the financial landcape has changed. Until, say, twenty years ago, the financial sector was clearly segmented. There was a distinction between financial intermediaries and financial markets. In addition, there was a rather strict distinction between types of financial institutions: banks, insurance companies and investment funds. Domestic financial systems were to a large extent isolated from each other, because of capital restrictions and the virtual absence of cross-border mergers between financial institutions. Over the past two decades, this segmented structure of financial markets has largely disappeared. Financial institutions have expanded and increased their range of activities; mergers have taken place both across sectors and across borders; and financial markets have become much more integrated at a global level. As a result, cross-linkages have become stronger and there is a greater risk that shocks are propagated through the financial system. Institutional developments are the second major change for central banks. These are closely related to changes in the financial landscape. In particular, the supervisory structure, which used to be organised along the same segmented structures as the financial sector, became increasingly obsolete. At the same time, international co-operation has become crucial, through international standards like the Basle Accord and more intensive bilateral co-operation between supervisors. In a number of countries, banking supervision has been integrated into broader supervisory frameworks. In the Netherlands, this is done by a very close co-operation between the Nederlandsche Bank, which is responsible for banking supervision, and the pension and insurance supervisor, PVK. In other countries, like he United Kingdom, supervision has even become the responsibility of a separate agency. As a result of these trends, central banks have re-orientated themselves regarding their role in preserving financial stability. Personally, I am convinced that especially the banking sector remains of vital importance for financial stability, more so than other parts of the financial system. Given banks’ pivotal role as both financial intermediaries and providers of payment facilities, problems with one institution can easily cause contagion effects. Central banks have an important task in mitigating these risks by offering secure payment settlement systems through which payments can be made in risk-free money. This also implies that central banks need to monitor their commercial counterparts intensively. At the same time, we cannot ignore the fact that commercial banks have become more exposed to other parts of the financial system, implying that our surveillance task should be broadened. For example, banks’ increasing use of credit derivatives to transfer their risks to institutional investors, implies that these investors’ ability to meet these financial contracts becomes a relevant factor. Let me elaborate a bit on this new development in central banking, and how we deal with it at the Nederlandsche Bank. What do we mean by financial stability? According to our own definition at the Nederlandsche Bank, a stable financial system is capable of efficiently allocating resources and absorbing shocks, preventing these from having a disruptive effect on the real economy or on other financial systems. Also, the system itself should not be a source of shocks. Our definition thus implies that that money can properly carry out its functions as a means of payment and as a unit of account, while the financial system as a whole can adequately perform its role of mobilising savings, diversifying risks and allocating resources. Financial stability is a vital condition for economic growth, as most transactions in the real economy are settled through the financial system. The importance of financial stability is perhaps most visible in situations of financial instability. For example, banks may be reluctant to finance profitable projects, asset prices may deviate excessively from their underlying intrinsic values, or payments may not be settled in time. In extreme cases, financial instability may even lead to bank runs, hyperinflation, or a stock market crash. How can we safeguard financial stability? Although this concept is hard to capture by clear and observable targets, our definition of financial stability gives some clues. Let me mention three. First of all, potential sources of shocks need to be identified. Examples of shocks are interest rate hikes, financial crises in other systems, but also non-economic events like earthquakes and terrorist actions. Obviously, shocks are hard to predict, but having some idea of their potential magnitude is useful for making financial systems more resilient. A second factor to look into is the way shocks are transmitted to the real economy and to other financial systems. In particular, contagion and herding behaviour are important transmission channels. Elements to survey are the solvency and liquidity of different segments of the financial sector, the concentration of bank exposures, and problems that may arise due to a lack of information. The third issue, finally, is how the financial system’s vulnerability can be reduced with policy instruments. Examples of such instruments are deposit insurance, supervisory guidelines, transparency codes and offering secure settlement systems. A combination of responsibilities for monetary policy, payment and settlement systems, and prudential supervision makes a central bank particularly well-equipped for its role as a ‘guardian of financial stability’. Our experience at the Nederlandsche bank shows that these three tasks are complementary. Vital information can be exchanged quickly within the same institution, which makes it easier to take appropriate actions if necessary. Furthermore, the three disciplines benefit from each others’ expertise, which makes it easier to deal with complex problems. For example, macroeconomic analyses for the preparation of monetary policy may also be valuable for supervision, if banks have a large exposure on sectors in the economy with a weak performance. In addition, as financial market participants, central banks automatically obtain information about market sentiment and specific financial institutions, which is useful for their supervision task. By contrast, separate supervision agencies have to do without this direct source of information. Let me give you a concrete example of how macroeconomic information can feed into supervisory practices. During the second half of the 1990s the growth rate of mortgage lending in the Netherlands accelerated to more than 20% per year. At the same time, house prices doubled in about five years. This was worrisome, not only because of inflationary risks, but also because excessive asset price inflation could eventually threaten financial stability. Specifically, there was a risk of a self-reinforcing spiral, with rising property prices leading to higher loans and vice versa, and with house prices departing from their intrinsic value. To get more grip on the underlying forces, the Netherlandsche Bank carried out an in-depth study among banks, based on both monetary and supervisory data. In this way, we obtained a clear insight in the development of bank lending criteria and other demand and supply factors, which made it easier to take appropriate measures in the supervisory field. Specifically, we urged banks to improve their administrative controls and to carry out more stress tests to assess the vulnerability of their loans portfolios, and extended banks’ monthly reports of their mortgage lending. The terrorist attacks on the World Trade Center on September 11 last year again illustrated the benefits of having monetary policy, payment systems and supervision under one roof. This was a direct attack on the world’s main financial center, and the stability of the international financial system was at stake. A prompt and adequate response of policymakers was crucial to mitigate financial stability risks. At the Nederlandsche Bank, we immediately organised a crisis meeting with our Governing Board and the heads of our departments of payment systems, supervision and monetary affairs. In the subsequent hours, we were able to take stock of the main potential problems in the payment systems, liquidity problems in the money market and the situation at Dutch banks. Together with the other central banks in the eurosystem, the Nederlandsche Bank provided a liquidity injection of almost 70 billion euro, which proved to be sufficient to help the money market clear. The close cooperation and direct information exchange between the Bank’s various departments has truly facilitated the crisis management process. In this context, it should be stressed that the concerns that were at stake forced us to act quickly in a demanding environment characterised by uncertainty and risks of information shortages. It goes without saying that changes in the financial landscape have strengthened the international dimension of financial stability. This is especially important for Aruba and the Netherlands, as we are both small, open economies. Given our economies’ international exposure, we both have a key interest in a well-functioning, sound international financial system. Because the main Dutch financial institutions have become global players, shocks may come from many sources. This has made supervision more complex. Aruba’s position as an Offshore Financial Center (OFC) has also implications for its supervision policy, given the increased international attention for OFCs. In the past years, the international community has become more demanding towards OFCs. Of course, this is related to the fight against money laundering, tax competition and, most urgently, terrorist financing. Nonetheless, from the perspective of financial institutions there are legitimate reasons to use OFCs. Prime motives are low taxes and limited bureaucracy. There are also legitimate reasons for countries to develop an OFC. For Aruba, for example, it is an attractive way to diversify its economy, which is dominated by the tourism industry. In addition, historical factors make Aruba wellsuited as an OFC. The country has a sound legal system, is politically stable, has a well-educated population and has relatively good airline and telecommunications connections. An OFC can also have a positive impact on the resident financial sector, through better access to international capital markets and more financial expertise. However, despite these advantages, many OFCs realise that they cannot ignore the growing concerns regarding their role in the international financial system. Let me elaborate on the importance of OFCs for international financial stability. Note that in our definition, we defined a stable financial system as a system that prevents shocks from having a disruptive effect on the real economy, but also on other financial systems. The latter part of this definition has become more relevant as financial systems have become more interrelated. The importance of OFCs for international financial stability can be illustrated by a few figures. In the first quarter of this year, BIS reporting banks’ claims against OFCs comprised almost ten percent of their total cross-border claims, creating a total risk exposure of almost 400 billion US dollars. These exposures are larger if off-balance-sheet activities are taken into account. In addition, insurance corporations and investment funds also use OFCs. Unfortunately, information on these off-balance and non-bank exposures is scarce. Two years ago, the Financial Stability Forum identified OFCs as a weak spot in the international financial system. In particular, OFCs were spurred to strengthen their supervision and regulation frameworks and co-operate more intensively with the onshore authorities. Subsequently, the IMF has been asked to monitor the progress in this area, by carrying out Offshore Financial Sector Assessments. For Aruba, this assessment was completed in June of this year, and looks very encouraging. After all, only two years ago Aruba was classified by the Financial Stability Forum as one of the OFCs with legal structure and supervisory practices of a lower quality. Compared to other OFCs, offshore banks and insurance corporations are relatively unimportant in Aruba. By contrast, the large number of small, corporate vehicles is of particular interest. Actually, almost 5000 offshore corporate entities are registered on the island. Up to now, these were not supervised and not very transparent, and therefore represented a potential risk from a financial stability point of view. Following the IMF’s recommendation, however, the Central Bank of Aruba will probably be appointed as regulator of this sector. In particular, the Bank will supervise Company Service Providers, which act as legal representatives of the offshore corporate entities. As a motivation for recommending the Central Bank of Aruba, the IMF stressed synergies with the Bank’s other tasks. I agree. As I already indicated, at the Nederlandsche Bank we see important advantages of having various activities under one roof, and I am convinced that this new task will further strengthen the Central Bank of Aruba’s position as the guardian of financial stability. Ladies and gentlemen, let me conclude. Because of the rapid changes in the international financial landscape, central banks need to be flexible, indeed more flexible than in the past. By considering financial stability as their main responsibility, central banks should be able to take up new tasks. Both the Central Bank of Aruba and the Nederlandsche Bank have proven to be flexible organisations. As small, open economies, Aruba and the Netherlands are more vulnerable to external shocks and therefore have a particular interest in maintaining financial stability at a global level. Given this common interest, I am sure that the relationship and kinship between our central banks will remain as close as it has been in the past 16 years. | netherlands bank | 2,002 | 11 |
Address by Dr Nout Wellink, President of the Nederlandsche Bank and President of the Bank for International Settlements, at the Euro Seminar: ¿A test of faith¿ in Tokyo, Japan, 26 November 2002. | Nout Wellink: Current issues in European monetary policy Address by Dr Nout Wellink, President of the Nederlandsche Bank and President of the Bank for International Settlements, at the Euro Seminar: “A test of faith” in Tokyo, Japan, 26 November 2002. * * * It is always satisfying for those of us who have been closely involved in the birth of the euro to see how widespread the interest in the new currency is. Actually, the birth of a new currency is in some respects similar to the birth of a child. You can prepare for both, but you soon have to learn that you cannot fully control how it develops. Both children and currencies develop a life of their own – and you are frequently faced with unexpected challenges. Similarly, you are pleased when others take an interest in your child. I think that I can safely say that we are now through most of the birth pains of the new currency and can now concentrate on the ‘normal’ challenges of monetary policy. My colleagues at the Bank of Japan are certainly well aware of the fact that challenges continue to develop. In that respect we have much to learn from each other. Consistent with this observation, my comments today will not be on the immediate outlook for euro area monetary policy. Instead I will dwell on some issues that are – to a large extent – topical in discussions on central banking around the world. They include the risk of deflation, risks to financial stability, how to cope with oil price hikes, fiscal policy developments and the enlargement of the monetary union. I hope that my comments will provide insights into the way we approach these issues within the Eurosystem. Is there a risk of deflation? Let me begin by responding to the question of potential deflation in the euro area. A number of countries around the world are currently experiencing falling prices. In contrast, Alan Greenspan has noted that he considers that the US is not close to the deflation cliff. Before discussing the euro area situation, let me first note that persistent deflation is damaging – at least as damaging as persistent inflation, and the risks are non-linear. A small fall in prices need not be damaging, but an ongoing fall certainly is. There is no need to dwell on that here – you know that better than I do. This aversion for deflation is captured in the ECB’s definition of price stability. We define price stability as a year on year increase in consumer prices of less than 2% and seek to maintain that over the medium term. In practice, we have a preference for inflation lying within a range between around 1 and 2%. This reflects potential measurement error in price indices as well as our desire to avoid deflation. Having flagged our aversion to persistent deflation, let me turn to the substance of the question. My answer is clear – in the present situation I see no immediate risks of deflation in the euro area, albeit for the wrong reasons. Service price inflation accounts for around 40% of the HICP index and competition in this sector is rather low. In addition, the sizeable government sector has a role in price setting in many areas. Both factors tend to put a floor under price increases. Our wage and price setting mechanisms are simply not flexible enough to allow widespread or persistent deflation in the absence of a severe or prolonged recession. Although formal wage indexation in Europe is considerably lower than in earlier decades, we are not at the point where nominal wage cuts are likely to be broadly accepted. Similarly, nominal price declines are also rather rare. Deflationary risks generally arise from one or more of the following factors – the bursting of an asset price bubble, difficulties in the financial sector or ongoing losses by businesses. Clearly these triggers are generally interconnected, and can reinforce each other. These interdependencies make deflation such a difficult problem and its impact widespread and corrosive. Turning to a discussion of these triggers, a prolonged or severe recession is not what we are currently experiencing. In fact, we are in a situation where the relatively quick recovery we observed in early 2002 seems to have stalled. Part of the reason why we continue to feel that we are in a difficult situation is that we had hoped that the recovery would be rapid. At the beginning of this year we expected that economic growth would be close to trend by the end of this year. In fact, growth will remain substantially below potential this year and the recovery is unlikely to gain much momentum until next year. I do not want to go into the reasons behind that now. My point is simply that the current downturn is not sufficiently severe to generate deflationary pressures. And as I will argue below, the same conclusion holds as regards the other possible triggers for deflation – asset price declines or financial sector fragility. Overall, therefore, I am confident that Europe will not experience a period of persistent deflation – and the associated problems that this could cause. I can also assure you that we are aware of the risk. In particular, we are aware that it is difficult to put the deflation genie back in the bottle once it has come out. If signs of widespread problems emerge, we will act swiftly to counter them. An advantage of our measured monetary policy response to date is that we have plenty of policy room available to react if necessary. Is there a risk to financial stability Closely related to the question of deflation is the issue of financial stability. A period of deflation could be caused by, or contribute to, financial stability problems as real debt burdens rise and borrowers struggle to service their debt commitments. Again, I expect that you know more about this than I do. However, let me give you my interpretation of recent developments in Europe and their implications for financial stability. Asset price declines One concern has been that recent stock price declines could trigger financial instability by weakening balance sheets across the economy. Clearly there has been a significant adjustment in stock prices around the world over the past year or so. Europe has also been affected. European stock prices are now back around the levels seen in 1998 and have fallen by around 30% since the beginning of this year. Nevertheless, to put this fall in perspective, stock prices remain well above 1996 levels, which was when Chairman Greenspan made his comments on irrational exuberance. This holds true even when you adjust for inflation. Regardless of whether or not stock prices are too high, a decline of the magnitude we have seen is bound to have some impact on the macroeconomy. At the Dutch central bank we have estimated that a sustained decline of 30% would have a cumulative negative impact of just over ½ % on European growth over three years. Our model implies that there will be an insignificant impact on prices. However, these estimates are for the direct influence of lower stock prices only and abstract from confidence effects. As an aside, it is interesting to note that the wealth effects from changing share prices are considerably stronger in the United States. For example, a fall of 30% in US share prices results in a cumulative negative impact of over 3½ percent of GDP over the same three year period. There would also be a negative impact on consumer prices of a little over ½% over three years. The different impacts stem largely from the lower extent of share ownership in Europe than in the US. Although direct share ownership is gradually spreading in Europe, it remains considerably less widespread than in the United States. In addition, market capitalisation as a percentage of GDP is around 70% higher in the United States than in Europe. House prices are the other major component of household wealth. Any widespread and significant decline in house prices would have a more substantial effect than stock price declines. This is particularly true for the euro area, where homeownership is more widespread than direct share holdings. Estimates suggest that a 30% fall in house prices would have a cumulative negative impact on GDP of over 1% in the euro area. For the US the comparable figure is over 3%, although I should note that these house price estimates are very imprecise. There are signs that the rapid house price increases some of the smaller euro area countries have experienced are coming to an end – that is certainly the case in the Netherlands. However, actual declines in house prices seem to be concentrated in only a few segments of the housing market in some euro area countries. In particular, they are concentrated in the more expensive end of the market, where there is likely to be an interdependence with the adverse demand effects stemming from capital losses in the stock market. I do not expect substantial declines in house prices to be widespread across the euro area. Banking system concerns The banking system in some parts of the world is being tested as a result of the current economic slowdown and the associated credit losses. Still, the European banking sector shows, broadly speaking, no sign of any widespread distress of the sort that might lead to financial stability concerns. In fact, the banking system has come through the recent decline in share prices, crises in Latin America, and the economic slowdown, rather well. European banks generally have smaller shareholdings than Japanese banks, so their exposure to falling share prices is lower. Some consider that the German banking system is vulnerable, although I think that it remains fundamentally sound. There are signs of increasing risk aversion, as lenders distinguish more carefully between rating classes. This is showing up in wider credit spreads and in some cases in limits on lending volumes. Supervisors are alert to these trends. In the Netherlands we continue to conduct a range of stress tests to assess the vulnerability of the financial system to further shocks. We closely monitor exposure in particular markets, including in real estate, which have been a cause of problems in some countries in the past. Stress tests and monitoring have the further advantage of making the management of financial institutions more aware of the risks they face. Discussions at Basel on the new capital accord also place more attention on stress testing. My conclusions on financial stability are therefore clear. There are no signs of financial instability in the euro area. I hope, and central banks throughout the Eurosystem are committed to ensuring, that this will remain the case. Problems that may be experienced at a few banks are not indicative of problems across the euro area as a whole. In any event, central bankers, including myself, are continuously assessing financial stability risks. I will not pretend that we will always be able to prevent instability occurring. The world and financial markets change rapidly and the lessons that we can learn from earlier experiences need to be updated. However, I do hope that we can reduce the chance of instability. Oil prices, conflict in the Middle East and the impact on monetary policy Let me now turn to a risk that points to higher, rather than to lower, inflation. Oil prices have been one of the most significant influences on inflation over the past three years and they remain volatile. Given the impact that even relatively moderate oil price changes can have on inflation, this volatility poses an ongoing challenge for monetary policymakers. The possible consequences of any conflict in the Middle East only increase the uncertainty as we look ahead. Oil prices currently incorporate a risk premium, to an unknown extent, regarding a possible Middle East conflict. Therefore, the additional impact on prices from a conflict is unknown. It is also possible that oil prices could decline within a short period of time. Any conflict might also result in an exchange rate reaction, although the direction and size of this is unknown. It is possible to develop plausible arguments both for and against a strengthening of the US dollar. Given these uncertainties, I am not going to try to forecast the exchange rate. If I could do that with any degree of accuracy, I would probably be sitting on your side of the room as an analyst or trader, rather than standing here as a central banker. Whichever way the exchange rate moves, its impact could be critical in determining monetary policy reactions – not only in Europe, but also in other countries. Policy makers with appreciating currencies will have less need to tighten policy – or more room to ease – than those confronted by depreciating currencies. So, instead of trying to achieve the impossible task of describing the precise policy response to any conflict, I will say something briefly about the framework we use in assessing the issue. An obvious but sometimes overlooked point is that ECB monetary policy is based on an comprehensive assessment of the outlook for price stability. This is affected, but not solely determined, by movements in oil prices. To the extent that oil prices do alter the outlook for price stability, we try to look through the so-called first round impact, but try to counter any second-round impact. In the oil crises of the 1970s, we learned that we need to prevent an upward wage-price spiral developing. Luckily this is nowadays easier to achieve for two reasons. Firstly, there is less wage indexation so such a spiral is slower to develop. Having inflation expectations anchored at low levels also helps. The second key factor is that our dependence on oil is now lower. Fiscal policy developments and the Stability and Growth Pact Let me now turn from issues closely connected to monetary policy decisions, to two that form part of the environment within which we operate. The first is fiscal policy. While all central bankers sometimes face challenges from fiscal policy makers, I think that those in the euro area are rather unique – and stem from the fact that we are a monetary union of sovereign states. Within Europe there is clarity and consensus about the institutional framework covering the relationship between fiscal and monetary policy. Despite this consensus, discussions continue about the detailed implementation of the framework. As you know, a number of countries have made insufficient progress towards fiscal consolidation in recent years. Some countries are not going to reach a balanced-budget position by 2004, as intended. More seriously, several have, or are likely to, post deficits exceeding 3% of GDP. The lacklustre economic climate obviously plays a part in explaining this fiscal slippage. Equally obviously, several countries failed to make sufficient consolidation efforts during the earlier period of robust economic growth. Instead, they took advantage of the growth years to lower taxes and raise spending in the mistaken belief that the good years would never end. Sadly, one of life’s lessons is that all good things eventually come to an end. Countries that did not follow the rules are now suffering the consequences. Again, the analogy with children comes to mind. As any parent knows, children need clear rules – and these rules need to be enforced. Both parents and monetary policy makers understand the need to be consistent if credibility is to be maintained. We’ve learned that the hard way. The same rules of life apply to fiscal policy. Credibility suffers if you do not do what you promised to do. Moreover, if these rules are not adhered to, problems could also develop in other areas of common European policy. Enforcement mechanisms will lack credibility. In a sense, it is this risk of the loss of credibility that is most concerning about current developments in euro area fiscal policy. Everyone agrees that there can be no return to the large fiscal deficits of the 1970s. That simply crowded out private sector investment. The importance of reaching a sound fiscal position is reinforced by the need to plan ahead for the fiscal consequences of population ageing. Postponing the adjustment will not make it any easier – and nor will the problem disappear. Had countries undertaken the necessary fiscal consolidation in the good years and reached a position of fiscal balance, the 3% deficit limit imposed by the Treaty would have been sufficient to deal with the slowdown. However, we should keep the current events in perspective. The budget deficit for the euro area as a whole is expected to just over 2% of GDP in 2002 and 2003. By way of comparison, the US deficit is expected to be over 3% in both years. Enlargement of the European Union and the European Monetary Union The last issue that I want to discuss today concerns European enlargement. As you know, up to 10 countries are likely to join the European Union in 2004. Two years later, at the earliest, these countries could be eligible to join the monetary union and to participate in the decision making processes within the ECB. Some commentators have argued that enlargement could prove damaging for the expanded monetary union. Two main arguments seem to be given. The first is that decision making will prove impossible within such a large group. The second is that if economic conditions in accession countries are different from those in the rest of the euro area, and their governors vote on the basis of national economic circumstances rather than euro area developments, monetary policy settings will be incorrect. Let me first cover the discussion about the number of decision makers. In comparison with other central banks, the current size of the ECB’s Governing Council is large. We have 18 members. That has not been a problem in taking interest rate decisions to date. In fact, my experience is that we are able to efficiently discuss the key issues and reach our decisions. Nevertheless, we cannot continue to expand the Council without limit. However, the problem is, in my view, largely one of perception. There are concerns that we will be unable to take decisions efficiently and that enlargement may lead to a focus on national developments, rather than on the euro area as a whole. To address these concerns, a rotation model might be introduced that would restrict the number of national central bank governors with a vote at any point in time. The United States Federal Reserve uses a form of rotation for their Federal Open Market Committee. However, let me stress that I do not expect the substance of our discussions or decisions to change. The fact that we will all continue to participate in discussions, even if we have no vote, will facilitate this continuity. Our focus will continue to be on the euro area as a whole. Conclusions Looking at the key issues currently facing us at the ECB, it seems to me that our new currency has rapidly ‘grown up’. Our challenges are no longer those uniquely associated with the birth of the euro. Instead, we are mostly concerned with issues that are challenges for central banks around the world. That doesn’t make our job easier, but does at least mean that we are moving out of uncharted territory. Of course, financial market analysts and the media have also had to get used to the issues we are confronted with, and our style of dealing with those issues. I think that our coming of age as a currency is also reflected in the comments we now attract from analysts and the media. There seems to be increasing understanding about what we are trying to do and how we go about it. There is, naturally, always room for improvement. I hope that my comments today have made a contribution in this respect by adding to your understanding of how we go about monetary policy formulation within Europe. | netherlands bank | 2,002 | 11 |
Address by Mr Nout Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, on the occasion of AkzoNobel¿s New Year¿s function for its management, 8 January 2003. | Nout Wellink: The business cycle in perspective Address by Mr Nout Wellink, President of De Nederlandsche Bank and President of the Bank for International Settlements, on the occasion of AkzoNobel’s New Year’s function for its management, 8 January 2003. * * * You are of course familiar with the phenomenon of perspective distortion, which makes things close by look bigger. Interestingly, the effect becomes less strong as the distance from onlooker to object increases. Similarly, a certain distance in time is often required in order to put things in their right perspective. This is why historians so seldom discuss events of less than several decades ago. Economists and policy makers, however, cannot afford to keep that much distance. And by consequence, much of what they write and say shows the effects of perspective distortion: the current recession invariably looks greater than the previous one. Architects in 15th century Florence discovered how to draw a correct perspective. Much later, the architects designing the building of the Nederlandsche Bank used this knowledge: By making the tiles that line the outside of the building larger for higher stories, they cancelled out the distortion in the eye of the observer below. Today, I have set myself the ambitious goal of putting the business cycle in perspective. I intend to regard recent cyclical developments in the light of preceding business cycles. This gathering presents an eminent opportunity to discuss the international and Dutch business cycles, for AkzoNobel is an international concern - active in 80 countries. But you are also a Dutch company, with its head office established here and almost 20 per cent of production concentrated in this country. At the same time, I suspect that AkzoNobel has a greater than average interest in the analysis of cyclical developments: An important part of the firm’s activities - basic chemicals - may be characterised as early cyclical. For us, incidentally, this makes companies in this sector interesting, because they provide a leading indicator for the business cycle. The economic slowdown since the year 2000 has so far been roughly simultaneous in Europe and North America. It has often been claimed that this is the result of the increasing economic intertwinement of both large blocks. That increase can, of course, hardly be denied. World trade today represents 17% of global production, against only 8% in 1914. And this excludes the increased internationalisation of businesses, through the establishment of branches and plants abroad and through cross-border mergers. Also highly visible is the fact that the connection between financial markets has become stronger over time. The terrorist attacks in the United States and the dubious accounting practices revealed in the aftermath of the Enron collapse have hurt stock market sentiments world-wide. Recent research conducted at the Bank confirms this image: the correlation of German, British and US share prices has more than doubled over the past twenty years, from around 0.30 to 0.65. The simultaneous cyclical movements of the large economies are not determined primarily by increased intertwinement but through the occurrence of global shocks. Cyclical coherence between Germany and the US was especially strong in the aftermath of the oil crises of the 1970s. The current cyclical harmony is explained by two recent global shocks: the oil price rises and the bursting of the ICT bubble. Almost continuously for the ten years up to 1998, oil prices moved within a bandwidth of 10-20 euro per barrel. In the course of 1999 and 2000, however, the oil price rose by almost 300% from the lower limit of this bandwidth to over 37 euros. Since late 2000, oil prices have come down under the impact of global economic slowdown. But a possible war against Iraq might push them up again. The second shock was caused by the bursting of the ICT stock market bubble. Share prices of ICT companies took a plunge from the peak reached in March 2000, losing two-thirds of their value. ICT investments - which in the US had risen by 10% to 20% every year since the early 1990s - have been falling since mid-2000. The present synchronicity of international cyclical movements has largely been caused by these two shocks. There is a good possibility, however, that the international convergence will dissolve again when the effects of both shocks have ebbed away. When the tide turns, the speed of recovery may be different on both sides of the Atlantic. Another, related phenomenon is the decline in amplitude which cyclical waves have shown in recent years. In most industrialised countries, cyclical movements have been strongly damped since the first half of the 1980s. Several explanations have been offered, one of which is the gradual shift in the economy from industry to services. This may cause damping because fluctuations in industrial production tend to be relatively large. The share of services in overall employment has increased from 47% in 1960 to 70% today. However, research based on US figures shows that this shift has played only a minor part: it appears that the industrial and the services sectors both follow more stable patterns than they did a few decades ago. A second explanation offered for cyclical damping is that ICT developments have led to improved inventory management efficiency. ICT applications have enabled businesses to organise their inventory management in more efficient ways. But ICT applications have not helped predict the future development of consumers’ inclination to spend. If consumers spend 100 million euro less than expected on their Christmas shopping, stocks increase by 100 million euro’s worth. In other words: greater or smaller-than-expected sales affect inventories just as much as they did ten years ago. Therefore, the observed damping of the business cycle must be attributable to other causes. A third explanation given for the flattening of cyclical patterns is that monetary and budgetary policies nowadays tend to be aimed more towards the medium term. Over the past two decades, monetary policy has succeeded reasonably well in curbing inflation, thereby enhancing the predictability of the macroeconomic environment. The risk that a cyclical boom will trigger a wage-price spiral has also diminished. As for budgetary policy, the 1960s and ’70s were characterised by activism, which served to magnify rather than damp cyclical movements. The 1980s were the years of austerity measures, taking away the potential stabilising effects of public finance. Since then, the budgetary position of the Netherlands - and of some other countries - has greatly improved, allowing a trend-based budgetary policy to be pursued. Such a policy implies that in principle, public finance has a damping effect on the business cycle. In the meantime, however, developments in the US show that active budgetary policy is not yet entirely a thing of the past. The US budgetary position (as a percentage of gross domestic product) has deteriorated by 4½ percentage points in just two years’ time. A fourth factor connected with cyclical damping is the fact that fewer global shocks have occurred during the last twenty years. So damping is also a matter of chance. The 1990-91 recession in the US, for instance, was mitigated somewhat by the boost which the European economy received from German reunification and which kept up the level of US exports to Europe. A few years later, the reverse happened. Despite the multitude of possible causes, only 40% to 60% of the damping effect can be explained. The latter two factors - less activist budgetary policies and fewer global shocks - each account for 20% to 30% of cyclical damping since the early 1980s. Against this background of more moderate cyclical movements, I should like to "zoom in" on the current cyclical downturn in the Netherlands. Contrary to some allegations, this downturn is not very different from previous periods of cyclical decline - in fact, it is a textbook case. The depth of the cyclical trough clearly varies across cycles, but its average level has been 1½ to 2 per cent below the trend. Thus over the past decades, cyclical lows in the Netherlands have tended not to bring an actual shrinkage of the economy. The current five-quarter period of nearly zero growth also appears set to steer just clear of recession. What was unusual about the last cycle was the length of its upturn. After the economy had reached its potential production level, there followed three more years of relative strong growth before the cycle turned down. The prolonged rise is attributable to consumer spending. A strong autonomous increase of employment led to a favourable development of households’ incomes. This, combined with low real interest rates and a generous disposition by mortgage lenders, led to a sharp rise in housing prices. The withdrawal of the resulting equity on the value of home property gave a strong additional push to household expenditures. The decline also shows a few distinct features, most prominently the development of foreign trade. In the past, a decline in the Dutch business cycle usually began with a fall in exports - which should not come as a surprise in such an open economy. This time, however, the downturn in exports was somewhat delayed, indicating that the current cyclical movement has been driven to a much larger extent than usual by domestic factors. The decline of investment demand set in relatively early on and has been stronger than average. On the face of it, the situation here seems to parallel that in the United States. There, the recent slowdown seems to have been initiated by the fall in ICT investments. The development of other investments (i.e. excluding ICT) has been relatively stable. But things are different in the Netherlands. It is true that the share of ICT in total investments increased strongly from 1995 to 2000, from 11% to over 16%. But the cyclical curve of non-ICT investments hardly deviates from the overall pattern. The fall in investments in the Netherlands is mainly attributable to an erosion of private sector profitability from 1998 onwards. The early slump in investment growth seems also to have been caused by supply restrictions, for instance in the construction industry: during the second half of 1999, almost 80% of vacancies in construction were difficult to fill. Reinforcing the downturn in investment demand was the incipient deflation of the stock market bubble from the third quarter of 2000 onwards - a few quarters after the cyclical turning point. Added to this, the sharp increase in housing prices levelled off in 2001, and with it the boost it had given to consumer spending. This has had a negative impact on private consumption. Another remarkable feature of the current downturn is the fact that Dutch inflation has risen relatively strongly, not only compared to earlier business cycles, but also compared to other euro area countries. In all EMU countries, inflation was pushed up by rising oil and food prices and the decline in the exchange rate of the euro. In the Netherlands, however, this development was compounded by the unusually low rate of unemployment reached well before the cyclical peak in output. Labour market tightness resulted in strong wage increases, and hence in an acceleration of the Dutch inflation rate. Dutch prices have risen more sharply than elsewhere in Europe, and I do not have to tell this audience what that means for Dutch competitiveness. And although the difference in inflation between the Netherlands and the euro area has declined from 2.2 percentage points in January to 1.2 percentage point in November. This indicates that the rate of deterioration has come down. It does not mean that any lost ground has been regained. Analysing recent cyclical developments is not an art for art’s sake. Understanding the nature of the downturn may contribute to more accurate economic projections. The ongoing adjustments in the Dutch business sector, like those elsewhere in the euro area, have not been completed. Thus far, the US economy has appeared the more resilient. Recovery on both sides of the Atlantic is therefore unlikely to be simultaneous. According to the latest figures, the US economy has already returned to 2½ per cent growth over the past year, whereas the recovery in Europe which was expected for the second half of 2002, failed to materialise. Current expectations are that the European economy will only start to pick up in the course of 2003 - the latest economic projections by CPB, the Netherlands Bureau for Economic Policy Analysis, predict 1¾ per cent growth for the euro area during 2003. The inflation picture is rather flat, with a projected 2% on average for 2003. The projections are surrounded by fairly large uncertainties. I want to mention the developments of the dollar exchange rate and the price of oil in particular. Since 2000, the growth of the Dutch economy has lagged behind that of the euro area, whereas our economy used to outgrow that of the euro area during nine out of ten years in the 1990s. During the past year, the Dutch economy has hardly grown at all, for a number of reasons. Declining stock market prices, rising unemployment and political tensions in the Middle East have sharply depressed both consumer and business sentiments. Added to this, the wealth effect of rising house prices on consumer spending has disappeared. The economy will recover only slowly in the next few years. According to the CPB, economic growth will be only ¾ per cent in 2003, which is well below the projections for the euro area as a whole. Both business investment and employment are expected to show negative growth in the year to come, while Dutch exports will fall behind the expected growth of world trade. At the same time, the inflation rate for the Netherlands is estimated to come out at 2½ per cent. This means that the decline - from an excessively high level in 2001 continues. I have reached my conclusions. Or rather, returning to the terminology of spatial perspective, I have reached the point at the horizon where all lines merge: the central vanishing point. In this address, I have been dicussing recent cyclical developments in the light of previous business cycles. Basing my argument on a quantitative analysis, I have attempted to avoid being deluded by perspective distortion. Regrettably, it will be some years before we may determine how successful my attempt has been. | netherlands bank | 2,003 | 1 |
Address by Dr Nout Wellink, President of the Nederlandsche Bank and President of the Bank for International Settlements, at the Conference on ¿Women at the Decision Making Positions¿, organised by the Rusian Association of Regional Banks, Amsterdam, 24 February 2003. | Nout Wellink: The position of women in the financial sector Address by Dr Nout Wellink, President of the Nederlandsche Bank and President of the Bank for International Settlements, at the Conference on “Women at the Decision Making Positions”, organised by the Russian Association of Regional Banks, Amsterdam, 24 February 2003. * * * I rarely have the privilege of addressing an audience largely made up of women. That in itself is telling - and is not a good sign. But the fact of the matter is that the financial world is still dominated by men. That applies to both commercial and central banks, and the Netherlands is no exception. So, in the run-up to International Women’s Day, you have every reason to hold this conference to focus on the role of women at senior management levels in the financial sector. The position of women in the labour market can and must be improved, notably in the financial sector. That’s not just because I think women deserve a better deal but also, if not mainly, because it would be good for companies and for society as a whole to see an improvement in women’s labour market participation and their chances to advance to the top. The world would be a bleaker place if it only consisted of men, and the same applies to organisations. An organisation with a mix of men and women on all levels has a more pleasant atmosphere, which possibly makes for a better performance. Moreover, the economy as a whole will benefit from higher women participation rates, for the participation rate among women in the euro area is one of the reasons why the growth of income per capita here lags behind that in the United States. And women should be appropriately rewarded, of course. Which reminds me of what was written about Alan Greenspan in a recent biography. When still running his own financial consultancy, some 40 years ago, Greenspan chose to recruit women rather than men. His motivation was purely rational. He was convinced that women were just as qualified as men, but since the labour market did not fully appreciate the quality of women they were undervalued and hence cheaper. Greenspan used his sharp insight to benefit from this arbitrage opportunity. Back to the present day. The good news is that in the euro area the labour market participation for women aged between 24 and 45 is far higher than that for those of 45 and over. This indicates an improvement over time and is a promising development. The bad news is that women still lag far behind in terms of qualitative participation. Let me keep to the Netherlands on this point. According to a report by our Social and Cultural Planning Office a few years ago, not a single woman sat on the Managing Boards of the top 25 Dutch companies. In the top 100, there was only one woman to over 400 men, and women made up no more than 2.5% in the top 5000. The situation on the Supervisory Boards was better, but with an average of one woman to 12 men, still not exactly positive. And as far as our banking sector is concerned, I am not sure whether we would have sufficient women top managers to create a delegation like yours. As regards the position of women in senior management, I must unfortunately share some of the blame. The Nederlandsche Bank has one women among the 12 members of its Supervisory Board. Prince Claus, the late husband of our Queen Beatrix, was instrumental in getting her on our Supervisory Board by stressing time and again that the successor to him should be a woman. Our Governing Board is made up entirely of men, so in that respect we have a lot to learn from your country. Two of our eight deputy executive directors are women. While this is an improvement on the past, we still have a long way to go. We are hence actively working on a plan for a larger number of women at the Nederlandsche Bank, with more advancement to the top. Before I tell you how we intend to do this, let me first go into the reasons why women lag behind. Both demand and supply factors play a role. As regards demand, all too often, women are passed over as potential candidates for recruitment or promotion. Whereas some feel that this is done with intent, I am inclined to think that it is an unconscious process, arising from a stereotyped view of men and women. In fact, research indicates that men are inclined to appoint men, and women are inclined to appoint women. Since management traditionally consists of men, it is easy to see where the glass ceiling comes from, and that it will not disappear unless we make a conscious effort. Turning to supply, and women themselves have a role to play here, several causes present themselves. Women are less self-confident than men, are not as quick to think that they’re suitable or to push themselves forward. That is not just my impression, it has been confirmed by psychological research. Another factor is that women sometimes have other preferences in respect of combining their career and family. That is only to be respected and means that, wherever we can, we should create the conditions for combining work and childcare. Not every job can be done part-time but there are plenty of positions, even at senior levels, that offer the flexibility that women prefer because of personal circumstances. That brings me to the Nederlandsche Bank’s policy in this area. Let me begin with the plus-es. Our general terms of employment are well-disposed towards women. We have a standard 36-hour working week, opportunities for all, including senior staff, to work part-time, flexible working hours and good financial arrangements for childcare. Our recruitment policy is geared to attracting women employees, and in fact over time more women, especially the higher educated who are the high potentials for advancing to the top, have joined the Bank. To give you some figures, whereas our percentage of female employees increased merely from 30 to 34 percent over the last 6 years, the percentage of women in the higher salaried positions has doubled in that period. But, and that is a minus, we apparently don’t do enough to allow women to advance to the top. Whereas 25% of our female employees has an academic background, only 11% reaches the level of senior management. So we still have a long way to go. One initiative in the Netherlands to promote the advancement of women in the boardroom has been the creation of a network of ambassadors, comprising top male executives in larger organisations who are willing to push for more opportunities for women. I was recently asked to join this network. As one of the ambassadors, I am obliged to draw up three personal points for action and to stick to them. Your conference gives me a wonderful opportunity to announce my three personal points for action or, to use words that I feel more confortable with, policy targets. If it’s up to me, what will the Nederlandsche Bank do in the near future to stimulate women’s advancement to the top? · My first personal point of action is to make it more visible, both to the outside world and to everyone working at the Nederlandsche Bank, that I am committed to promoting the career possibilities of women in our organisation. Research has shown that explicit commitment by board members makes women more confident to apply for senior positions. Moreover, it makes managers more aware that they are expected to pay attention to women candidates when it comes to promotion, and to be flexible when it comes to the demands of those who have the ambition to combine a career with the care of a family. This conference is one way to create this visibility, for which I thank you. Giving interviews on the subject is another and I promise that in the course of this year I will actively look for possibilities to get press coverage of my views on the subject. · My second point of action is to invite high potential women working at the Nederlandsche Bank for a discussion about the problems they encounter in their job fulfilment and career planning. If I want to promote opportunities for women in my organisation, I must have a clear picture of how they perceive the glass ceiling. I intend to discuss the outcome of these conversations with our management. I expect that from this exchange of information we will be able to draw lessons that may be translated in specific measures for improvement of the career possibilities for women. · For my third point of action I would like to draw upon that information. I intend to establish a (moving) target figure for the participation of women candidates in our management trainee programme. Not all high potential women may be interested in a career to the top, for the reasons I mentioned earlier. But, depending on the number of women that are, I will establish a target rate of participation of women in our management development programme. Moreover, when it comes to promotions I want every shortlist to contain as a rule at least one woman. Sticking to these three personal points of action, or policy targets, is a question of commitment. Being a central banker, I am well aware of the importance for my reputation of holding on to this commitment. But not only my reputation is at stake. Promoting opportunities for women in the financial sector is very important, as we are responsible for bringing out the best in our human capital, male and female. I hope that this conference, and the other activities being organised for International Women’s Day, will contribute to more equal and fair representation in management in general and in the financial sector in particular. | netherlands bank | 2,003 | 3 |
Address by Dr Nout Wellink, President of the Nederlandsche Bank and President of the Bank for International Settlements, fo... | Nout Wellink: The Nederlandsche Bank in the media - thorough openness? Address by Dr Nout Wellink, President of the Nederlandsche Bank and President of the Bank for International Settlements, for the conference of the Association of Editors-in-chief, The Hague, 30 October 2003. * * * In the novel “Being There” by Jerzy Kozinsky, Chauncey Gardener is an unworldly gardener who is rather simple-minded. For many years he tended an old man’s garden, completely isolated from the outside world. When the old man dies, he leaves the garden for the first time in his life. By chance, he meets the American president, who asks his opinion on the economic recession. Chauncey doesn’t understand and talks about his garden in reply: “In a garden, growth has its season. There are spring and summer, but there are also fall and winter. And then spring and summer again. As long as the roots are not severed, all is well and all will be well.” The President is so impressed by this unintended metaphor that he uses it in a speech. The illiterate Chauncey thus becomes a celebrity. The media seek his opinion on all kinds of subjects, and his pronouncements are seen as words of great wisdom. Chauncey’s statements went down so well because he unwittingly increased confidence in the economy. Confidence is essential for the functioning of our economy. Confidence in price stability ensures, for example, that incomes policy is not distorted by high inflation expectations. And thanks to confidence in the euro, you could go out and buy an expensive banker’s pinstripe suit - if you wanted to, that is - and pay with a wad of paper which cost only a few cents to produce. Promoting confidence may well be the core task of a central bank: confidence in the value of the currency and the stability of the financial system. Unlike Chauncey however, we back up our pronouncements with economic analyses. But we learn from Chauncey that communication is important too. And that’s what I want to discuss today. I’ll start by showing just how much the work of a central bank is influenced by communication and will then look at the relationship between the Nederlandsche Bank and the Dutch media. I’ll conclude with the Bank’s image in the press. Influence of communication on monetary policy For a central bank, communication goes beyond hiring a press officer. Communication touches on one of a central banks core tasks: implementing monetary policy. We obviously communicate about our other tasks too, such as the payments system and supervision, but in no other area is communication such an integral part of our objective. Short-term interest rates (money market rates) are controlled via monetary policy, but the economy is influenced largely through capital market rates. Capital market rates not only depend on prevailing money market rates, but also on expected future money market rates. So what is important for monetary policy is that a central bank can influence expected key interest rates. This calls for an open, transparent communication with the financial markets. Transparency enhances the effectivity of monetary policy since it provides more insight as to the way that a central bank interprets economic developments, and why it reaches certain decisions. Transparency hence makes for less “noise on the line” between the central bank and financial markets. Moreover, an independent central bank in a democratic system of government also has an obligation to observe transparency. I’m inclined to say that the more independent you are, the more transparent you should be. Monetary decisions have an effect on economic development. In addition, inflation reduces the value of assets and the purchasing power of income. Monetary policy therefore influences people’s prosperity. Unlike decisions on, say, the budget, monetary decisions are taken independently of democratically elected politicians. This independence enhances the credibility of a central bank. But precisely because of its independence, a central bank must account for its decisions. However, transparency is not an aim in itself, but belongs to the set of instruments needed to realise the central bank’s objective. The importance of transparency is also acknowledged by the European Central Bank. Duisenberg and as of the day after tomorrow, Trichet - holds a press conference once a month during which he responds to journalists’ questions. No other large central bank dares to do the same. The ECB President also speaks to the European Parliament four times a year. In addition, the ECB has a clear objective, namely price stability. This long-term objective of the ECB is clearer than that of the Fed, which must seek a balance between price stability and economic growth. Citizens and financial markets can be confident that the ECB will keep inflation low. And they do have that confidence, judging by the low inflation expectations that emerge in surveys and are reflected in the price of some financial instruments. Nonetheless, the ECB is regularly reproached in the media for a lack of transparency. The European Parliament, for example, recently called on the ECB, in announcing a decision on interests rates, to make public the minutes of the relevant meeting and the distribution of votes. I am not certain whether this information would actually enhance transparency. Minutes can also lead to misunderstandings, because the weight given to different arguments is not always clear. Besides, there is a danger that Member States would check out the consequences for their own country of their central bank President’s stance. That is not the intention, since all members of the ECB Council decide for the euro area as a whole. Integral publication of the minutes could also change the nature of the discussions. Nonetheless, we take the criticism seriously and regularly explore possibilities for improving communication, one result being a clarification of our monetary approach in May of this year. Communication not only influences policy, but also the policymakers. Central bankers are continuously subject to media attention. They can hence explain decisions and strengthen the confidence of market parties. But they also need to watch their step, because statements are sometimes interpreted like those of the Delphi Oracle. In other words, people hear what they want to hear. It is completely understandable that journalists enjoy analysing the decision-making in the ECB Council. But as a central banker, you must always be aware of how far these interpretations can go. The press likes to divide the members of the ECB Council into hawks and doves. And I once mentioned in an interview that structural reforms would lead to lower inflation, theoretically giving scope for interest-rate reductions. The next day’s headline in the Financieele Dagblad was: “Wellink: interest-rate reduction in return for structural reforms”. That is obviously not what I meant, but it shows that a slight remark can sometimes have major consequences. Nederlandsche Bank’s relationship with the media This brings me to the relationship between DNB and the media. The traditional image of central banks as ivory towers is outdated. The Bank has regular contacts with the media, and the days when it only communicated through publications such as annual and quarterly reports are long gone. Over the past year, members of the Bank’s Governing Board gave more than 50 speeches, and as many as 150 interviews and television appearances. In addition, during the introduction of the euro, a documentary maker from the Dutch broadcasting company VPRO extensively filmed routine activities within the bank - even the Governing Board at lunch. Our basic premise in these media contacts is complete openness. Obviously, there are limits, for example that we are - rightfully - prohibited by law from publishing information on individual banks. We are even relatively open on this point, witness an information session for journalists about the obligation of secrecy. Though I must admit that the session was off-the-record. In brief, we aim to inform the public in the most honest and open manner. That’s why our information officials are always ready to answer questions. But you won’t find any spindoctors such as Alistair Campbell, and leaks to the press are absolutely out of the question. The best example of the importance of the media is the introduction of the euro. For the Bank, this was not just a major logistical operation; informing the public was at least as important for the success of the euro conversion. The Bank made a concerted effort to provide information, for example on the security features of the banknotes and the exchange of old guilders. My firm impression is that the media also felt directly responsible for the provision of (critical) information. Our contacts with the media during that period were very intensive, since we wanted to reach as many people as possible within a short time. The Bank even used channels which we otherwise rarely encounter, the highlight being my own appearance in the women’s weekly magazine Libelle. At that point I could deliver the factual message off by heart, but the interest in the colour of my jacket came as a surprise. Following the euro introduction the Bank was subject to some criticism in the press, notably in respect of the possible inflationary effects. The idea quickly took hold that the euro had made life more expensive. Some 90% of the Dutch population were convinced of this in July last year, according to a Bank survey. Estimated inflation was then as much as twice as high as actual inflation. In itself, this perceived inflation is understandable. People had to become familiar with the new currency and the new prices, while strong economic growth had driven up Dutch inflation. Moreover, price increases were highest in the most visible sectors, such as catering and retail. Unfortunately, the impression arose that the Bank had deliberately underestimated the price-raising effects of the euro. That is not correct: as early as June 2001 we estimated that the inflationary effects could amount to between 0.2 and 0.7 percentage point. The corresponding increase in retail prices (the effect on daily purchases) amounts on average to between 0.5 and 1.8%. Initially, we thought that the inflationary effects would end up at the lower end of this range, and that is what we made public. This may have been a little premature, because, with hindsight, the inflationary effects appear to be closer to the top end. In my view, the provision of information on this point could have been better. Besides a source of news, the Bank is of course a consumer of economic news in the Dutch press. I find the quality of financial and economic reporting quite sound. Dutch journalists are generally wellinformed and are able to put news items quickly into context. The latter helps us to fine-tune our own analysis. It is good to know how others interpret economic and social developments, such as the consequences of austerity measures for society. But one is obviously extra critical when it comes to one’s own profession, so I do have some comments. Compared to the British, American and German press, economic reporting is less in-depth. Newspapers such as the Wall Street Journal, Financial Times or Frankfurter Allgemeine more often succeed in bringing analyses that give a surprising perspective or new insight. The Dutch press could also be a little more critical in the field of economics. I don’t wish to directly oppose a recent statement by my fellow supervisor Docters van Leeuwen, as to the reversal of the burden of proof, but if I had been a journalist, I would have gone a little further than simply reporting this standpoint. Just as an independent parliamentary press is essential for the functioning of a democracy, an independent economic press is essential for the functioning of a capitalist society. Scandals surrounding Lernout & Hauspie in Belgium or Baan and Ahold in the Netherlands came to light mainly thanks to the Anglo-Saxon press, and not the Dutch. In the small Dutch market there is obviously less time and manpower available for economic analyses or investigative journalism. But the press does indeed have a curious and critical attitude in other areas. So some improvements may be possible. A comparison with the Anglo-Saxon press also reveals some positive aspects. I think the Dutch press is generally neutral and balanced. Some English newspapers, say, take a consistently anti-EMU approach, in which the Stability Pact and the ECB’s monetary strategy always have to take the rap. Fortunately, you encounter that kind of prejudice far less in the Netherlands. This objectivity also holds true for more complex and politically sensitive issues. That struck me in the reports on the new distribution of votes following the accession of the new EU Member States to EMU. And on looking at a completely different section of the British press (the tabloids), then I appreciate the Dutch media’s total lack of interest in my private life. DNB’s image in the Dutch press So the Bank has an opinion about you, but we are also curious about your opinion of us. To communicate well, it is important to know how our message comes across. Another factor is that the role of the Nederlandsche Bank has been changed by EMU. We are no longer the guardian of the guilder, but the co-guardian of the euro, in line with the deliberately chosen federal structure of the European System of Central Banks. In addition, we supervise banks and - following the merger with the PVK - also the pensions and insurance sector. We also advise the government on numerous issues. The Bank commissioned a survey of its image among Dutch journalists. The results were not disappointing, but our efforts leave room for improvement. A surprising amount of journalists find that the Bank has a clear profile. Many mentioned our role as supervisor and the merger with the PVK. I also found it surprising that most people ascribe a wide role to the Bank, seeing it as an “important knowledge institute”, which “presents its opinion in many areas” and as a “cautious, critical observer of economic developments”. Critical notes were sounded too, of course. Many journalists have the idea that our set of tasks has been reduced, judging by statements such as that we are a “branch of Frankfurt”, “dull, without a clear function” and even “a 19th century phenomenon”. These comments are tough, but, as I see it, show that we still have much to explain. We are all too well aware that we need to adapt to a changing environment. For one, we are now in the process of a far-reaching reorganisation and merger. The positive reactions show that we are on the right path. I’d like to mention one other outcome from the survey. Some journalists found that the Bank had become more open and more approachable in recent years. Moreover, the Bank still has plenty of credibility. Words such as trustworthiness, soundness and independence clearly resonate in our image. The Dutch and European economy A speech for the Dutch media would of course not be complete without some news, but the news I had has been somewhat overtaken by the publication of the latest Commission forecasts for the European and Dutch economy. Our open economy has suffered considerably from the recent worldwide economic downturn. We are also contending with the after-effects of the boom in the late 1990s which eroded our competitiveness. This was a contributory factor in the abrupt reversal in Dutch growth from well above the EMU average to the lowest in the euro area. But there is light at the end of the tunnel. The American economy is clearly picking up. The crucial question now is whether the euro area, and the Netherlands in particular, can benefit from this revival. Owing to the poor growth figures in the first two quarters, the Netherlands will this year see a significant economic contraction. Growth is expected to be more negative than our last projection of –0.4% in the June Quarterly Bulletin, and will hence be closer to –1% than–0.5% over the whole year. According to the latest DNB projections, next year’s growth will barely exceed 0.5%. Despite these setbacks, the nadir of the recession is now behind us. Producer confidence has now reached its highest level this year, having shown an increase for four months in a row, while industrial order books and capacity utilization have slightly expanded. Although 2004 will still be a year of adjustment, solid foundations will be laid for a sustainable economy recovery. Wage moderation and cost-reductions will restore corporate sector competitiveness, renewing growth in business investment for the first time in four years. Thanks to this and other factors, growth in 2005 will return to its potential, a potential that will in due course benefit from the range of structural measures now in the pipeline. Despite the hesitant start, the economy will hence eventually gain full speed. Whereas the economic signals are green, all warning lights in the budgetary area in Europe are flashing bright red. Three countries have already crashed the red light, with a deficit exceeding the 3% ceiling under the Maastricht Treaty. France will do this next year for the third year in succession, and should hence be penalised. The penalty for France could reach 0.3% of GDP, representing more than EUR 4 billion. However, this fine need only be paid if France fails to narrow its deficit to below the 3% ceiling within two years. So France would have to break the rules until end-2006. Until that time, the amount of EUR 4 billion merely takes the form of an interest-free deposit, meaning that France only forfeits the interest on that sum. At an interest rate of 5%, that is equivalent to around EUR 200 million a year. Having driven through a red light, France should not look for excuses but should simply accept the penalty. Why should Italian farmers pay a total of around EUR 1 billion in European fines (for exceeding the milk quota), and a government that pays no heed to the rules be spared? I hope that I have given you enough material for further discussion. But I can’t say for certain since, as the story of Chauncey illustrates, messages can sometimes come across very differently than intended. | netherlands bank | 2,003 | 11 |
Address by Dr Nout Wellink, President of the Netherlands Bank and President of the Bank for International Settlements, for the Canadian Netherlands Business and Professional Association (CNBPA), Toronto, 27 January 2004. | Nout Wellink: Prospects for the European economy Address by Dr Nout Wellink, President of the Netherlands Bank and President of the Bank for International Settlements, for the Canadian Netherlands Business and Professional Association (CNBPA), Toronto, 27 January 2004. * * * Wellink is optimistic on the prospects for the Dutch and European economy. Structural reforms and budgetary discipline should be continued. Prospects for the European economy: the only way is up Ladies and gentlemen, according to your website, one of the reasons to join the Canadian Netherlands Business Association is “to celebrate cultural heritage through special events such as Sint Nicolaas and rijsttafel.” While I fully appreciate such events, I suggest to focus tonight on the prospects for the European economy. After all, given your business interests in the Netherlands, you will probably be most interested in the developments in economic prosperity in the Netherlands and in Europe at large, although I could certainly recommend a rijsttafel to you, if you do not know this yet. I will first address the growth perspectives in the Netherlands and Europe. Then, I will discuss two important preconditions for sustained growth: the continuation of structural reforms and the maintenance of budgetary discipline. Growth perspectives in the Netherlands and Europe Being here in Toronto, it is tempting to compare Canada with the Netherlands. Both are open economies and relatively dependent on economic developments in their big neighbouring country, the United States and Germany, respectively. One thing that strikes me is that, whereas after a number of booming years the Dutch economic growth performance deteriorated substantially over the last few years, the Canadian economy proved exceptionally resilient in the face of the global downturn, including in the US. This good performance owes of course much to the straightforward implementation of structural reforms and budgetary consolidation since the beginning of the early nineties. However, a number of other factors have also played a role in sustaining economic growth in Canada. Domestic investments and household consumption remained robust, the latter partly caused by ongoing gains in real estate prices. Moreover, export demand remained supportive to growth. The absence of these latter supportive factors is an important explanation for the sharp downturn that has occurred in the Netherlands. Indeed, from the best performing European economy, the Netherlands turned into the worst performer. To put the current slump into perspective, let me first go back to the end of the nineties. During the period 1994 to 2000, the average annual growth rate of GDP in the Netherlands was 3.5%. This was well above the potential growth rate of the Dutch economy and 1 percentage point above the average of the so-called eurozone, the economy of the 12 countries that have adopted the euro as legal tender. The current cyclical downturn thus was - to some extent - to be expected after a prolonged period of economic expansion at a speed above potential. It is worthwhile to look into the reasons for this over performance, as they might give a clue for the subsequent downturn. Mostly, the seeds for downturns are sawn during the upturn. The main growth engines during the upturn were, firstly, rapid consumption growth due to among other things a booming housing market. Secondly, exports thrived as a result of a substantial improvement of our international competitiveness as well as favourable global economic conditions. The robust growth subsequently led to a tightening of the labour market, culminating in an unemployment rate of only 2.4% in 2001, compared to 8% for the eurozone as a whole. Incidentally, employment figures in the Netherlands are as flattered as in other European countries, such as Germany: in our own country because of the relatively large number of inactive people as a result of initially generous disablement insurance schemes. In Germany , the existence of subsidised jobs cloud the picture. Nevertheless, the labour market developments in the Netherlands caused a strong increase in unit labour costs, for which we ultimately had to pay the price. The eventual significant loss in price competitiveness, in combination with the global economic downturn, stalled our exports. Moreover, the disappearance of wealth effects due to the stabilization of house prices has taken their toll on households’ disposable incomes, and as such on consumption. To give an example of the magnitude of these forces: the annual contribution to GDP growth from housing wealth has turned from an annual 1%-point impulse between 1998 and 2000, into a negative contribution of half a percentage point in the past three years. Taking these wealth effects stemming from the housing market into account scales down the present growth gap between the Netherlands and the eurozone. Another possible downward effect on growth in the short term stems from the significant budgetary adjustment the Dutch government is implementing. Nevertheless, this adjustment, which is larger than in most other eurozone countries, is necessary not only to adhere to the European budget rules but also to enhance durable growth recovery. I will come back to the need for budgetary discipline at the European level at the end of my speech. For the future, I am optimistic. We have passed the turning point in the cycle. For this year, I expect growth to be 0.7%, rising further to 2% in 2005. An important driving force is the global recovery, which will stimulate our exports, even though we have to regain competitiveness. Nevertheless, the strength and sustainability of this recovery will to a large extent depend on the persistence and speed at which the reforms that have already been set in motion are pushed through. In particular, next to the substantial budgetary consolidation efforts, the continuation of wage moderation to foster price competitiveness is essential. The tripartite agreement that was reached last autumn to freeze nominal wage rises in the next two years is a positive development in this respect, as it clearly shows that the importance of wage moderation is now in the minds of both employers and employees. Turning to the economy of the eurozone, it is clear that the slowdown has been less steep but more prolonged than in the US. In the US, economic growth deteriorated with 3.5 percentage points from 2000 to a virtual standstill in 2001, after which it quickly regained speed with a growth rate of 2.5% in 2002. In the eurozone, the slowdown was much more gradual, with a fall in economic growth of 3 percentage points over a period of three years, from 2000 to 2003. This pattern of the slowdown - a gradual deceleration of growth, rather than a sharp fall in output - may have meant that the immediate pressure on corporations to adjust their balance sheets and labour force was less intense, delaying the adjustment process. High debt levels in comparison with those in earlier cycles may also have contributed to this relatively prolonged downturn. Nevertheless, for this year, the economy of the eurozone is expected to grow with 1.6% and with 2.4% in 2005. Like in the Netherlands, this turnaround has been mainly driven by rebounding exports due to the recovery of global trade. In addition to the strengthening of external demand, domestic expenditures in the eurozone will take their part in the recovery. With respect to household spending, both short-term and long-term interest rates are at historical lows, which have eased debt servicing costs of households. Of course, the fact that interest rates are so low, also raises the risk of renewed increases in the future, with possible adverse effects on households’ debt profile. Furthermore, although the appreciation of the euro that has taken place is not conducive to export growth, it will, all other things being equal, gradually feed into a further decrease in inflation which in turn will raise real disposable income of households. In this context, simulations within the Nederlandsche Bank show that a permanent appreciation of the effective euro exchange rate of 10% will have a short term negative effect on economic growth in the eurozone of 0.35%. However, the effect of a 10% euro appreciation turns positive in the longer term, cumulating to 0.7% after six years, partly due to an increase in consumption. Corporate investments can gain momentum too, due to the pick-up in foreign demand in combination with the limited degree of excess capacity in the manufacturing industry. Also, corporations have improved their financial position by bringing down the share of short-term debt. Moreover, low interest rates, low corporate bond spreads and the recovery of the stock markets have improved the financing conditions for European corporations. Being a central banker, it is part of my duty to draw your attention to the downward risks as well, which could dampen the pace of the recovery. These risks mainly stem from the persistent and significant budgetary and external imbalances in the US economy. But there is no need for undue pessimism with regard to the cyclical upturn in Europe. Whether this upturn will prove to be sustainable, however, depends, like in the Netherlands, to a significant extent on the continuation of structural reforms and the maintenance of budgetary discipline. I will now turn to these two issues. Continuing with structural reforms In March 2000 in Lisbon, Europe ‘s leaders committed themselves to turn the European economy into the most competitive and dynamic knowledge-based economy in the world by 2010. To accomplish this, they agreed on implementing far-reaching reforms of labour, product and capital markets, on completing the European Single Market, and on enhancing Europe ‘s innovative capacity. Clearly, this structural reform agenda, also known in Europe as the “Lisbon strategy”, was and still is quite an ambitious challenge. Nevertheless, structural reforms are no end in itself. By removing bottlenecks and obstacles in the European economy, these structural reforms enhance the economy’s capacity to generate sustainable growth rates, with low unemployment and sound public finances. Let me give an impression of the quantitative effects of these reforms. The OECD has recently calculated that continuation with product and labour market reforms would lead to higher productivity and employment growth, which would over the medium term boost potential per capita output growth of the eurozone from 1.75% to 2.25% a year, the same as the US growth rate. Moreover, reducing red tape and creating more flexible and integrated labour, product and capital markets, promote cross-border activities by, and financing of European companies. Looking ahead, the opportunities for businesses are likely to expand further. Recent research conducted for the European Commission shows that a materialization of a fully integrated European financial market will eventually contribute to a reduction in the cost of equity and bond finance of 0.5, respectively 0.4, percentage points. The assumption behind this projection is that trading costs could fall sharply as a result of full financial market integration, due to greater depth and higher liquidity of these markets. These lower trading costs would allow investors to accept lower returns on corporate equity and bond issues, which would translate into lower financing costs for firms. However, not only European corporations, but also corporations from outside the EU gain from the reform process in Europe. The existence of a single system makes access to the EU market much easier for firms from third countries, which is for instance reflected in the steep increase of foreign direct investments into the EU since the establishment of the Single Market. Finally, structural reforms benefit European consumers, by reducing prices and increasing the choice and quality of services. So much for the theoretical gains of structural reforms. Allow me some remarks about the progress in implementing these reforms. There are clear signs that European governments are increasingly aware of the need of putting structural reforms at the top of their policy agenda. The Netherlands, for instance, have already implemented three-quarters of the reform measures agreed in Lisbon. In the three largest European economies, Germany, France and Italy, together constituting almost 70% of the GDP of the eurozone, a wide ranging and impressive reform program has been enacted, encompassing reforms of labour markets, pension and health care systems. The labour markets reforms are aimed at reducing rigidities and improving incentives to work. Germany, for instance, will implement in the context of its so-called Agenda 2010 an easing of its stringent job protection legislation and a reduction of the unemployment benefit duration. In another area, that of pension and health care, reforms are being implemented that constitute a structural break towards containing the financial consequences of an ageing population. To this end, the Italian government proposed, for example, that as of 2008, workers will need 40 years of pension contribution, instead of the current 35 years, if they want to retire before the statutory retirement age. With the same perspective, France has aligned the shorter contribution period for civil servants to that of the private sector. Finally, in order to increase economic dynamism, reform measures such as a relaxation of shop opening hours, a simplification of tax law and bookkeeping obligations for small and medium sized enterprises, and a reform of the civil service have been initiated in these countries. These measures may sound strange or self-evident to you, but they constitute a significant culture change in parts of Europe . True, these reforms will not be implemented overnight and their effects will only become tangible after a number of years. Moreover, in a number of areas, such as strengthening the innovative capacity of the European economy, completing financial market integration and integrating services markets, further progress is still needed. To give a few concrete examples in these areas, to further a knowledge-based economy, the level and effectiveness of spending on research and development in Europe, which is currently lagging behind the US and Japan, could be increased. Another important challenge is to integrate the still fragmented system of clearing and settlement of securities transactions in Europe, to foster an efficient operation of security markets. Also, legal and administrative barriers should be dismantled further, in order to enable a completely free movement of services across Europe , such as in engineering and consultancy. Therefore, the Lisbon target of 2010 indeed looks very challenging. But there is no doubt that the modernization of the European economy has taken off and is moving forward decisively. Maintaining budgetary discipline I now come to the final part of my speech on the need to maintain budgetary discipline. It is widely acknowledged that fiscal discipline contributes to long-term sustainable economic growth, by creating a stable macro-economic environment, which for instance allows for undistorted consumption and investment decisions. Also, budgetary consolidation, in addition to the pension and health care reforms I mentioned earlier, is important to prepare for the financial consequences of the ageing European population, which is expected to reach its peak in the middle of this century. While these two arguments apply in fact to any country, the need for fiscal discipline in a monetary union, like the one we have in Europe, is even higher. An important reason for this is that the negative side-effects in the form of higher interest rates of expansionary budgetary policy in one country, are not entirely borne by this country alone. Instead, these are widely shared by all their fellow participants in the monetary union. To guarantee budgetary discipline and to strengthen mutual trust in each other’s budgetary policy, a fiscal policy framework has been established in Europe. This framework basically consists of two rules. The EU Treaty stipulates that Member States should avoid excessive deficits, which are defined as deficits above 3% of GDP. The so-called Stability and Growth Pact gives a further refinement of the Treaty, by requiring Member States to achieve and maintain a budgetary position of close to balance or in surplus in the medium term. By abiding to this latter requirement, a country creates enough budgetary room and flexibility to ensure that public finances can absorb normal economic fluctuations without breaking the 3% deficit limit. As such, this framework combines budgetary discipline with country-specific flexibility. Clearly, the budgetary problems in especially Germany and France over the last few years are not encouraging. These problems culminated in the decision by the Council of European Finance Ministers in November last year to deviate, for the time being, from the formal budgetary procedures of the Stability Pact for both countries. Instead of adopting the proposals by the European Commission under the Stability Pact, the Council made recommendations to Germany and France to correct their deficits outside the framework of the Stability Pact. To put these developments into perspective, allow me to take you a number of years back in history. Between 1991 and 1995, before a monetary union in Europe was considered to be a realistic prospect, the average budget deficit of the eurozone was 5% of GDP. The subsequent pressure for fiscal discipline emanating from the desire to qualify for Economic and Monetary Union, resulted in an average budget deficit of 2.3% of GDP at the end of 1998. After qualification for EMU, governments of the participating Member States were obliged to adhere to the central prescription of the Stability Pact, namely to reach balanced budgets over the cycle. Due to the gradually deteriorating economic growth, the European Finance Ministers decided in 2002 that countries that had not yet reached a balanced budget, were given a few years extra to attain this position. However, prolonged economic weakness and insufficient budgetary consolidation efforts during the preceding economic upturn, have ultimately resulted in some countries not only breaching the Stability Pact requirement, but also the 3% deficit limit. This clearly is a highly unfortunate and disappointing development. At the same time, however, we should keep in mind that despite these problems, a significant improvement in European budgetary discipline has indeed been attained in the course of time. It might in this respect also be illustrative to look at the United States , which experienced a downward swing in their federal budget deficit of 6.5 percentage points between 2000 and 2003, although this was partly due to special factors, such as the war in Iraq . How can we solve these problems, or in any case make sure that they do not arise again in the future? In 1992, the EU Treaty that laid down the path towards Economic and Monetary union was signed in the Dutch city of Maastricht. Although it was clear that a potential conflict exists between a single monetary policy and decentralised fiscal policies, it was also clear at that time that establishing a political union, or in other words an independent European fiscal authority, to supplement the monetary union was a bridge too far. Instead, a rather artificial solution in the form of the Stability Pact was created. However, the experiences with implementing the Pact over the last few years have made it very clear that governments are reluctant to accept constraints on national sovereignty through limitations on budgetary policy. This holds especially true in times of subdued economic growth. Discussions about fundamentally improving the adherence to the European budgetary rules are in my view therefore inextricably linked to discussions about curtailing national budgetary sovereignty, and as such to forming a political union. Although I realize that this obviously will be a realistic solution only in the long term, we should not hesitate to bring this under discussion. To a certain extent, the discussion on the appropriate role of national budgetary sovereignty has already started. Recently the European Commission decided to challenge the decision by the Council of European Finance Ministers in November to deviate from the Stability Pact, by bringing legal action before the European Court of Justice. The reason for this decision is not to challenge the substance of the decision, as in fact there is no major difference between the budgetary consolidation path under the proposals by the European Commission and under the eventual recommendations by the European Council. Rather, the aim is to seek legal clarity regarding the fundamental question that emerged from the Council decision in November, that is whether the European budgetary framework ultimately is of a supranational or of an intergovernmental character. Of course, a fundamental discussion like this should not distract us from the search to find solutions to improve the enforcement of the European budgetary rules in the shorter term. A contribution towards such a solution is to deny countries with excessive deficits their voting rights in the Council of European Finance Ministers, when decisions are taken on another country with an excessive deficit. This prevents countries from taking their own budgetary problems into consideration, when votes are casted on countries that face the same problems. A more far-reaching contribution is to give objective and independent institutions, such as the European Commission and the European Court of Justice, a much stronger role in enforcing the implementation of the budget rules. The role of the European Court of Justice in this case is not to judge the procedural elements as such, but rather to enforce that individual countries stick to their budgetary commitments. The Dutch government is actively striving to incorporate these changes to the budget rules in the new European Constitution, and I fully support their efforts. Summing up Let me sum up. I am optimistic about the prospects for the European economy. We clearly passed the turning point in economic growth, both in the Netherlands as in Europe as a whole. Moreover, the conditions for sustainable growth recovery are favourable. Firstly, European governments are increasingly living up to their promise made in Lisbon to implement far-reaching structural reforms, although it remains to be seen whether the deadline of 2010 will be reached. Secondly, it is clear that Europe currently faces budgetary difficulties. This holds not so much for the sheer size of the budget deficit as such, although the still more limited flexibility and the more gradual recovery of the European economy compared to the US, implies that reducing deficits might take a longer period of time than in the US. The main difficulty, however, stems from the deficiencies in the European institutional budgetary framework. To overcome these deficiencies, discussing drastic solutions, most notably the eventual establishment of a political union, should not be avoided. From this perspective, the current problems, although unpleasant, should in my view be seen as occasional and temporary setbacks on the road to an increasingly integrated Europe. I am confident that this integration process brings benefits to both European citizens as their partners outside Europe. | netherlands bank | 2,004 | 2 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and President of the Bank for International Settlements, at the Chamber Luncheon of the American Chamber of Commerce in the Netherlands, Amsterdam, 23 September 2004. | Nout Wellink: Business cycles and foreign direct investment Speech by Dr Nout Wellink, President of the Netherlands Bank and President of the Bank for International Settlements, at the Chamber Luncheon of the American Chamber of Commerce in the Netherlands, Amsterdam, 23 September 2004. * * * I feel honoured to speak to this distinguished group of people today. To the general public in the Netherlands, the ‘AmCham’ may not be a well-known organization. However, the list of its members proves that its goals and purposes have wide support in the Dutch business community. As we have known since centuries, foreign investment and trade between countries enhance welfare in both countries, and it is vital to sustain and promote this in a globalizing world economy. Your active role in this process is highly appreciated. Traditionally, Dutch-American trading and investment relations have been extensive. In particular, on average around a quarter of outward Dutch direct investment flows is directed towards the United States. Over the last ten years mutual direct investment flows have increased. This increase was similar to the global increase in foreign direct investment that started in the 1980s. In 2000, the Dutch foreign direct investment position in the US had a value of around 20% of Dutch GDP, which is a quarter of the total Dutch foreign investment position. Fifteen years earlier, in 1985, this value was just 12%. In my talk this afternoon, I will further explore the effects of increased direct investment exposures. In particular, their effects on the behaviour of international business cycles. I will start by elaborating on two observations concerning business cycles. First, in contrast to the past, when business cycles generally became more moderate over the longer term, the Dutch business cycle has become more volatile recently. Moreover, Dutch and US business cycles have become more synchronized. Let me elaborate on the increased volatility of the Dutch business cycle first. According to our current knowledge, the Dutch economy has passed the trough of the cycle around the end of last year. Last year, GDP growth reached its lowest rate in the past twenty years, at a negative rate of 0.9%. Compared to other European countries, our growth rate was exceptionally low; more than one percentage point below the average. This low performance was in strong contrast with performance in the second half of the nineties. In those years Dutch GDP growth was consistently higher than the euro area average. This illustrates that the Dutch economy has acquired a kind of boom-bust character, which indicates a more volatile cyclical growth pattern. Another indication is given by the rise in the standard deviation of growth rates. This measure of volatility has almost doubled over the last four years, compared to the four years before. For a significant part, the comparative strength of the upturn and the severity of the downturn in the Netherlands can be attributed to the open character of the Dutch economy. The spectacular growth of world trade since 1995 and the declining exchange rate of the euro have boosted exports. The downturn that followed had an opposite and - again comparatively strong effect on the Dutch economy. However, more can be said about the latest Dutch business cycle - I will return to that later. First, we should take a view from a longer term, more global perspective. Although the volatility of economic growth during the latest Dutch business cycle was higher than before, the long term, global pattern is very different. Since a long time, at least since 1960, but even more pronounced since 1980, the volatility of GDP growth [measured by the standard deviation] has shown a downward trend. In other words, from a longer term perspective, the business cycle has become more stable. All G7 economies, as well as the Dutch economy, have become more stable. This increasing stabilization has been labelled by economists as ‘the Great Moderation’, especially with respect to the US economy. To give a quantitative illustration, the standard deviation of quarterly growth rates in the Netherlands was 2.4% in the 1980s; over the period since 1990 it has fallen to 1.4%. Similar figures have been found for the US. Extensive research has been devoted to an explanation for this moderation of the business cycle over the past twenty years. There are two explanations which I would like to focus on in this speech. The first explanation that has been proposed is structural change. This explanation suggests that there have been improvements in the ability of modern economies to absorb shocks. For example, due to improved methods of inventory management, there are less severe fluctuations in inventory stocks. Other examples are deregulation of financial markets, and the improved resilience and strength of the financial sector. Financial institutions are more able to diversify their risks, both internationally and among types of financial products. Therefore, the supply of credit to the private sector has become more sophisticated, enhancing the ability of firms to smooth their activity during the business cycle. Second, economic research convincingly shows that the number and size of shocks hitting economies has diminished over the past twenty years. In this sense, the observed moderation of business cycles since the 1980s can be seen as the result of good luck. However, as a consequence, it is possible that we may experience an increase in volatility again, if we run out of luck. Besides volatility, there is a second characteristic of recent business cycles that deserves attention: international co-movement - or synchronization - of cycles. Business cycles in modern economies tend to move together. For example, the rate of correlation between the US and Dutch growth rates varies between 0.4 and 0.5, since 1960. An extensively studied question has been whether there has been an increase in the amount of synchronization of business cycles. In general, the available evidence indicates that there is no overall tendency towards closer synchronization or co-movement, over the past quarter century. However, at a more detailed level, the picture is different. There are cases of increased synchronization within groups or pairs of countries. For example, within the group of euro area countries, synchronization has become closer since the nineteen-eighties. Moreover, in the latest cycle, correlation between US and Dutch growth rates has increased significantly, to a value of 0.65. From this, we may conclude that Dutch and US growth rates have become more synchronized in the most recent cycle. In general, there are two sources for co-movement of economies. First, it is clear that general shocks to the economy, which affect many countries, lead to correlated national economic developments. This reflects a common reaction of more or less comparable countries to the same exogenous factor. Examples are energy price shocks, or major developments in technology. Second, in addition to common shocks, country-specific shocks are important, to the extent that they spill over to other countries. Spill overs of shocks require economic linkages between countries, like trade and financial flows. Hence, stronger linkages raise the probability of co-movement. For example, an increase in economic activity in one country boosts activity in its trading partners because of higher foreign demand. More recently, another transmission channel between countries has increased in importance: foreign direct investment, or FDI. Several factors have contributed to the strong increase of FDI flows since the mid-nineties, like the liberalization of capital flows, reduced trade barriers and the widespread use of ICT-technologies. Interestingly, results from empirical analysis at DNB have shown that countries with comparatively large bilateral FDI positions tend to have a higher correlation of output growth rates. In other words, FDI may intensify co-movement of business cycles. In particular, this appears to be the case in the period 1995-2001. There are two ways in which FDI acts as a transmission channel for economic shocks, depending on where the shock occurs: in the home country or the host - the foreign - country. First, shocks in a foreign investor’s home country may affect its financial position at home, and force it to cutback its activity in host countries as well. Second, due to shocks in a host country, the value of a firm’s investments abroad may be affected. Consequently, that firm’s net worth at home is affected as well. Net worth, in turn, is related to financing costs, so it is obvious that a reduction of the value of foreign investments may reduce investments in the home country, because of higher costs. Let me try to integrate what I have said so far. On the one hand, international economic linkages, like trade and FDI flows, have become stronger and more sophisticated. In itself this would lead to more co-movement (or synchronization) of business cycles, because common and country-specific shocks are transferred more ‘effectively’ and rapidly between countries. For example, accounting problems in the US not only had national effects, but were also transferred to European countries through channels within multinational firms (like Ahold and Anderson). On the other hand, there are signs that the amount and strength of common shocks has decreased. I mentioned this earlier as an explanation for the global moderation of business cycles. As a result, the enhanced transmission channel for country-specific shocks has been compensated for by smaller and less frequent common international shocks. This explains why, on a global scale, co-movement of cycles has remained fairly stable. Having discussed the global picture, I will return to the Netherlands now. As I said, the Dutch business cycle has become more volatile recently, as well as more synchronized with the US. Both observations are in contrast to the global picture of more moderate cycles with stable synchronization. In my opinion, these atypical features of the Dutch business cycle can be explained in the terms that I used to describe the global picture. First, the Dutch economy has been subject to some especially powerful country-specific shocks. An example is the exceptionally favourable housing market development in the nineteen-nineties, which had a positive effect on private consumption. Later on, consumption has been negatively affected by political developments, which reduced consumer confidence significantly. Besides, the size of the external sector and the large FDI positions make the Dutch economy particularly sensitive to international developments, especially from the US. This is also reflected in the stock market - our own research indicates that the Dutch stock market is traditionally highly correlated with the US stock market, in comparison to other European countries. In terms of FDI, the US is by far the most important partner of the Netherlands. As a percentage of GDP, Dutch investments in the US are larger than those of any other European country. Hence it is no surprise that some international and US shocks have had a sizeable effect on the Dutch economy, like the sharp correction in international stock markets in 2000, as well as the geopolitical tensions of the recent years. As a consequence, the Dutch business cycle was more volatile and moved more closely together with the US economy than did business cycles in other countries. It is challenging now to take a look ahead. What do these observations, that I have sketched here, imply for global business cycles in the near future? Will business cycles remain moderate and will co-movement remain stable? Let me try to discuss some implications from my remarks so far. One implication to take note of, is related to the vulnerability of economies to international shocks. Several studies have concluded that business cycles have moderated, because the amount and size of shocks have diminished. However, this might not continue indefinitely - we may run out of luck. Major international shocks could occur again, significantly enhancing international business cycle volatility and co-movement. In fact, we have recently experienced that terrorism and geopolitical tensions may act as a shock to the economy, for example through global shocks in confidence levels or through disruptions of energy supply. An obvious result could be a disruptive shock to oil prices. In this respect, the results of a recent study on oil price shocks are striking. It found that an oil price shock that is related to political factors and supply side conditions has more severe implications than other types of oil price shocks, such as shocks related to demand conditions. Since 1984, an oil price shock of this type has not occurred, except in the past half year. Were such a large international shock to materialize, one should be aware that the partial consequences for the exposed countries can be larger than in the past. This is because the transmission channels of shocks, such as FDI and trade flows, have increased over time and will probably continue to do so. However, this is not to say that we should aim at reducing these international linkages. Let me elaborate on this. First, one should not forget that international trade and other linkages may transmit economic disturbances, but have beneficial effects as well. FDI has become an important mechanism for the transfer of technology, including management techniques. In this way, FDI supports a smooth adoption of technologies that can make an economy less vulnerable to cyclical factors. For example, scale economies may drive multinational firms to apply state-of-the-art ICT-technology or management models in different countries. I will not conceal that there also have been mistakes in this respect there have been clear cases of overinvestment during the global boom in mergers and acquisitions. However, there is reliable empirical evidence that technology transfers through FDI have stimulated the rate of technological progress. Second, the negative effect of international shocks may be kept in check by ongoing improvements in the resilience of the financial sector. This month, the IMF reported (in its WEO) that the global financial system is in its strongest shape over the past three years. Finally, there are structural changes in the economy that indicate that firms are becoming more flexible and are less affected by cyclical developments. Let me illustrate this by focussing on the Dutch economy; however, similar developments have been found for the US economy. A remarkable development can be observed in the sectoral pattern of employment changes. More than before, sectors or industries may be denoted as either structurally shrinking or structurally growing; independent of the state of the business cycle. Less than before, industries that shrink in a downturn can expect to grow again in the next upturn of the cycle. Consequently, employees are made redundant in sectors which are subject to structural shrinking, and must find new jobs in growth sectors. During the 1995-2002 cycle, these sectors accounted for 96% of employment, as compared to 71% during the 1987-1994 cycle. This changing pattern of sectoral employment indicates that labour and product markets have become more dynamic and flexible. A flexible labour market is conducive to labour productivity growth in the long term. Moreover, the ongoing changes in the sectoral composition of employment indicate that companies are forced to carry out ongoing restructuring, for example, as a result of increasing competition and innovation. Let me conclude here. Every business cycle is unique. However, we may try to find patterns and take lessons from the past and from other countries. In summary, over the long run, business cycles tend to be more moderate and co-movement appears to be less strong than we would expect. Most of this can be explained by the absence of international shocks to the economy. However, since economies have increasingly become integrated, the risks of disturbances spilling over to other countries seem to be greater than ever. On the other hand, as I have indicated, modern economies are becoming more resilient at the same time. This may be viewed as a positive effect of increased economic linkages. It is my opinion that this effect should be encouraged; and I am convinced that the task of improving economic linkages is well dedicated to the AmCham. Looking at the current business cycle, I am convinced that the worst part is behind us now. Most indicators point to a sustained recovery of the US and the world economy. As we emerge from this downturn it will become clear that the Dutch economy has experienced a volatile business cycle and that strong linkages to the US economy can be a great advantage. | netherlands bank | 2,004 | 9 |
Speech by Professor Arnold Schilder, Chairman of the BCBS Accounting Task Force and Executie Director of the Governing Board of the Netherlands Bank, at the Plenary Session of the International Conference of Banking Supervisors, Madrid, 23 September 2004. | Arnold Schilder: Dynamics in accounting and auditing in relation to banking supervision Speech by Professor Arnold Schilder, Chairman of the BCBS Accounting Task Force and Executie Director of the Governing Board of the Netherlands Bank, at the Plenary Session of the International Conference of Banking Supervisors, Madrid, 23 September 2004. The following speaking points should be read in conjunction with the related PowerPoint presentation. These points have been organised under the relevant slide numbers and headings. * * * Good morning, everyone! It is a privilege and a pleasure to be asked to introduce today’s panel discussions on the important changes taking place in accounting and auditing and their impact on banking supervision. 1. “Dynamics in accounting and auditing in relation to banking supervision” It strikes me just how appropriate the title of my presentation truly is. Yesterday’s discussions on the new capital framework confirmed to me that dynamics exist everywhere and are not confined just to accounting and auditing matters. And last evening many of us were able to attend the wonderful and very dynamic Zarzuela performance, for which we thank our hosts from the Bank of Spain. This morning, we have just heard Malcolm Knight speak about the remarkable and equally dynamic evolution taking place in accounting, fuelled by convergence trends within banking, between banking and insurance and across global markets. I’m pleased that my remarks today will echo many of these same thoughts, and that the topics chosen for our workshops will focus on some of the key issues we supervisors need to think about as we and the institutions we regulate prepare for these changes. 2. The interaction: an overview This slide gives an overview of the different components that feed into and are supported by financial information. My presentation has been built around this overview and will look at these various interactions one by one. The role of sound accounting and adequate disclosure in the creation of useful information for markets and investors is obvious. Sound auditing standards applied properly by auditors who also maintain high standards of professional conduct also contribute to market and investor confidence. In turn, these disciplines are also responsive to the changing needs of market, investors and other external stakeholders. The remaining elements on this slide also interact with the financial information process. For example, yesterday Chairman Caruana mentioned the importance of alignment between sound risk management and financial information. On the one hand, financial information generated from risk management activity should be provided to all external users of financial statements, but at the same time that information also provides important feedback to risk managers about their own performance. On the other hand, the requirements of banking supervisors also shape what information is created about banking risks and risk management activities and will tend to influence bank behaviour. Such information is also an important tool used by supervisors to evaluate institutional and systemic safety and soundness. And while our key focus at this conference is banking risk, we should not forget what Malcolm Knight said this morning about the growing similarities between banking and insurance, and, for us, the need to be able to supervise, or jointly supervise, financial services conglomerates. 3. Contents The rest of my presentation is organised into three parts. The first is focused on accounting, the second on auditing, followed by some closing remarks. Under accounting, I will look first at accounting and disclosure - what are the drivers and trends? Then, accounting and supervision - where they converge, and, unfortunately, where they diverge. Then I will look at the challenges this situation creates for banking supervisors and the need for regulatory action. Under auditing, I’m going to look at recent developments first, then specific enhancements to the quality of the auditing process that have resulted from these developments, and finally what could be done to improve the process even further. 4. Accounting & disclosure; drivers & trends First, developments in accounting and disclosure. There is no question that trends in this area have been driven by a demand for greater transparency in financial reporting. One important development is the IASB’s recently published Exposure Draft #7 on Financial Instruments Disclosures. This draft proposes several sound principles to guide what should appear in published financial statements. Increasingly, international accounting standards also support broader and more sensitive recognition of risks in several ways. First, more risks are moving onto the balance sheet than ever before. Second, IAS 39’s increased use of fair value measurement is helping to quantify various types of risk that may not have been identified or fully understood under the traditional cost-based model. Finally, the drive toward enhanced financial risk disclosures in the new ED 7 proposals should improve discussion of any risks that do not appear in the balance sheet and of how financial risks are being managed. It’s clear that Pillar 3 disclosures were looked at by the IASB during development of the current exposure draft and we’re happy about that. Finally, we need to recognise that one major objective behind the current development of international standards is a desire by countries and markets for a single, high quality financial reporting model that will be widely acceptable and broadly applied. One important additional consideration is the potential for convergence between IFRS and US GAAP. 5. Points of convergence with banking supervision There are strong parallels between these drivers and trends and those underlying Basel II. As I noted on the previous slide, the IASB’s work on disclosure of financial instruments - first in IAS 32, but especially in its new ED 7 proposals - has been inspired by concepts and guidance first proposed in Basel’s Pillar 3. Second, one of Basel II’s starting points has been the need to develop more refined approaches to the measurement of risks. This means allowing banks to make greater use of their own risk modelling approaches where supervisors are satisfied that these models are sound and will be used responsibly. Third, supervisors have become very conscious of the need to harmonise their principles and practices at both a global and regional level. Basel’s Accord Implementation and Core Principles Liaison Groups are focused on this objective at the international level. A good example of similar activity at a regional level is the work of the Committee of European Banking Supervisors. So far, so good. But now we’re going to look at where standard setting and banking supervision diverge, and what this means for banking supervisors. 6. Points of divergence from banking supervision As this slide suggests, accounting is increasingly moving toward a neutral picture of enterprises and their risks. This may appeal to the markets and investors, but it is not consistent with the perspective that banking supervisors must adopt in order to look at longer-term safety and soundness issues. Malcolm Knight suggested this morning that this is due to different “DNA”, and he could be right. This drive toward neutrality is reflected in several ways. I mentioned increasing use of fair value accounting in a previous slide, and while this approach does have some benefits it is not without a few concerns. For example, “prudence”, as a supervisor would understand it, will no longer play the same role in valuing financial assets and liabilities. “Fair values” won’t discriminate between gains and losses, or, in the case of gains, between those that are realised in cash and those that are not. “Prudent” valuations won’t be accepted any longer if they are materially different from those produced under a fair value scenario. And, as noted in other workshops, “rainy day” provisions that neutralise effects of the economic cycle won’t be permitted. As a result, changes to current accounting practice will also have a direct impact on the quality of accounting capital and on how supervisors assess that capital for regulatory purposes. 7. Points of divergence from banking supervision Accounting standards operate under a different time horizon than capital standards and have their greatest impact in the area of loan losses. Under IFRS and US GAAP, allowances for incurred losses must be based on the occurrence of a given loss event rather than historical trend information alone. For some banks at least, this means that allowances at any point in time are unlikely to be sufficient to meet full EL requirements although, amazingly, we did see some excesses during our QIS work. Also, dynamic provisioning approaches that provide “through the cycle” accounting are unlikely to be acceptable. This means banks must take the credit risk premium charged to cover expected losses to income, even if the related losses cannot be recognised until a much later date. 8. Points of divergence from banking supervision Standard setters also don’t appear to give much consideration to the financial stability implications of their proposals. First, they seem indifferent to how much additional volatility could be created in banks’ financial statements as a result of the wider use of fair values. Second, they do not share the concerns of supervisors and many others that fair valuing changes in own credit risk is inappropriate, especially when this means recognising gains based on deterioration of one’s own credit. Even if supervisors can make appropriate adjustments to these items for regulatory capital purposes, how users will react to what is published in the financial statements is a worry for both banks and banking supervisors. Finally, supervisors are deeply concerned with the apparent disconnect between how banks manage portfolios of risk and the models produced by standard setters to capture these activities. The key issue is that international standards apply fair value to whole instruments rather than the underlying risks, and to single contracts rather than portfolios, and we believe that standard setters need help to better understand the business of banking. As Chairman Caruana noted, good accounting should support sound risk management practices. Certainly the two pictures should not be in conflict. 9. Additional challenges for banking supervision If these issues were not enough, supervisors must grapple with more subjective balance sheet measurements and what this means for the reliability of financial statement values. In this case, subjectivity takes two forms: the need to use models for instruments that do not have active local markets, and the potential for an enterprise to choose from wide ranges of possible “fair values” in pricing a given instrument. Also, financial statement disclosure is moving toward a generic approach for all types of entities. This is most evident in the new ED 7 proposals on disclosure that are intended to replace bank-specific disclosures found in IAS 30. The key question for supervisors is how assets and liabilities of banks should be classified on the balance sheet - by measurement classification, or by type of product? 10. Need for regulatory action: a mixed blessing Despite these many challenges, banking supervisors are positioned to compensate through regulatory means. They can issue supervisory guidance (for example, on provisioning, and on various aspects of fair value accounting) at any one or all of the Basel, regional and local levels. They are able to apply prudential filters to the accounting results, such as was done through two recent press releases on suggested capital treatments of certain IFRS items. Developing supervisory reporting and disclosure frameworks, for example the current CEBS initiative) can also help to re-establish consistent and comparable information for supervisory use. 11. Need for regulatory action: a mixed blessing At the same time, these additional measures create additional administrative burdens for banks, and supervisors are very sensitive to the need to keep this additional burden to a minimum. Also, as the Basel Committee supports the use of sound IFRS for supervisory as well as public reporting, applying prudential filters to these standards could create the perception that we do not have full confidence in the quality of IFRS-based financial information. Now, let’s turn to auditing trends and issues. 12. Significant recent developments in auditing Recent accounting scandals - Enron, Worldcom, Parmalat and others - have raised fundamental questions concerning auditor responsibility, auditor independence and audit quality. Since that time, auditing standard setters and others have been hard at work on improvements needed to restore public confidence in the profession. For example, the U.S. Sarbanes-Oxley Act and revision of the EU’s Eighth Directive have been designed to address several important elements related to standards development and approval, auditor independence and standards compliance. Also, the international profession is dealing proactively with a number of initiatives designed to promote improved audit quality and much more transparent quality control processes. These important developments are very similar to approaches found in Pillars 2 and 3 of the revised framework. Auditors are also revising the scope of their work in ways that speak to many of the Basel Committee’s concerns. For example, strengthening the responsibility of a lead auditor in group audits should be helpful to home and host supervisors involved with the same financial services group. Also, enlarging the scope of audit responsibilities to address internal controls and fraud should support supervisory assessments of how “know your customer” risk is being managed. 13. Significant recent developments in auditing Another means to improve audit quality has emerged in the form of auditor oversight. Internationally, a number of international regulatory organisations (the World Bank, the Financial Stability Forum, IOSCO, the Basel Committee, the IAIS and the European Union) have worked with the international auditing profession to agree on the creation of a Public Interest Oversight Board. In the United States, the Public Company Accounting Oversight Board is already up and running under the chairmanship of Bill McDonough. Knowing Bill from his days as chairman of the Basel Committee, that’s no surprise. And there are similar initiatives emerging in the EU and elsewhere. These groups are interested in not only how audits are conducted but in the quality of auditing standards. 14. Audit enhancement benefits supervision In addition to helping supervisors carry out their Pillar 2 and 3 responsibilities, a stronger auditing regime provides several broader benefits. For example, auditors could be able to assist in verifying not only regulatory returns and financial statements, but, in the context of Basel II and IFRS, various capital and accounting models. 15. Audit enhancement benefits supervision The need for high quality audits is growing and auditors must keep pace with the increasing complexity of the banking business and bank accounting. Identifying the substance of complex transactions, often tailored to meet unique customer or institutional needs, is not easy. Neither is understanding the complex rules that have been developed on how to account for financial instruments. As much as auditors need to understand these developments, supervisors must also be in a position to appreciate the quality of their work so that we know how and how much to rely on it. 16. Further audit development and enhancement are welcome For this reason, the Committee supports continuing work on improving the audit quality chain. This means several things: completing the process of creating and implementing the PIOB; evaluating governance processes within individual firms and dealing with any issues identified; improving transparency around the nature and scope of audit work performed; and, developing high quality standards to cope with critical challenges such as fair value measurement, marking to model, and transnational audits. 17. Closing remarks: accounting To wrap up, accounting is moving forward, but not necessarily in the same direction as supervisory guidance. This will require the Committee to do several things over the near and the longer term. First, we must remain closely involved in the standard setting process if we are to be effective. Our task is to maintain and promote a prudent and forward-looking stance in the interest of financial stability. Earlier this morning, Malcolm Knight referred to the benefits of creating a “common language”, and in principle we agree with that. However, as supervisors, we will still need to determine what role we feel fair value accounting should play in financial reporting, and do our best to encourage standard setters to adopt an even more appropriate credit risk accounting model than the one we have right now. Nevertheless, I should give credit to the IASB, as IAS 39 already incorporates important concepts such as recognising impairments in groups of loans and applying experienced credit judgment to the determination of impairment. But they can still do better. 18. Closing remarks: accounting In parallel, we also need to develop ways to bridge the gap between the accounting and supervisory models where we can. This involves identifying where the gaps are and putting appropriate filters in place based on regulatory and capital reporting requirements. I hope that these filters can be kept to an absolute minimum and only over the short term. Nevertheless, in the interests of maintaining financial stability and promoting sound risk management, these filters will have to remain for as long as the gaps exist. In addition, some buffers against the effects of short-term volatility may still be needed, although this need will be determined in the context of related prudential filters. 19. Closing remarks: auditing For auditing, the Committee will need to remain focused on two objectives. First, improvement of the audit quality chain must continue. Second, we need to consider further what role the external auditor can play in relation to Basel II. In a moment I’m going to introduce you to the chairs of our workshops who will lead today’s discussions of the four subject papers prepared for this conference. I’ve tried to incorporate many of the questions from these papers into my comments this morning. Let me set out the objectives I would like to see achieved in these sessions. First, I hope that you’ll share your experiences. We need to understand how these topics affect you, your banks and the way you supervise. Second, please express your ideas on what we should be looking at. These will be useful in guiding the future work of the Committee and the ATF. Finally, don’t hesitate to ask questions or raise any short-term issues that we may have overlooked. Restricted The interaction: an overview Markets & investors, stakeholders Accounting Banks’ risk management & reporting Disclosure •Measurement •Information •Assurance Banking supervision Auditing Restricted Contents z Accounting & disclosure • Drivers & trends • Accounting & supervision: convergence and divergence • Additional challenges for banking supervision z Auditing • Recent developments • Audit quality enhancement and benefits for supervision z Closing remarks Restricted Accounting & disclosure: drivers & trends z Greater transparency • More usable and more useful information for market participants z Greater risk recognition • More risks on balance sheet (e.g. derivatives, securitisations) • More risk-sensitive measurement of assets and liabilities (e.g. fair values) • More disclosure of risks not recognised on balance sheet z Greater international harmonisation • Convergence of standards (e.g. IFRS/US GAAP) Restricted Points of convergence with banking supervision z Greater transparency and greater risk recognition are also drivers behind Basel II • Transparency: Pillar 3 disclosures (compare with ED 7) • Risk recognition: More refined risk-weightings, IRB approaches z International harmonisation is also a supervisory objective • Ongoing convergence of supervisory principles and practices at global and regional levels: Basel (AIG, CPLG), EU (CEBS) So far convergence, but… Restricted Points of divergence from banking supervision z Trend in accounting is an equal appetite for upward potential and downside risk • More fair value accounting • The role and meaning of prudence is changing, e.g. in relation to (1) fair value accounting, (2) provisioning: no more “rainy day” provisions • The accounting trend has consequences for the quality of accounting-based regulatory capital, e.g. through the increased recognition of potentially temporary gains Restricted Points of divergence from banking supervision z Accounting standards consider a different time horizon compared to capital standards • IFRS/US GAAP require allowances for incurred loss based on a given loss event; Basel II requires a capital buffer for unexpected loss and, additionally, for expected loss not provided for in accounting (“shortfall”) • There is little room for through-the-cycle accounting (e.g. dynamic provisioning) Restricted Points of divergence from banking supervision z Financial stability issues are not a concern for the accounting standard setter • Potential impact of fair value volatility • Potential impact of fair valuing own credit risk z Accounting standards often do not consider banks’ risk management practices • With some exceptions (e.g. hedge transactions, embedded derivatives), entire financial instruments are fair valued, not the underlying risks (e.g. credit risk, interest-rate risk, other forms of market risk) Restricted Additional challenges for banking supervision As if that is not enough… z Accounting is moving towards greater subjectivity in measurement, thereby raising reliability issues • More mark-to-model accounting • Possibility of wide ranges in reported fair values z Financial statement disclosure requirements are becoming less bank specific • Replacement of IAS 30 with a financial instruments-based standard (ED7) Restricted Need for regulatory action: a mixed blessing Advantages…. z Divergences & challenges result in need for supplementary norms and measures • Supervisory guidance (e.g. credit loss allowances; fair value accounting: fair value option, fair value measurement) • Prudential filters to adjust accounting figures for regulatory purposes: numerator, denominator, scope of consolidation • Supervisory reporting & disclosure framework (e.g. EU common regulatory reporting framework, Pillar 3 disclosures) Restricted Need for regulatory action: a mixed blessing Disadvantages z Supplementary norms and measures result in administrative burden for banks • Compliance with more than one standard • Need to administer various sets of data Restricted Significant recent developments in auditing z Greater focus on auditor responsibility, auditor independence and audit quality in the wake of accounting scandals • Revision of standards and guidelines (e.g. Sarbanes-Oxley Act, EU Eighth Directive) • Audit profession initiatives for greater transparency and better audit quality z Revision of scope of work • Greater lead auditor responsibility in group audits • Broader field of work e.g. in relation to internal controls, fraud Restricted Significant recent developments in auditing z Establishment of auditor oversight to improve quality of audits • Global and national initiatives: PIOB, PCAOB • Oversight not only of practices but also of principles (e.g. PCAOB authority to approve audit standards) Restricted Audit enhancement benefits supervision z Continuing important role of audit in supervisory methodology • Data verification: Regulatory returns & financial statements • Model verification: increasingly important under Basel II with various risk-weighting approaches and greater application of marking-to-model Restricted Audit enhancement benefits supervision z Growing business complexity, and related accounting complexity, enhances need for high-quality audits • Financial engineering & exotic products: reporting substance over form (e.g. securitisations, structured products) • Complex accounting rules for financial instruments: greater use of fair values, hedge accounting, accounting for (embedded) derivatives Restricted Further audit development and enhancement are welcome z Continued work on audit quality chain • Actual implementation & operation of oversight process: rollout & review of PIOB activities • Continued focus on governance at individual firms in addition to oversight • Greater transparency of audit process: what work have the auditors actually performed? • Further development of high-quality audit practices (e.g. fair value measurement, marking-to-model, transnational audits) Restricted Closing remarks: accounting z Significant emerging accounting developments are not all moving in parallel with supervisory developments • Need to remain vigilant, well-prepared and involved in the standard-setting process; constructive but critical dialogue • Importance of maintaining and promoting a prudent and forward-looking stance in the interest of financial stability • Determining the role of fair value accounting from a supervisory perspective • Working towards an appropriate credit risk accounting model Restricted Closing remarks: accounting z Significant emerging accounting developments are not all moving in parallel with supervisory developments (cont’d) • Need to bridge gap between accounting and supervisory models • Identifying the gaps and implementing appropriate filters: financial reporting vs. regulatory reporting, accounting capital vs. regulatory capital Restricted Closing remarks: auditing z Not only accounting, but also auditing, requires continued supervisory attention • Continued involvement in improving the audit quality chain • Oversight, governance, transparency, high-quality audit practice standards • Assessment of external auditor’s role in supervisory methodology • Refining the auditor’s role in relation to Basel II | netherlands bank | 2,004 | 10 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and President of the Bank for International Settlements, on the occasion of a luncheon conference of the Limburgse Werkgevers Vereniging, Herten-Roermond, 26 January 2005. | Nout Wellink: On the euro and exports, speculation and global trade Speech by Dr Nout Wellink, President of the Netherlands Bank and President of the Bank for International Settlements, on the occasion of a luncheon conference of the Limburgse Werkgevers Vereniging, Herten-Roermond, 26 January 2005. * * * I shall speak to you about the euro and the consequences of its rising rate for the exports sector. But I shall also dwell on the global causes as well as the macro-economic effects of the strong euro. Consequences of a rising euro rate for businesses Exchange rate movements may have considerable impacts, in particular at the level of industrial operations. While perhaps it was not the low dollar rate that finished Fokker, adverse exchange rates did play a role in that company’s fate. This stiff westerly wind rose just when Fokker was most in need of the right updraught. And, if you will allow me to use an example from your region, Océ – which over the course of time has proved a rich source of supervisory board members for DNB – realises much of its turnover in US dollar. In addition, many of its competitors are based in the United States or in countries whose currencies are pegged to the dollar. Small wonder that they keep a sharp eye on the exchange rate of the euro. On the one hand, exporters are recording declining sales and are compelled to settle for lower profit margins as a result of the high euro rate, whereas, on the other, citizens and businesses are benefiting from cheaper products from abroad. A case in point is the moderating effect of the rising euro rate on the increasing oil price. Since early 2003, the dollar price for a barrel of crude oil has gone up by 48%, while expressed in euro the price increase amounts to 21%. Also some of the activities of financial institutions profit from exchange rate fluctuations. An increase in the number of businesses hedging against – or speculating for – exchange rate fluctuations leads to higher commission income from currency translations and future contracts. The euro exchange rate not only influences the proceeds from business activities, like imports and exports. Exchange rate movements also work through to the value of assets and liabilities expressed in foreign currencies. The 20% fall of the dollar rate in 2003 translated into a EUR 4 billion loss for Dutch businesses, approximately 1% of Dutch national output. The net wealth effects of exchange rate and price movements in 2003 were insignificant, as overall cross-border claims and liabilities rose by about just as much. Macroeconomic consequences of the rising euro rate The consequences for individuals and businesses translate into macroeconomic effects. On this scale, too, there are pros and cons attached to an appreciation of the euro. The main minus point is that competitiveness will weaken, in particular initially. This in turn will affect exports, just when this sector is of vital importance as engine of the Dutch economy, domestic dynamics in the Netherlands and the rest of the euro area being less than optimal. The credit side of the balance sheet shows that we have grown richer on account of the appreciation of our currency. With imports becoming cheaper, the appreciation of the euro – while on balance hampering economic growth, especially in the shorter term – is favourable for inflation. According to DNB simulations, in the next three years the euro’s appreciation in 2003 and 2004 will reduce production growth in the euro area by about 0.3 percentage point per year on average. Inflation will each year come out circa 0.5 percentage point lower than it would have without the euro’s appreciation. In making these technical calculations, we should remember that the euro appreciated significantly right after its launch. Set off against the dollar, the value of the euro is not much higher than it was in the mid-nineties. The euro also turns out to be less strong than may seem at first sight if we bear in mind that, besides the American dollar, also other foreign currencies are important. For example, for the Netherlands, United Kingdom is more important as a trading partner than the United States. Of our goods exports, 11% goes to the UK, against 5% to the United States. Compared to all foreign currencies in terms of their weights in international trade, the euro has risen 11% in value since 2003, against 25% opposite the dollar. The US dollar is more important to Europe than the trade flows between the United States and our continent would suggest. Many commodities are priced in US dollar. Besides, many countries seek to keep the value of their national currencies stable against the dollar. This policy may well be considered a source of concern. The preference of some countries, like China, not to use the exchange rate as an adjustment tool in their relations with the United States adds pressure to other currencies, e.g. the euro and the Canadian dollar. Explanation for the strong euro versus the current account deficit of the United States I would like to dwell briefly on the factors underlying the strong euro. The prominent role of the dollar is tied up with the United States ’ global leadership, in both economic and political terms. Its prominence does not necessarily signify that the dollar is strong. At this moment, the dollar is weaker vis-à-vis the euro than in the period between 1980-2000, because the United States has lived beyond its means for so long. Both the average American citizen and central government are consuming too much and saving too little. Private savings in the United States make up a meagre 0.4% of disposable income. In the euro area, citizens lay by more than 10% of their income. While the low level of private savings in the United States is not easily accounted for, stock exchange and housing price movements are probably an important factor. From surveys it emerges that especially citizens in the higher income brackets are dissaving. They look upon their assets as a substitute for savings. Not only American citizens are not saving much, if at all, even central government is dissaving, witness the high budget deficit. The expense of the war in Iraq and internal security is one of the causes of the high budget deficit. On the balance of payments, the national savings deficit of the United States translates into a current account deficit to the tune of 6% of the gross domestic product, or about 1.25 times the total annual output of the Netherlands. This means that funds must be raised from other countries on a structural basis. This cannot go on forever. A tad more Calvinism would not hurt. In some areas a lot can be achieved with little effort. The American administration might decide, for example, to raise tax on energy consumption, after the European example. This measure would bring down the public sector deficit and put a brake on private spending. Besides, it would enhance national security by limiting dependence on oil imports. And this measure would benefit the environment into the bargain. However, it is not just the United States that should be doing something to lessen the global imbalances on the balance of payments. The rest of the world, too, should pull its weight; Asia, by observing greater exchange rate flexibility, and Europe, by generating more growth. Healthy public sector finance may make a contribution within this scope. The vicissitudes around the Stability Pact show that the European house is also not in order in this respect. The other side of the coin: the accumulation of dollar reserves in Asia The countries that for internal reasons have resolved to stabilise their currencies against the dollar, have had to buy up substantial amounts of dollars to prevent their currency from increasing in value in dollar terms. As a result, they have built up unprecedentedly high dollar reserves. I’m referring to Japan, China and several other Asian countries. This policy cannot and will not be continued forever. Neutralising the monetary consequences will be at increasing cost. On top of that, the potential foreign exchange risks rise with each dollar by which the reserves increase. The present situation shows a remarkable resemblance to the early seventies. Also back then, many countries had pegged their currencies to the dollar. In the post-war period most developed countries had adopted a system of fixed but adjustable exchange rates. This system was named after Bretton Woods, the American town where it was devised in the final year of World War II. The guilder and other currencies had fixed their exchange rates against the US dollar, which in turn was pegged to the gold standard. In the early seventies, the American balance of payments likewise began to deteriorate due to public sector overspending. This situation was related to the war in Vietnam. Also, the central bank kept interest rates low and oil prices were high in real terms. Under these circumstances, the fixed parity between the dollar and gold proved unsustainable and, in 1973, the Bretton Woods system collapsed once and for all. This historical parallel underscores the vulnerability of a combination of an unbalanced balance of payments and fixed exchange rates. By way of an anecdote, I might add that an American delegation visited the Nederlandsche Bank in 1971 in order to beg of us not to exchange dollar reserves for gold. In response, the then President, Jelle Zijlstra, decided to do the very opposite and to do so without delay and on a massive scale. Global economy structurally sound So, let us consider where we stand: the dollar is weak. In itself, this is not positive for our export sector. But the exchange rate is not the only factor determining our export position. The growth of world trade is of much greater importance. And as to that, the stars are favourably disposed. In our region it may hardly feel that way, but for the world economy 2004 was a peak year. At about 5%, real growth was the highest of the past two decades, and exports benefited accordingly. In all likelihood, 2005 will also be a propitious year, seeing the economy grow by approximately 4%, a rate that is still above-trend. In 2005, our export sector will continue to profit from a global trade growth by approximately 8%. And we should factor in something else. As economies grow more flexible, so will their ability to cope with exchange rate fluctuations. Take the Canadian, Australian and New-Zealand economies, for example, which in the past 5 years expanded by 3% or more. This contrasts sharply with the average growth rate of 1.6% in the euro area. The hefty movements in the euro/dollar rate seen in the past five years should therefore bring home the need for greater flexibility in the economy. The favourable global picture is largely accounted for by the United States and Asia, more in particular China and India. Over a period of six years, exports from China doubled to 6% of world exports in 2003. China ’s tempestuous economic development is taking place at the expense of the environment. It would be bad for the global environment if every Chinese citizen had a throbbing car and a humming fridge. And while signs are pointing to a gradual awareness in China of the downside of booming energy consumption, this does not take away the fact that we are dealing with a colossal problem. However, we should also count our blessings: it is pure gain that so many world citizens are sharing in wealth. I consider China’s breakthrough final. From now on, we should refer to the G4, instead of G3. We live in a quadrupolar world, made up of the United States, Europe, Japan and China. Europe is lagging behind the United States and Asia. More growth in Europe would be desirable, also from a global perspective. It would increase the United States ’ export potential. What is especially required is a stronger European drive in the structural field. The EU enlargement in Central and Eastern Europe will provide an impulse in the short term. This is the only part of Europe that does share in the global growth acceleration. Furthermore, we should hope that the growth spurt seen in the nineties in the United States will spread to Europe. In a recent study, the American central bank estimates annual labour productivity growth at 2.6% in the next ten years. It is about time that Europe also manages to realise a substantial rise in productivity. If markets function properly, the chance of that increase materialising will be greater. Let us hope that the implementation of the Kok Committee proposals for structural reforms within the scope of the Lisbon agenda will get off the ground. Conclusion Considering all this, how are we to look upon exchange rate fluctuations? What it amounts to in simple terms is that highly integrated economies forming, so to speak, one economic block, benefit from fixed exchange rates. Economies that differ widely from each other and do not interact much, profit from mutually flexible exchange rates. Admittedly, exchange rates sometimes tend to move too uncontrollably, creating a breeding ground for speculation. But if exchange rate changes arise from structural factors, we should welcome them. It is satisfying that these days there are fewer complaints about the euro exchange rate than before. At the macro level, this is appropriate. Rather than with the rock-bottom level seen several years ago, the current level of the euro/dollar rate should be compared with the average level over a prolonged period. To assess our competitive position, it would therefore be better to take the exchange rates with all trading partners into account and correct them for mutual inflation differences. This so-termed real effective exchange rate of our currency is now 8% above the average for the period 1980-2000. Moreover, there is little reason to complain about the euro exchange rate as its consequences are not that overwhelming. To the extent that the Netherlands is a small, open economy, the vast majority of its trade is confined to countries that also calculate in euro. On a corporate level, some operations are obviously sensitive to the exchange rate. They must adopt strategies that anticipate the adverse effects of exchange rate fluctuations. This is just what they are doing. The German car manufacturers BMW and Mercedes are cases in point. And judging by the parking area outside this building, they are successful enterprises. The fact that both costs and revenues would be expressed in dollar played a weighty role in their decision to set up production facilities in the US. With this move, both companies have covered themselves against exchange rate fluctuations in a natural manner. Another much-used way to do so is by means of financial instruments. I suggest that we send the euro rate as scapegoat for wrong economic moves into the desert, just as happens in the Jewish tradition at the time of the Day of Atonement. | netherlands bank | 2,005 | 2 |
Speech by Professor Arnold Schilder, Chairman of the BCBS Accounting Task Force and Executive Director of the Governing Board of the Netherlands Bank, on the occasion of the leave-taking of Mr Jan Hommen, member of the Executive Board of Philips, Amsterdam, 11 April 2005. | Arnold Schilder: Good governance Speech by Professor Arnold Schilder, Chairman of the BCBS Accounting Task Force and Executive Director of the Governing Board of the Netherlands Bank, on the occasion of the leave-taking of Mr Jan Hommen, member of the Executive Board of Philips, Amsterdam, 11 April 2005. * * * This speech will highlight the role of public oversight concentrating on recent developments in the field of governance, accounting and supervision. Some concrete examples will be used from the practice as prudential supervisors and to show you how at DNB ´Sense and Simplicity´ are an objective as well. Introduction Ladies and gentlemen, it is a great pleasure to speak here on Good Governance. I will highlight the role of public oversight concentrating on recent developments in the field of governance, accounting and supervision. I will use some concrete examples from our practice as prudential supervisors and to show you how for us at DNB ´Sense and Simplicity´ are an objective as well. I am sure you are familiar with that slogan. The main subjects of this speech In the first part of my speech I will briefly discuss the way DNB has incorporated governance issues in its supervisory approach and how this compares with views held among the business community. I would like to emphasise here that as prudential supervisors for the financial sector we highly value Good Governance, especially such aspects as checks and balances - mainly in risk management structures - quality of management and accountability. The second part of my speech is about how public overseers can help establish the rules of the game. In this capacity DNB uses its influence in the international regulatory environment. There we liaise with standard-setting bodies to ensure that new regulations and standards advance the public good. I will illustrate how we have played this role in practice, using recent developments of International Financial Reporting Standards as an example. Governance as part of our supervisory approach The widespread attention Good Governance receives nowadays could give the impression that this concept has only a brief history. On the contrary - looking back across the history of prudential financial supervision – we see that governance has been on our agenda for decades. Over time, the concept has been broadened and deepened, partly, of course due to the eruption of scandals. Undoubtedly, one of the milestones in the development of Good Governance is the 1997 Report of the so-called Peters Committee. This Report contained 40 recommendations to promote good governance. It appeared that these recommendations were not followed up satisfactorily. But the report set out important principles about a company´s risk management and necessary checks and balances. Its recommendations were based on the COSO-framework, an internal control framework of global standing. The Peters Report was, in fact, the first Dutch Code of Corporate Governance. It gave an impulse to the development of explicit requirements on good governance for banks. How? Well, in 1999 DNB issued its Regulation on Organisation and Control or ROC. In drafting the ROC, we used the governance framework of the Peters Report as its backbone. So in addition to risk management requirements, this Regulation includes checks and balances for the Managing and Supervisory Boards of banks. For example, the ROC requires all banks to establish an audit committee function involving knowledgeable and independent Supervisory Board Members. All banks, you may wonder? Yes, we require such an audit committee function for all, but we allow smaller institutions to meet this requirement within their limited capabilities. This is an example of a principle-based regulation which allows congruence with reality. It will come as no surprise that the second Dutch Code on Corporate Governance, the Tabaksblat Code, contains many of the same aspects as DNB´s ROC, since both are based on the same source. The same goes for some papers of the international Basel Committee on Banking Supervision, in which we were again able to integrate the Peters Committee´s recommendations. Oversight promotes a level playing field This leads us to an important purpose of public oversight. I refer to the aspect of promoting a level playing field. Maintaining a level playing field requires not only adequate regulations but also transparent supervision. You will agree with me that supervising an organisation that applies Good Governance will differ strongly from supervising an organisation that applies Bad Governance. Supervisory action towards supervised organisations can have direct or indirect benefits for those who apply Good Governance. In that sense supervision is in the corporation´s as well as in the public interest. Transparency I have just mentioned transparency as an important aspect of supervision. It is beneficial for enforcement purposes. After all, it is important for supervised organisations to know what our enforcement instruments are and when we will use them. An important new development here results from the Revised European Directive on banking Capital Requirements. This Directive adopts the new Basel II capital framework for European legislative purposes. It also requires supervisory disclosures from all European competent authorities - a development which we support actively. So in future everybody will be able to compare the supervisory level playing field for banks through the websites of the European Banking Supervisors. The view of Jan Hommen Such supervisory objectives compare well with those of the business community. To illustrate this I will select some sound bites from a recent speech by Jan Hommen. Speaking before a financial reporting oversight seminar organised by VNO/NCW and AFM, Jan stressed the importance of oversight in preventing regulatory arbitrage, and of harmonised accounting standards. Such prevention is important, according to him, in order to guarantee a level playing field. He also said that public oversight of financial reporting contributes to the confidence in financial markets. And he went even further to say that the benefits of this type of public oversight may be diminished if not accompanied by good governance within the company itself. Indeed, congruence is important both ways. Rules and regulations should align with internal practices, and internal practices should be in line with formal governance structures. It is good to see that our views align to such a great extent. Conclusion on the role of public oversight In sum, only a balanced mix of sound governance structures and related practices together with transparent public oversight will give Europe a competitive Internal Market. Public overseers´ efforts for ´Sense and Simplicity´; an example I now come to the second part of my speech. The business community, including the financial sector, also needs legislation, standards, codes and guidance to be able to play the game. The rules of the game should, however, be conducive to the ´sense and simplicity´ in their appliance. As you know better than anybody, this is an important principle, but far from easy to apply. This is also an important aspect of the role of the public overseers. Allow me to illustrate this role by taking an example from recent experience. As you know, the International Accounting Standards Board has issued the revised Standard on Financial Instruments, IAS 39. The European Community faced the issue of endorsing this revised accounting standard by the end of last year. A key issue here was the so-called Fair Value Option. This option allows financial reporting entities to use fair values for the financial instruments in their accounts. The business community, amongst others banks and insurers, expressed concern about the revised Standard. Moreover the European Central Bank and the Basel Committee on Banking Supervision criticized in particular the risk of inappropriate use of the Fair Value Option. The Fair Value Option What was the problem? The International Accounting Standards Board, as a matter of policy, issues standards which can be applied by all relevant organisations, without specifics for individual sectors. For some sectors, such as the financial sector, these standards appear to be too broad. Regarding the Fair Value Option, the gap between the parties involved related mainly to the reliability, comparability and relevance of accounting figures in firms´ financial statements. There were fears that the unrestricted use of fair values could open the door to manipulation and the use of inaccurate valuation methods, which might hurt reliability. Moreover, different institutions could use the Fair Value Option in very different ways, which might hamper comparability. And finally, the use of fair values might not be in line with sound risk management practices within institutions, bringing into question the relevance of reported figures. Now, congruence between sensible standards and sound internal risk management practice is important. Jan Hommen said as much, in the speech I referred to earlier: for financial institutions, accounting requirements must align as much as possible with internal risk management policies. And with time running short, the question how to bridge the gap became more and more urgent: between a broad standard on the one hand, and the restriction to a context of good governance and risk management on the other. Searching for an acceptable outcome It is important, in this kind of process, to listen carefully to each other and to search for common ground. IASB was strongly bent on an unrestricted option for reasons of principle and in order to maintain simplicity. Banks and insurers disagreed on the proposed restrictions. And regulators were concerned about the possible abuse of the option. We as banking regulators then engaged in very informal discussions with banking representatives. We drafted proposals that made sense to both banks and banking regulators. This was possible because we applied a simple principle: good governance banks want a level playing field based on sound risk management practices. Four months later, the now likely outcome is that IASB will have framed the Option within sensible boundaries – and will require comprehensive disclosures about underlying risk management practices, thereby serving transparency. Simple, in the end, and sensible – but after much perspiration. This outcome should strike the right balance between IASB on the one hand, and financial institutions and prudential regulators on the other. I trust this balance in outcome will receive the support of the European Commission as well. Wrap up Let me now wrap up my speech. I have given you DNB´s view on some elements of public oversight and how we contribute to transparency and to solutions that make sense. Both from a business and a supervisory perspective, one thing is of particular importance, and that is congruence. This means the congruence of sensible structures and regulations with sound internal practices and vice versa. And transparency can help achieve this. How gratifying it is, then, that Jan Hommen recently also marked these terms as overarching principles for the Philips corporate policy. He did so, not only for financial reporting, but also, if I understand correctly, for the governance structure in general. And as you will understand from my speech, I would like to congratulate Philips on these outstanding principles and Jan Hommen on his undoubtedly large contribution to their development. Ladies and gentlemen, thank you very much. | netherlands bank | 2,005 | 4 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and President of the Bank for International Settlements, at the ABP/PGGM-Congress ¿Pension Plan Design for the Future¿, The Hague, 25 April 2005. | Nout Wellink: Pension in motion - the Netherlands in an international perspective Speech by Dr Nout Wellink, President of the Netherlands Bank and President of the Bank for International Settlements, at the ABP/PGGM-Congress “Pension Plan Design for the Future”, The Hague, 25 April 2005. * * * “The Dutch pension system is among the best in the world. But does it have a future?” This is how the opening question reads on the invitation to this two-day conference. A challenging question, to be sure, one that is bound to release many emotions. For a discussion of pension and the future cannot be held without raising the need for reforms. And politicians do not win public favour with proposals towards reforms. On the contrary, strikes and mass demonstrations are their lot all over Europe and even in the Netherlands. Even so, many citizens, the younger generation in particular, seem convinced of the need for pension reforms. The main cause – the ageing of the population – is leading to increasing fiscal pressure in most Western countries. Considerable fiscal deficits or pension contribution rises are imminent if we do not take action. In this address, I will therefore look at the situation in several European countries. Has any progress been made yet? And how is the Netherlands doing in this context? Subsequently, I will highlight two other themes: transparency and freedom of choice. Transparency is a very topical theme for pension funds in the Netherlands. Greater transparency is vital for the system to be future-resistant. Transparency regarding the financial position, the risks and the risk distribution. For the traditional actuarial and accounting techniques no longer afford consistent insight into the financial position of pension funds. Deficits are not identified in time, and once they are established, it is not always clear by which party they should be absorbed. Things just have to improve. The Financial Supervisory Framework will bring relief. This is my first message for you. My second message concerns freedom of choice. The increasing diversity of labour patterns among workers calls for customization of pensions schemes. However, the Dutch appear to hold pension security very dear. Greater freedom of choice must therefore not be provided at the expense of pension security. More than that, for the truck system that is typical of our system, a high degree of security is a prerequisite. People must be able to rely on a given minimum level of pension rights. Above that level, they could be allowed more freedom of choice in the risks they run. How Dutch pension funds will be able to realise such a system is what I’m going to explain next. Europe First, the situation in Europe. Everywhere in Europe, life expectancy is rising and birth rates are falling. In particular in countries relying heavily on the pay-as-you-go system, the attendant increase in the “grey” pressure leads to ever higher pension contributions. This situation applies to most European countries. Exceptions are the United Kingdom, Denmark, Sweden, Ireland and our own country, where money is set aside for pension, the so-termed second-pillar. A number of countries, like Germany, are seeking to develop a capital-funded private pillar, but it will take a lot of time and a long period of double burdens before this goal is achieved. Countries like the United States and the United Kingdom, which were already convinced of the need for adjustments decades ago, started reforming their pension systems in recent years. As early as 1983, the United States decided to raise the age of retirement stepwise from 65 to 67 between 2003 and 2022. The United Kingdom, too, has a long tradition of pension reforms. As early as in the 1970s, it was recognised that something had to be done in order to raise private pension savings and reduce the state pension’s share. To this end, enterprises were initially stimulated to set up collective pensions schemes. However, this plan failed under Thatcher. Her government encouraged citizens to build up their old age pensions individually. Thousands of those risking this change were set back for large amounts on being wrongly advised by questionable intermediaries. As a result, the cutbacks in state pensions were not set off by improvements in private arrangements. The pension issues have meanwhile been brought home to continental European countries, too. Solutions are proving politically nettlesome, though. Most countries are taking the first cautious steps now. For example, in a large number of countries the ages of retirement and early retirement or the number of years of service required for entitlement to pension benefits are being revised. In Italy, for one, the retirement age of men will be raised from 57 to 62 years, between 2008 to 2014, while in France not the pensioning age, but the number of years of service will be increased, i.e. to 40 in 2008. In a number of countries, the austerity measures are combined with the introduction of a flexible age of retirement. Workers in Finland, for example, may choose to retire at an age between 63 and 68. Every year they postpone retirement they secure a higher pension. Italy and Sweden are interesting cases when it comes to life expectancy risk. They have converted their system into a Notional Defined Contribution (NDC) system, which provides for a closer link between the contributions paid and the pensions paid and uses the life expectancy at the moment of retirement as a basis for the pension rights. In other words: the costs of a longer life expectancy are no longer shouldered by the next generation, but translated into lower pensions. The Dutch situation Indeed, rising life expectancy is one of the main causes of the increasing burden. As a result of rising life expectancy, many more people reach the age of 65. When, back in 1957, the Netherlands adopted the old-age pension system for people aged 65 and upwards, the average age of death was still about 61 years. It would last another small decade before the average age of death for men had risen above 65 years. At the time, men did not reach the age of 65 as a rule. By the time you were 65, you were simply unable to work anymore. If we were to extrapolate this line of reasoning, the age of retirement would need to be raised to 79 on the grounds that the current average age of death is 75. This comparison, while absurd, serves to demonstrate how much better and, hence, more expensive our pension provisions have become. The number of people receiving an old-age pension has grown substantially because the age of retirement has remain unchanged. To avoid an abrupt adjustment of the age of retirement, it is therefore advisable to start discussing a system by which the average age of retirement is gradually raised, while allowing individual flexibility as to the age of retirement and, hence, freedom of choice as to the height of the pension benefit. Unlike most other European countries, the Netherlands is so fortunate as to have built up high pension reserves. As a result, the ageing of the population affects our total pension benefits to a lesser degree. All the same, our second-pillar pensions are sensitive to the ageing of the population. This sensitivity is reflected, among other things, in the effectiveness of the contribution instrument: it is becoming increasingly difficult to absorb setbacks with contribution adjustments. In recent years, many arrangements have been converted from final pay to average pay schemes, with conditional indexation of pension accruals and benefits. This permits a more flexible use of the indexation instrument and makes for a different risk distribution between the parties concerned. Through this development, our system seems to be shifting towards a “defined contribution” system, for lower than expected investment results and reduced indexation will result in lower benefits. However, it certainly still is not a DC system in all respects. In a DC system, the risks are entirely borne by the individual worker, while average pay schemes are characterised by risk sharing and intergenerational solidarity. If returns are lower than expected, the active and next generation may be resorted to in order to safeguard post-actives’ benefits. However, the use of indexation as a steering instrument increases the risk of erosion of the future value of our pensions. This risk is directly related to the indexation ambition and the corresponding contribution reduction that pension funds will be required to formulate under the Financial Supervisory Framework. Social partners are of course free to determine the indexation ambition themselves, but everybody should bear in mind that their pension’s value will be considerably eroded if during the accrual phase indexation is incomplete. Proceeding from 2% indexation, one-third of the total capital accumulated at the age of 65 is made up of these indexation allowances. To the extent that full indexation is too ambitious, a stable value pension must surely be feasible? This ambition may be pegged to the ECB’s inflation target of 2%, the lowest indexation percentage that a pension funds should strive to ensure. Transparency The adjustments in the supervisory framework and the transition to the average pay scheme are closely related to the financial recession that pension funds have faced in recent years. This brings me to transparency. Owing to the traditional actuarial and accounting techniques, the actual financial position of pension funds was insufficiently transparent. Pension funds were required to value their investments at current prices, whereas liabilities were valued at a fixed actuarial interest rate of 4%. This led to a situation that prevented timely identification of hidden surpluses and deficits. Due to this lack of transparency, the higher yields realised during the stock market boom were translated too soon into contribution reductions and more generous pensions, without it being evident how lower-thanexpected yields would have to be absorbed. To many Dutch pensioners it came as a complete surprise that “lower than expected investment yields” could mean no or lower indexation. Apparently, they had failed to read the key features document, or gave up reading when they came to the small letters section. Nearly all pension regulations contain an escape clause that renders indexation only obligatory if permitted by the funds available. This makes it imperative, though, that the actual value of these funds can be verified. Transparency is therefore of the utmost importance. And transparency is just what was lacking. I shall show this to you on the basis of the following two figures (see Annex). The first figure reflects two funding ratios. The blue curve represents the traditional funding ratio, the red curve the funding ratio based on market rates. The figure shows that the funding ratio based on the fixed actuarial interest rate rose in the second half of the nineties and did not decline until after 1999, when the creeping slump had set in. If you just look at the liabilities side, thing become a lot clearer yet. The blue curve stands for the liabilities at the fixed actuarial interest rate. The red one, for the liabilities at the market rate. What may be concluded from this chart is that the room for indexation did not start to narrow until as late as 2000, but, due to the declining trend in the capital market interest, already in the early nineties. In fact, the use of a fixed actuarial interest rate has masked half of the actual increase in pension liabilities. The financial problems in recent years have made all the parties concerned more aware of the risks incurred by pension funds. Implementation of the financial supervisory framework should enhance transparency and consistency between the values of investments and liabilities, making hidden reserves visible. Compare this to the Tower of Winds by the renowned Japanese architect Toyo Ito. The Tower of Winds, a ventilation tower for the subterranean space of Yokohama station, is equipped with 2,000 computer-steered light bulbs that respond to wind, sound and temperature. In daytime, the light is reflected by aluminium panels, bringing out the building’s cylindrical shape. In night time, the lamps transform the tower into a transparent structure. Our pension system should eventually resemble that Tower, looking beautiful during the day, and revealing its internal structure and robust foundation during the night. Besides making visibility of reserves mandatory, the Financial Supervisory Framework contains stricter provisions regarding cost-effective contributions, with a view to creating more clarity about the market-comparable costs of pension commitments. Moreover, funds should offer more insight into the way they have distributed the risks between the parties concerned. They must communicate their indexation ambition to the participants in unambiguous terms. A great challenge lies ahead of them within this scope. They must be open about the risks run by each individual, as well as about the consequences of these risks, for running risks means suffering pain every now and again. The parties concerned might arrive at the conclusion that the decisions made were ill-advised. How is one to explain that the risk was deliberately taken and that the decisions made on the basis thereof were good, but that there is always a chance that things go wrong? In an unpredictable world, ex ante “good” decisions may prove “wrong” ex post, if the risk materialises. The very fact that pension funds take risks also obliges them to render an account for their policy, as such conduct will ensure the public’s confidence in the system. This also fits in with the demands made by today’s society on institutions. In short, for a system to be future-resistant all parties involved must be aware of the risks they run and the possible consequences thereof. Transparency regarding the financial position of funds is a prerequisite to this end. Freedom of choice This brings me to my second theme: freedom of choice. Not only is it necessary for participants to know the risks they run, but for pension funds it is equally important to know what risks their participants are willing to run. When it comes to their pension provisions, the Dutch turn out to be risk-averse and consider themselves financially incompetent. This emerged from a recent survey by De Nederlandsche Bank. The outcome of this survey is that the vast majority of Dutch workers are not interested in a transition to a DC system. The majority value security and are willing to pay for that. This means that more freedom of choice must not be provided at the expense of pension security. More than that, for the truck system characterizing our present system a high degree of security is a prerequisite. People must be able to rely on a given minimum level of pension rights. Above that level, they could be allowed more freedom of choice regarding the risks they run. What can pension funds do to accommodate these preferences and the diversity of risk profiles? By offering a lower, but guaranteed indexed pension, supplemented with an individual pension build-up based on a risk profile of the participant’s free choice. This does not imply that participants must be showered with thousand-and-one different options. In his book “The Paradox of choice: why more is less”, Barry Schwartz explains that maximum freedom of choice is not necessarily always better. There is a boundary across which more freedom leads to diminishing returns. People tend to grow depressed when offered abundant freedom of choice. The sense of not having enough time to make the right choice causes stress and, not seldom, to disappointments. Also experiences in Sweden, where workers may choose from 650 different collective investment schemes for their public DC pension show that an abundance of choice is felt to be a burden. Pension funds had therefore better offer a limited number of risk profiles. Subsequently, participants can choose the risk profile that suits them best. The risk-averse will opt for a no-risk profile; those willing to run high risks, for a high-risk profile. And, naturally, those finding themselves in between these two categories will pick the low-risk variety. The security of the basic pension in any case offers participants a minimum guaranteed pension they can fall back on. For the guaranteed basic pension, pension funds should make sure that the mismatch risk is minimal. This is in compliance with the Financial Supervisory Framework, which makes clear that either side of the balance sheet is sensitive to market rate changes and, hence, makes the interest rate risk visible. The interest rate risk is determined by the difference in maturity between investments and liabilities. As, at present, the average maturity of fixed interest assets of the pension funds varies from 5 to 7 years and that of liabilities runs to 15 years on average, a mismatch, also referred to as “duration gap”, is in evidence. This gap renders pension funds vulnerable to interest rate decreases. It is expected that pension funds will shift their focus to the overall risk profile in order to close this gap. They can do so by buying bonds with a longer maturity or off-balance sheet products like swaps, futures and swaptions. And to hedge the inflation risk, they can include index loans or index swap products in their investment mix. The European governments are meanwhile responding to the risen demand for long-term loans from both European and American pension funds. Recently, the French government issued a 50-year loan. Also Greece, Germany and Italy recently sold long-term paper. And, this month, the Dutch government will issue a 30-year loan. The market for index loans is still limited, but if demand picks up, index loans will automatically become an attractive financing instrument for general government. General governments are able to complement the current financial markets by issuing index loans. They are in a unique position to do so, since tax revenues are positively correlated to wage movements. A continuously changing world calls for regular assessments of new developments and subsequent adjustments. Or as John Kenneth Galbraith puts it in his History of Economics: “In fact, economic ideas are always a product of their own time and place, they cannot be seen apart from the world they interpret. And that world changes – is, indeed, in a constant process of transformation – so economic ideas, if they are to retain relevance, must also change.” This is why this conference is a laudable initiative. Today and tomorrow you will be learning a great deal about innovations in the financial markets and the new possibilities to combine collectivity and risk sharing with more freedom of choice and tailor-made pension schemes. Stability of pension values, transparency and freedom of choice are the chief challenges in the process towards a future-resistant system. For our system to be sustainable, it is necessary that everybody knows the risks and the possible consequences thereof. The Financial Supervisory Frameworks offers a solution. Moreover, participants should be allowed more freedom of choice regarding the risks they run. Pension funds can provide this by offering a specific guaranteed minimum pension, supplemented with an individual pension build-up based on a risk profile of the participant’s own free choice. I wish you much inspiration in the next few days and much wisdom in the years ahead. And please try to keep your emotions under control. As the Dutch pension system is among the best in the world, we would like things to stay as they are. | netherlands bank | 2,005 | 5 |
Speech by Dr A H E M Wellink, President of the Netherlands Bank, on the occasion of the China Congress, 'The Culture of Sharing Knowledge', Amsterdam, 3 October 2005. | Nout Wellink: China's rise and its impact on Western economies Speech by Dr A H E M Wellink, President of the Netherlands Bank, on the occasion of the China Congress, 'The Culture of Sharing Knowledge', Amsterdam, 3 October 2005. * * * Thank you for inviting me to this conference organised by the Asia house. China is returning to the place it occupied in the world economy hundreds of years ago, when it was a centre of trade and innovation. Direct trade relations between the Netherlands and China go back to the early 17th century, but it is largely due to the opening of the country in the past decades that China’s image as a ‘mysterious’ and ‘inaccessible’ country has changed radically. China is already one of the leading world economies, yet as in every rapidly developing country, its economic policy faces challenges. In addition, I would like to share my views on China’s impact on the European economy. Note that while I will focus on China during my talk, we should not forget the other large, Asian country – India. The challenges faced by India might be of a slightly different nature, yet it reinforces the points I will make about the economic impact of China on Western economies. How important is China now? China dominates newspaper headlines. China’s economic growth has averaged almost 10 percent per year over the past two decades, so that during that time its national income has been doubling every 8 years. Compare this to the euro area: our last doubling of national income took 30 years. In brief, China’s growth represents one of the most sustained and rapid economic transformations seen anywhere in the world economy. And it has led to a significant reduction in poverty levels, too: by some accounts, over half of the reduction in absolute poverty in the world between 1980 and 2000 occurred in China. While the shock itself occurs in China, it is transmitted to the Western world. Direct effects can occur through trade, leading to more international competition. The term ‘globalisation’ is typically used to describe changes in the world economy resulting from dramatically higher international trade. The ratio of worldwide exports to worldwide GDP rose from about 8 percent in 1960 to 27 percent last year. The Netherlands imported for almost 15 billion euro goods from China in 2004. This is about 6 percent of total Dutch imports. In addition, there are indirect effects. For instance, China’s appetite for resources drives up prices for commodities, including – as you may have experienced at gas stations– oil. Oil consumption from China has risen by 15 percent in the past year, helping global oil demand to grow at the fastest pace since 25 years. Not surprisingly, such increases drive up oil prices. Moreover, a redistribution of wealth takes place from oil-importing countries to oil producers. Looking forward: policy challenges for China Economic expansion can result from two sources: first, use of more inputs (growth in employment and the capital stock); second, increases in the output per unit of input (increases in productivity). Productivity in China is rising, but so far an even more important part of China’s success story is driven by an astonishing mobilisation of inputs: China’s population is about 1.3 billion people, and there is still a large amount of surplus labour in the rural area. As the Chinese economy is transformed, around 25 million jobs are created every year. In the same period, about 2-3 millions jobs are created in the U.S., and only about 1.5 million in the euro area! China’s rise is a shock to world labour supply of unprecedented magnitude. If the pace of job creation is sustained, China’s rapid growth could last for another decade or so. Clearly, if economic growth is based on expansion of 1/3 resources, its pace is not sustainable.1 At some point all inputs are fully used. From that point on, China’s growth will slow down to its pace of productivity growth. At present, China’s growth gets an additional boost from keeping its currency undervalued. This improves its international competitiveness and fuels export growth. But a country cannot keep its real exchange rate fixed forever. Eventually a revaluation will occur: If a country grows faster than the rest of the world, economic fundamentals require an appreciation of one’s currency over time. The adjustment can occur via two channels: a nominal appreciation, or high inflation. By fixing the nominal exchange rate, the pressure on inflation will increase. By limiting the room for an interdependent monetary policy, it also magnifies the risk of financial imbalances, such as bubbles in asset markets. Moreover, liberalisation of capital flows and financial globalisation implies that keeping one’s exchange rate undervalued nowadays has become more difficult than in the 1980s. There is a second issue to having a flexible Chinese exchange rate. To restrict exchange rate flexibility, capital controls are used. At present, Chinese control the outflow of capital. The Chinese savings rate is extremely high (40 percent), but interest rates offered to Chinese investors are relatively low. Therefore, an opening up of the capital account could lead to high outflows of Chinese capital, causing difficulties for the banking sector. Therefore, changes to the exchange rate system must go hand in hand with efforts to strengthen the banking sector. China’s accession to the World Trade Organisation (WTO) comprised commitments to substantially liberalise its financial sector by 2006. Clearly, the pace at which market participants need to comply with international practices may differ – e.g. different requirements may be in place for local banks than for international banks – but large commercial banks will certainly have to adopt international standards. To ensure a level playing field, this will also imply that at some point, large Chinese financial institutions will have to follow the same international rules and practices as European financial institutions – including Basel II. In a general sense, Basel II represents an improved and internationally comparable way to look at risk taking in financial organisations over time. This also implies that the supervisory framework needs to be strengthened, in order to be able to cope with the supervisory challenges resulting from advanced instruments to manage risk. Finally, no discussion of China’s growth would be complete without mentioning the notoriously poor quality of China’s statistical data. When browsing through China’s official statistics, one cannot fail to notice inconsistencies, such as shares of investment per sector adding up not to 100 percent, but to 120-or-so percent. I suspect that data for the service sector could be even more unreliable, given the particular difficulties of measuring output and detecting underreporting. To take good decisions a policymaker needs good data. Part of the problem could lie in the fact that private parties are not allowed to compile statistics. That said, progress is being made almost as I speak, as Chinaworks hard to improve the quality of statistical data and to bring it up to international standards, such as those of the OECD. How should western economies react? Despite the policy challenges there can be little doubt that China’s presence in the world economy will grow further. Emergence of new economic powers is not a new phenomenon: since the 1950s, for instance, we have witnessed the rapid rise of Japan. The rise of China is different from that of any other country in terms of its size. It is not different in the sense that the world as whole will benefit. If the productivity of 1.3 billion people increases, world production increases and we all benefit. Consumers experience this every day: international competition has resulted in cheaper goods, and has contributed to the success of central banks in maintaining price stability.2 But it is not just that prices have fallen, in addition consumers can also choose from more variety: where Henry Ford once joked that his famous T-model comes in ‘any color as long as it is black’, today’s consumers can purchase a wide array of goods not available in the past. P. Krugman. The myth of Asia's miracle. Foreign Affairs 73 (6):61-79, 1994. Krugman’s main message is confirmed in Duo Qin, Marie Anne Cagas, Pilipinas Quising, and Xin-Hua He. How much does investment drive economic growth in China? Queen Mary University of London Working Paper 545, 2005. K. Rogoff, 2003, Globalization and global disinflation, paper prepared for Jackson Hole conference, August. 2/3 A recent U.S. study found that the welfare gains from consumers having a broader choice of goods are equivalent to 2.8 percent of GDP.3 China has a huge cost advantage in producing labour-intensive goods. Consequently, Europe’s economic structure will change: as Chinese wages are much lower than European wages, production of labour-intensive goods is shifted to China. Europe will specialize in capital-intensive production. One area where massive relocation of business activities is already taking place is the textile sector. We must acknowledge the hardship imposed on those who find themselves out of work. And we must ask ourselves: which policies are needed to ease the adjustment? Let me be clear: protectionism is not the answer. This would not only hurt Chinese workers, it would also deprive European consumers from the benefits of international trade. Instead, competitive, sound firms in Europe must have opportunities to grow, while policymakers should limit assistance to firms that will no longer remain competitive. Structural change brought about by globalisation is not very different from structural change imposed by technological progress. Had we banned cars, we would still be using horses and buggies. Viewed from that angle, it is clear that we would become poorer by protecting industries that cannot compete with cheaper foreign products, or by protecting employment in these sectors. Europe’s advantage lies in the production of capital-intensive goods. And given that the most severely affected jobs are typically those requiring the least education, our efforts must be directed to improve education and to offer training for those affected. I am often asked whether Dutch wages are too high in the face of competition from low-wage countries. I believe that the gap in wages will fall, but there are two sides to that issues: (1) what will happen in China, and (2) what will happen in Europe. A consequence of China’s rapid productivity growth will be that real wages in China will rise. Economic history offers no example of a country that experienced long-term productivity growth without a roughly equal rise in real wages. The idea that somehow the old rules no longer apply and that China will always pay low wages, despite rising productivity, has no basis in actual experience. The second issue is what will happen in Europe. Here my approach is a pragmatic one: we should not a priori exclude the possibility that part of the adjustment could occur via wages. I would like to remind you that we are dealing with a world labour-supply shock of unprecedented magnitude. We simply do not know what the exact effects on European wages will be, but one thing is clear: if real adjustment is needed, we cannot prevent it from happening. The more restrictions we impose on the adjustment process the worse off Europe will be in the end. Restricting wage adjustment could result in adjustment occurring via a lower exchange rate. But with one important downside: wage adjustment can allow for sectoral differences, while adjustment via the exchange rate hits the entire economy. This is most likely not an optimal solution. Conclusion The world economy is increasingly integrated. Therefore, China’s rise transmits shock waves to Western economies as that country continues to develop and prosper. Europe will face tough competition. New possibilities will open up for European firms, but Europe’s production of labourintensive goods is likely to come under pressure. China offers tremendous opportunities for Western consumers and firms, and there is little reason to be scared of China’s rapid development. To fully reap the benefits of China’s rise, European policymakers must not hesitate to reform our economies. In particular, our labour markets need to become more flexible, as the pace of change is likely to increase. Changes imply that in the short run, there will be winners and losers. Overall, however, welfare will rise, as was the case when we moved from the horse to the car. Changes in the European production structure towards more capital-intensive production will imply that some workers will have to change jobs. We have to continue to stimulate an environment of lifelong learning to facilitate retraining and to ease this transition period. C. Broda and D. Weinstein. Are we underestimating the gains from globalization for the United States? Current Issues in Economics and Finance (Federal Reserve Bank of New York) 11 (4), 2005. 3/3 | netherlands bank | 2,005 | 10 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Bank for International Settlements, at the Fortis pensionfund seminar, Utrecht, 15 February 2006. | Nout Wellink: How regulators contribute to a sustainable pension industry Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Bank for International Settlements, at the Fortis pensionfund seminar, Utrecht, 15 February 2006. * * * A seminar on the consequences of new legislation and other rules for pension funds cannot take place without the pension regulator, not least because it is his duty to enforce compliance with the new rules and regulations. After all, the objective is to ensure that the pension quality promised is actually delivered. I was therefore only too keen to take this opportunity to exchange views with you on “how regulators contribute to a sustainable pension industry”. I have taken the liberty to split my theme. In the first part of my address, I wish to look at the concept of sustainability and what it means for the Dutch pension system. Sustainability depends on three elements: discipline, transparency and a strong pension industry. In the second part, I will discuss the close link between pension supervision and these three elements, and their contribution to a durable pension system. The messages I wish to convey are: • First of all, a durable pension system is based on discipline: everyone must stick to the rules of the game. The future is unknown and the ensuing risks to the sustainability of our system are considerable. From the perspective of sustainability, both cost-effective contributions and adequate buffers are a sine qua non. • In the second place, sustainability goes hand in hand with transparency. Pension funds need to be sufficiently transparent about what their participants, including future participants, may expect. • Thirdly, a durable pension system depends upon a strong pension industry. Legislators, regulators and the sector have a shared interest in maintaining and propagating the comparative advantages of the Netherlands when it comes to pension provisions. A durable pension system calls for discipline Let me begin with the importance of discipline. For a pension system to be durable, all players must abide by the rules. At the heart of the rules in the Netherlands lies a funding system, where commitments are sufficiently covered by provisions and risks by appropriate reserves. We need to beware of slackening discipline and refrain from allowing deviations from the rules out of short-term considerations. That was true yesterday, it is true today and it will be true tomorrow. I expressly mention “yesterday”, because it was only a short while ago, to be precise in the 1990s, that discipline throughout the sector was under pressure. Contributions were less than cost-effective, pension rights were made more generous and pension funds’ risk profiles were tightened. All this against the background of a falling cover ratio, at current prices. From 1999 on, the average nominal cover ratio at market value dropped sharply, from nearly 200% at end-1999 to 120% in 2002. However, the sustainability of stable-value pensions can be determined more accurately on the basis of the real cover ratio, in combination with the formulated indexation ambition. The real cover ratio may be roughly approximated by the nominal cover ratio, adjusted for actual price inflation. The real cover ratio then shows a similar picture to the nominal cover ratio, falling from nearly 150% at end-1999 to around 80% in 2002. As a result, full protection of nominal pension rights against inflation was no longer within reach, let alone inflation-proof pensions. Since 2002, both the nominal and the real cover ratio have stabilised. Today, the nominal cover ratio has been hovering somewhere between 120% and 130% for some time, while the real cover ratio is still well below 100%. The fall in the cover ratio since 1999 was due to the trend-based decline in long-term interest rates, the sharp drop in share prices and, not to forget, the relatively low pension contributions. In this context, we do well to recall what was known as the Broad Revaluation. In the early 1990s, it was rational for pension funds to set low contributions, so as to prevent the tax authorities from creaming off pension capital. Contributions were consequently not cost-effective. By 2001, when the economic tide had turned, pension contributions became subject to upward pressure. The average annual contribution as a percentage of remuneration went up markedly, from less than 8% in 2000 to nearly twice that figure in recent years. Since 2004, however, this rise has levelled off, and contributions have now stabilised at around a level which is cost-effective. Estimations for 2006 even indicate a slight decline in the average contribution. We see from this recent past that buffers are essential to a durable pension system. The trouble with the discussion about buffers is that it generally makes allowance for the risk of under-funding, but fails to take into consideration the degree of under-funding. The importance of buffers for durable pensions and stability shows up in probability calculations, which take into account both the chance and the measure of under-funding. An average pension fund, which invests half its capital in corporate equities, with a duration gap of around ten years, and a cover ratio of 130%, has a chance of about 2.5% of facing under-funding within the next year. This degree of risk, viz. 1 in 40, is considered acceptable by politicians. However, when the cover ratio falls to 105%, this chance rises to about 1 in 3. I can hear you thinking that this is a totally different matter and you are right. So you see how important it is to look at both the chance and the measure of under-funding. As soon as the average pension fund’s cover ratio falls below the required 130%, not just the risk of under-funding goes up, but so does the measure of under-funding. (When a fund’s cover ratio is 105%, that ratio will, by the time the fund is confronted by under-funding within one year, have dropped to 90%.) The point I wish to make is that, if our pension system is to be durable, such a situation needs to be avoided. Prevention is better than cure. We saw that low cover ratios necessitate much higher contributions, as well as lower indexation. In addition, low cover ratios hamper value transfers and labour mobility, and create uncertainty when the sponsor goes bankrupt. Adequate buffers, on the other hand, allow of stable contributions and lasting indexation. Buffers furthermore offer protection against downward risks, as well as the advantage of extra return, which can be used to realise indexation ambitions. But back in 2002, there was no question of sustainability. In its Quarterly Bulletin, the Nederlandsche Bank began to draw attention to the pension sector’s financial position. One article was titled “Sustainability under pressure”. The tone was sombre. Today, more than three years later, much has changed for the better. Far-reaching measures have been taken to put the Dutch pension system back on track again. The number of pension funds with a funding problem has fallen drastically, contributions are practically cost-effective again and the average cover ratio has all but recovered to the minimum desired level. This is good news. Transparency and sustainability go hand in hand Now let’s look at my second message: sustainability and transparency go hand in hand. Pension funds need to be sufficiently transparent about what their participants can expect to get. Transparency rules out surprises and thus enhances confidence among participants. This is a major principle of our pension system. After all, people trust that pension entitlements, accumulated during their active life, are paid out upon retirement. A recent survey by the Nederlandsche Bank shows just how much they value pension security. Nearly half the respondents are prepared to pay a higher pension contribution for more certainty about their eventual pension benefit. Only one in five participants opts for an arrangement without guarantees; the remainder are indifferent. It was noted that pension fund managers and participants may disagree on this point. In the Dutch system, transparency also means being open about the pros and cons shared with future generations. Future generations are stakeholders because they, too, will join the pension system at some point in time. With a view to the continuity of the system, access should be and remain attractive. In other words, sustainability also means that the needs of the current generation are not met disproportionately at the expense of future generations. Risk-sharing within and between generations forms an essential element in the collective Dutch pension system and offers many advantages. It makes the pension system more stable and more durable. After all, pension arrangements are about spreading risks, the main risks being: longevity risk, inflation risk and investment risk. When these risks are spread widely and over time, all participants stand to gain in terms of prosperity: in economics, this is known as a Pareto improvement. Where pensions are concerned, this advantage is reflected in a stable income pattern over the individual’s life cycle. The prosperity gains of our collective system should not be taken for granted. Spreading risks among generations works so long as future generations are not saddled with an unduly heavy burden; if they are, a funding system will be confronted with an unsustainable situation sooner or later. New entrants facing a situation where they are required to pay disproportionately more for their own pensions over a long period of time will vote with their feet. Or the mandatory nature of the pension system will be called into question. To prevent this from happening, discipline is needed so as not to overburden future generations, and transparency to keep up support for the distribution of the advantages and the disadvantages. A sustainable pension system stands to benefit from a durable distribution of the pluses and the minuses. A durable pension system depends on a strong pension industry This brings me to my third message. Apart from discipline and transparency, a durable pension system calls for a strong pension industry, with healthy pension funds, which flourish in a dynamic environment characterised by lasting expertise in managing pension risks. Legislator, regulator and the sector have a common interest in maintaining and propagating the comparative advantages of the Netherlands in terms of pension provisions. These comparative advantages are considerable. The Netherlands not only has one of the best capitalised pension sectors in the world, it also has much experience of pension insurance. This country harbours much knowledge and skills in the areas of asset-liability management, portfolio management, actuarial expertise, information technology, tax and pension legislation and administrative processes. Here, major advantages of scale can be had. Where asset pooling is concerned, too, the Netherlands offers a surprising potential investment alternative, a restricted fund for mutual account, comparable to much-praised Luxemburg and Irish constructions. Finally, the Netherlands has an edge in that both pension funds and regulators have wide experience with the implementation of the prudent person rule (which entails: (i) expert portfolio management, (ii) the investment of assets in the interest of (former) participants so that (iii) the safety, quality, liquidity and return on the portfolio as a whole is guaranteed,(iv) alignment of the risk and return profile of the entire portfolio to the fund’s liability structure and (v) sufficient diversification of investments.) In short, even though it is rarely mentioned in the media, the Netherlands has as much to offer as other countries, and even more. But there is no cause for complacency. Maintaining a sound starting position is not a matter of course. Where possible, we must continue our efforts to capitalise on national and especially international developments. Take, for example, the EU pension directive which entered into force in September 2005. This directive allows European employers to place pension commitments with pension funds in another EU Member State. Given its comparative advantages and its avant-garde position in the development of risk-based capital requirements for pension funds, the Netherlands is an attractive domicile for such institutions. Here lie opportunities for the Dutch pension industry. In conjunction with the Ministries of Social Affairs & Employment and of Finance, a working group of the Nederlandsche Bank are currently investigating how the Netherlands could become even more attractive as a domicile for pension funds. The working group are putting out their feelers within the sector, but welcome suggestions. I hereby invite you all to submit ideas on the Bank’s website, [email protected], which is open around the clock. How the regulator contributes to sustainability Having explained the importance of durability for the Dutch pension system, I would now like to take a closer look at the role of the regulator. By exercising supervision, the Nederlandsche Bank contributes to durable old age pensions and a strong pension industry. Supervision contributes to three principles which are related to the themes mentioned earlier, i.e. discipline, transparency and a sound pension industry. These principles are: (1) identifying risks, (2) preventing rising deficits, but should these occur, (3) applying a customised approach to the resolution of the problems, effected as soon as possible. These principles form the foundations of the Financial Assessment Framework. The Framework does not prescribe the substance of pension arrangements; that is the province of the social partners. Furthermore, as regulator, the Nederlandsche Bank is not responsible for the quality of pension arrangements. Incidentally, this does not mean that the Bank does not have an opinion on what constitutes quality. In my capacity as economic advisor, I have pointed out on several occasions that pension arrangements should include a serious indexation ambition. Nominal guarantees are nice, but protection of purchasing power is nicer still. A serious indexation ambition must therefore be at least in line with the ECB’s objective of price stability, i.e. around, but not more than 2% inflation annually. The Financial Assessment Framework contains standards for overseeing compliance with the pension contract. Basically, financial supervision addresses the question whether a pension fund’s assets are proportionate to its liabilities and prevailing risks. In other words, it seeks to prevent under-funding. This is the foundation of the funding system; in combination with adequate buffers, cost-effective contributions and sufficiently inflation-proof pensions, it makes for a durable pension system. But even in a sound, durable pension system, under-funding can never be ruled out altogether or only at a very high cost. Should an unhoped-for financial disaster take place, a customised plan, which takes into account the fund’s efforts to prevent under-funding, and ensures that the interests of the participants are best served will take effect. Such a customised plan is set in motion only if the pension fund’s management has deployed its instruments to the full, and the employer or the industry involved, have done their utmost. It is important that the problems be solved as fast as is possible, because prolonged under-funding has several harmful consequences. For instance, a financial shortfall has major consequences for participants in the event that the sponsor goes bankrupt. Under-funding also precludes indexation, and eats into retirees’ purchasing power. All this may be detrimental to the system’s durability. Conclusion A durable pension system requires discipline, transparency and a strong pension industry. It is these three elements which the Financial Assessment Framework seeks to achieve by (1) emphasising the identification of risks, (2) directing policy at preventing deficits, and (3) customising any remedies, should the deficits arise after all. This is how the regulator contributes to the durability of the pension system and a correspondingly durable pension industry. Here, today and in the future. | netherlands bank | 2,006 | 2 |
Speech by Professor Arnold Schilder, Chairman of the BCBS Accounting Task Force and Executive Director of the Governing Board of the Netherlands Bank, at the Asian Banker Summit, Bangkok, 16 March 2006. | Arnold Schilder: Banks and the compliance challenge Speech by Professor Arnold Schilder, Chairman of the BCBS Accounting Task Force and Executive Director of the Governing Board of the Netherlands Bank, at the Asian Banker Summit, Bangkok, 16 March 2006. * * * Compliance risk is becoming one of the major risks banks are facing. The increasing globalization, issues with the corporate governance of complex institutions, changing laws and regulations, the understanding of what constitutes sound risk management, and the continuous evolution of financial products create complex situations for banks that operate on a cross border basis. One may wonder whether the compliance framework in place is robust enough to effectively manage these rapidly changing factors. Creating a “best in class” compliance framework seems to be the best way forward. The development and implementation of such framework might well be a challenge equal to the implementation of Basel II. Introduction The subject of my speech is the challenges that banks face today with respect to compliance. You may wonder - why? The main reason for delivering a speech about this topic is that we have all recently seen banks involved in compliance related problems. Riggs Bank acts as a well known example of such problems. In July 2004, the U.S. Senate Permanent Subcommittee on Investigations of the Committee on Governmental Affairs published a report on Riggs Bank. The evidence reviewed by the Subcommittee staff establishes that, since at least 1997, Riggs Bank had disregarded its anti-money laundering obligations, maintained a dysfunctional anti-money laundering programs and allowed or, at times, actively facilitated suspicious financial activity 1 . In a more recent case De Nederlandsche Bank, together with the relevant regulators in the United States, issued a Cease and Desist order with respect to ABN AMRO Bank. The reason for ordering this Order had to do with compliance issues. The problems ABN AMRO was faced with, albeit less far-reaching then those at Riggs Bank, act as another example of compliance related deficiencies. Another reason for this speech can be found in the publication of the paper ‘Compliance and the compliance function in banks’ published by the Basel Committee on Banking Supervision (BCBS) in April 2005. In the related Press Release of 29 April 2005, BCBS Chairman Caruana said: “Compliance has emerged as a distinct branch of risk management within the banking system 2 .” So it is fully appropriate and timely to address this important topic in this Conference’s broader context of sound risk management in banks. Compliance risk is quickly becoming one of the major risks banks are facing. So the efforts banks should undertake concerning compliance, may become comparable in size and importance to the endeavours of banks in relation to the implementation of the new Basel II Capital Accord. However, unlike the various risks discussed by the new Capital Accord, holding additional capital to ‘cover’ compliance risks will not act as a mitigating factor. Other efforts are needed. During the first part of this speech I will briefly discuss what should be understood under compliance. Then I will go more in depth on the nature of the compliance related problems that not only banks, but the entire financial world is encountering. Subsequently, a closer look at what compliance really implies and what the international standard-setting bodies perceive as compliance. I will then discuss some issues involved in the ABN AMRO case and lessons learned. I will conclude with some broader perspectives on how to approach the challenges ahead. Case study involving Riggs Bank, United States Senate, Permanent Subcommittee on Investigations, Committee on Governmental Affairs, released on 15 July 2004, page 2. Press release of 29 April 2005, www.bis.org/press/p050429.htm Scope and definition of compliance The notion of ‘compliance’ literally means ‘obedience’ or ‘dutifulness’. It has a broad scope. As such it is known to have various interpretations. To avoid any misunderstandings during my speech, I will provide you with the definition used by the Basel Committee. In its Compliance function paper, the Committee has defined compliance risk as being “the risk of legal or regulatory sanctions, material financial loss, or loss to reputation a bank may suffer as a result of its failure to comply with laws, regulations, rules, related self-regulatory organization standards, and codes of conduct applicable to its banking activities” 3 . Hence, compliance generally covers matters such as observing proper standards of market conduct, managing conflicts of interest and treating customers fairly. Also, compliance typically includes specific areas such as the prevention of money laundering and terrorist financing, and may extend to tax laws that are relevant to the structuring of banking products or customer advice 4 . In my opinion, the compliance function should protect the institution against unlawful behaviour and strengthen its ethical consciousness. Drivers of compliance related problems As supervisors we provide frameworks and guidance for the financial sector to facilitate the functioning of the financial world - although I am aware that our efforts may not always be perceived as such by the industry. In the end, however, the industry and supervisors serve the same goal, which is to create a stable and prosperous financial industry worldwide. It is essential that clients are confident in the solidity of financial institutions and that they are assured that their salaries paid into their bank accounts are safe. So, the industry as well as standard-setting bodies should always reflect on irregularities and consider whether the current risk control framework in place is still adequate and warrants stability. By adequate I mean that the framework should be effective for the industry as well as for the supervisory community. It is therefore essential to consider the possible underlying drivers of recent compliance related irregularities. If we look at the financial world of today, one of the greatest challenges is the rapid globalization of the world economy. New economies such as China and India are emerging, and are rapidly attracting investors and financial institutions. This globalization does not only take place in a traditional way, i.e. through businesses´ presence in the countries concerned. What I personally find fascinating is the current trend with regard to outsourcing, offshoring and ‘smart sourcing’. Not too long ago, I myself observed how service providers in India even play along with the different time zones their customers are located in by tailoring work shifts of their employees to these time zones. A first complication that globally operating financial institutions are facing as a consequence of the globalization, relates to corporate governance, and especially head office oversight. Of course, a board of directors should approve and oversee the bank’s strategic objectives, and set a desired compliance culture. Also, the board should ensure the institution has adequate policies and procedures to ensure head office oversight of the activities carried out by the various business lines. However, given the increasing complexity of ‘cross border’ institutions, this sounds easier than it is. The board should ensure that adequate controls are in place to oversee the decisions made by its senior management, and to ensure that the entire organisation acts in line with the set objectives, and the desired compliance culture. This raises all kinds of organisational and managerial questions, varying from the amount of autonomy that the business lines should have, to issues with regard to control frameworks and reporting lines. There is no easy answer. Secondly, financial institutions have to make sure that they comply with applicable laws and regulations in the jurisdictions where they operate. As a result of the increasing globalization, financial institutions nowadays have to make sure that they are compliant with laws that have extraterritorial effects. These different legal requirements pose a challenge for institutions operating cross border. Another challenge is that our understanding of what constitutes sound operational management is continuously changing. What we all understood to be sound operational management five years ago Compliance and the compliance function in banks, Basel Committee on Banking Supervision, April 2005, paragraph 3. Compliance and the compliance function in banks, Basel Committee on Banking Supervision, April 2005, paragraph 4. no longer applies. The recent best practices papers produced by the Basel Committee sustain the view that the understanding of adequate operational management is rapidly changing 5 . The number of standards and regulations that banks have to adhere to, is tremendous and not by definition in accordance with how banks in practice have been conducting their businesses. The development of new products and the increasing complexity of the products being offered by financial institutions, are making life even more difficult. The specific risks of these complex products and their global distribution, should be analyzed by banks and be included in their global risk management framework. Given the ongoing evolution of the financial markets in Asia, it is essential for your institutions, like ours, to analyze the compliance risks that relate to the financial products sold by them, especially since these products will continue to evolve. The increasing globalization, issues with the corporate governance of complex institutions, the continuously changing understanding of what constitutes sound operational management, changing laws and regulations, as well as the ongoing evolution of products - combined with a determination with governments and regulators to fight money laundering, terrorist financing and other illegal financial transactions - all create complex situations for banks that operate cross border. The unavoidable conclusion is that banks need to address these compliance challenges in their risk management programs on a global basis, and that the most stringent requirement quickly becomes the benchmark. When reflecting on these challenges, one may wonder whether the compliance framework in place is robust enough to effectively manage the challenges and risks that financial institutions face. What, then, are the latest developments concerning such compliance framework? Closer look at compliance During the last couple of years, various international standard-setting bodies have published papers on compliance related issues. For instance, as a response to the increasingly sophisticated moneylaundering techniques the Financial Action Task Force has revised its recommendations in 2003. Also, the Basel Committee on Banking Supervision published a paper on customer due diligence in 2001 and the Consolidated Know Your Customer paper in 2004 6 . The cause for these papers was that supervisors around the world were increasingly recognizing the importance for banks to have adequate controls and procedures in place so that they know the customers who they are dealing with. Also, the Basel Committee published a paper on the compliance organization and the compliance function in 2005. This paper provides guidance on embedding a compliance organization within credit institutions. The compliance definition used by the Basel Committee considers the sanctions, or loss to reputation, that an institution may suffer as a result of failure to comply with laws, regulations and standards. As the laws, regulations and standards are continuously changing, compliance becomes a moving target. The question that arises from this observation is that one should continuously ask oneself: “how can I be sure that my organization is compliant”? The changes occur at such a high-speed that one may well be “compliant” today but no longer so tomorrow. Today’s challenges are tomorrow’s history. The Compliance function paper emphasizes that compliance starts at the top. Compliance will be most effective - if not, will only be effective - in a corporate culture that emphasizes standards of honesty and integrity. The board of directors and senior management should lead by example. The tone at the top is vital for a culture of awareness. The board of directors is responsible for overseeing the management of the bank’s compliance risk. To this end, the board or a committee of the board should at least once a year assess the extent to which the bank is managing its compliance risk effectively 7 . Having said this, compliance requires continuous attention of the board of directors and senior management; its responsibilities are not limited to the yearly assessment. Compliance implies a great E.g. papers published by the Basel Committee on the internal audit function, compliance function, operational risk and (very recently) corporate governance. Customer due diligence for banks, Basel Committee on Banking Supervision, October 2001, Consolidated KYC Risk Management, Basel Committee on Banking Supervision, October 2004. Compliance and the compliance function in banks, Basel Committee on Banking Supervision, April 2005, paragraph 14 et seq. involvement of the board of directors, especially since it is widely accepted that the board is ultimately responsible for the operations and soundness of a bank 8 . Without disclaiming the ultimate responsibilities of the board of directors, the responsibility for the effective management of the bank’s compliance risk resides with the bank’s senior management. One of the most important responsibilities of senior management with regard to compliance is to make sure that the main compliance risk issues an institution is facing, are identified and assessed on an annual basis. Subsequently, senior management - with the assistance of the compliance function - has to ensure that plans are prepared to manage these risks. Such plans should address any shortfalls (policy, procedures, implementation or execution) related to how effectively existing compliance risks have been managed, as well as the need for any additional policies or procedures do deal with new compliance risks identified as a result of the annual compliance risk assessment 9 . This risk assessment, together with the subsequent introduction of improvements to the control framework, form an essential step in the ongoing process to ensure adequate control of the risks banks are faced with. Aside from the responsibilities of the board of directors and senior management, the paper also mentions principles concerning the status and responsibilities of the compliance function. It is essential that the compliance function has a formal status within a bank. This in order to give the compliance function the appropriate standing, authority, and independence 10 . The responsibilities of the compliance function should be to assist senior management in managing effectively the compliance risks faced by the bank. Specifically this means that the compliance function should: • advise senior management; • provide guidance and education to employees on compliance issues; • identify, measure and assess compliance risks; and • monitor and test compliance and report the findings through the reporting line in accordance with the bank’s internal risk management procedures. Once more, I would like to stress the importance of timely identification, measurement and assessment of compliance risks. Citing the Compliance function paper “the compliance function should, on a pro-active basis, identify, document and assess the compliance risks associated with the bank’s business activities, including the development of new products and business practices, the proposed establishment of new types of business or customer relationship, or material changed in the nature of such relationships”. The paper continues by stating that the compliance function should consider ways to measure compliance risk (e.g. by using performance indicators) and use such measurements to enhance compliance risk assessment. It should assess the appropriateness of the bank’s compliance procedures and guidelines, promptly follow up any identified deficiencies and formulate proposals for amendments 11 . Institutions are expected to tailor their control measures to the risk classification of both their clients, and their products and to implement specific control measures for the nature and severity of the compliance risks posed by each category. Therefore, the question that each one of you will need to answer for his or her organisation is: “how can I be sure that my organisation is compliant?” The ABN AMRO case 12 Recently, the importance of an adequate compliance function was illustrated by events that took place within ABN AMRO, one of the largest credit institutions headquartered in the Netherlands, and one of the large internationally operating banks worldwide. Enhancing corporate governance for banking organisations, Basel Committee on Banking Supervision, February 2006, paragraph 17. Compliance and the compliance function in banks, Basel Committee on Banking Supervision, April 2005, paragraph 18. Compliance and the compliance function in banks, Basel Committee on Banking Supervision, April 2005, paragraph 22. Compliance and the compliance function in banks, Basel Committee on Banking Supervision, April 2005, paragraph 37 et seq. This section is based on publicly available information, www.dnb.nl, www.federalreserve.org, www.abnamro.com. Those of you who have read ABN AMRO’s press release of 19 December 2005, the related website publications of the regulators in The Netherlands and the United States, or subsequent press publications, may already be familiar with this case. However, for those of you that are not, I’ll provide a brief overview. In July 2004, ABN AMRO signed a so-called Written Agreement with US banking regulators concerning compliance-related deficiencies, identified by the regulators at the US dollar clearing activities of ABN AMRO in New York. These deficiencies were related to cases of non-compliance with the United States’ Bank Secrecy Act and OFAC regulations (the United States’ sanction regime). This Written Agreement, that addressed ABN AMRO’s anti-money laundering policies, procedures and practices, was designed to correct these deficiencies. In response to this Written Agreement, ABN AMRO strengthened its compliance function and its anti-money laundering programme in New York. Many measures were taken to achieve a best-in-class compliance programme. These measures varied from a centralisation and increase of its compliance function to the implementation of new ITsupport systems. Nevertheless, during the remediation process ABN AMRO itself identified other shortcomings in one of its overseas offices. Investigations from its audit department revealed that certain employees of the branch, without the enforcement or knowledge of anyone outside the branch, were not observing the bank’s policies and standards in relation to certain US dollar payment instructions sent to the bank’s US dollar clearing centre in New York on behalf of Libyan and Iranian clients. Under EU legislation, ABN AMRO was allowed to have dealings with said counterparties. Nonetheless, the United States’ OFAC regime imposed certain limitations. Further investigations by the bank made it clear that these procedures were aimed at not including certain client-specific information from the relevant payment instructions. As such, it was ensured that the payments would pass through the New Yorkbranch’ OFAC filter without being detected and blocked. Having been informed by ABN AMRO about these procedures, the United States bank regulators and De Nederlandsche Bank concluded that this constituted a pattern of unsafe and unsound practices warranting further enforcement action 13 . On 19 December 2005, an “Order to Cease and Desist” was issued by the joint regulators, requiring ABN AMRO to undertake comprehensive additional measures - in addition to the measures it had already undertaken in response to the Written Agreement. Amongst others, these additional measures related to: • the submission of a U.S. Law Compliance Programme, ensuring continuous compliance with state and federal laws of the United States; • the improvement of Head Office oversight to ensure effective control over and supervision of its foreign branches; and • the completion of a written plan to improve the effectiveness of the management oversight in the United States. On top of the “Cease and Desist Order”, the USbank regulators imposed a fine amounting to US dollar 75 million, and a voluntary endowment of US dollar 5 million to the Illinois Bank Examiners´ Education Foundation. Lessons learned It goes without saying that ABN AMRO’s Supervisory Board and its Managing Board respectively, have ordered detailed analyses of the compliance-related incidents, to ensure the lessons learned would be beneficial in the future. In addition to the institutions themselves, the regulatory community must learn from such incidents as well. Given the severe impact of such incidents, it is important that the regulatory community and financial institutions reflect on whether the so-called “principle based” approach is adequate in this area. The reality is that appropriate compliance means adhering to many rules in various jurisdictions. So even if supervisors apply a principle based approach, at least the financial institutions themselves need to Page 3 of the Order to Cease and Desist Issued upon Consent issued by De Nederlandsche Bank and the US Regulators. couple this with rule based instructions. Some banks have introduced a mix of risk-based and rulebased compliance programs. My point is that both supervisors and the industry need to reflect on their paradigms. It is not either principles or rules, but rather an intelligent combination of principles and rules. Another issue that warrants further consideration is that of “awareness cultivation”. It is widely believed that compliance should always be at the forefront of the employees’ thinking. Nevertheless, the modification of US dollar payment instructions acts as an example of deliberate attempts of employees to dodge internal and external regulations. Clearly, these employees lacked the desired mindset. Training and counsel remain very important tools to create the desired mindset: it helps employees to better understand not only the requirements and regulations itself, but also the “why” of such requirements. Unfortunately, training alone will not always suffice to get the message through. It remains difficult to deal with this issue, but alternative solutions are not inconceivable. You, as senior management of supervised institutions, continue to have, of course, an exemplary role within your own organisation. This enables you to influence your staffs´ behaviour by acting as shining examples. In addition, an interesting approach that you as senior management might want to consider, relates to annual appraisals of staff members. In addition to the traditional commercial objectives that usually dominate the appraisal process, one might consider including compliance-related objectives. Such objectives, of course, remain difficult to measure and, therefore, require careful consideration; the proverb “haste makes waste” is certainly applicable here. However, the growing usage of such performance objectives by banks like ABN AMRO as a tool to further influence employees´ behaviour, illustrates that - if properly applied - they have their merits. I am convinced that the importance of such factors will continue to grow, in the Netherlandsbut also in Asia. In the end however, whereas the aforementioned factors undoubtedly contribute to the observance of internal and external requirements and regulations, it is my belief that the tool ‘par excellence’ to achieve compliance remains the combination of control and enforcement. “Control” to increase the possibility of being caught, either by internal control bodies like the audit- and the compliance function or by external authorities like the banking regulators. And “enforcement” to exact compliance with rules, regulations and other requirements. Parallel with Basel II In the beginning of my speech I made a brief comparison between compliance and the new Basel Capital Accord. I can imagine that you may wonder what the afore-mentioned has to do with the new Basel Capital Accord. And yes, there seems to be little convergence between the capital requirements laid down in the Accord, and today’s challenges with regard to compliance. There are, however, some interesting links that I would like to highlight. “Compliance risk” is swiftly becoming one of the most important risk drivers that credit institutions are facing. Firstly, not having adequate controls to prevent, for example, money laundering or terrorist financing will be unacceptable for regulators, who - as illustrated by the fines levied against ABN AMRO in the United States- will not hesitate to take formal measures against your institutions. Secondly, and perhaps even more importantly, involvement in serious compliance related incidents can lead to reputational damage, the impact of which may be even larger than that of regulatory interference. As confidence remains one of the financial sector’s cornerstones, a substantial impairment of an institution’s reputation could very well lead to its collapse. Nevertheless, whereas the Basel Accord, of course, requires institutions to set aside capital to cover credit-, market and operational risk, “compliance risk” is not covered. Is this a missed opportunity? Should the drafting panels of the new Capital Accord have spent time on a concept like “compliance capital”? In my opinion, requiring institutions to set aside capital to cover losses from compliance incidents is not the issue. I believe that it is justified that the Basel Committee has not included compliance risk in its Capital Accord. Whereas (potential) credit losses can be financially compensated by holding additional capital, compliance incidents will not be mitigated by financial means. After all, compliance incidents will impact the reputation of a credit institution, which cannot be measured in financial terms. Compliance is not a financial matter, but a matter of principle. Nevertheless, the question about the position of compliance continues to intrigue me. You will undoubtedly be aware that Pillar II (the so-called Supervisory Review Process) of the new Capital Accord deals (amongst others) with the treatment of risks that are not fully covered by the requirements under Pillar 1 14 . Under Pillar II, the Accord requires banks to address all material risks faced in the capital assessment process, even those risks that cannot be measured or quantified precisely 15 . Banks are expected to further develop techniques for managing unquantifiable risks like reputational risk 16 . Although the language in the Capital Accord gives the impression that ‘something’ needs to be done, it also implies that holding additional capital for unquantifiable risks is not the solution. So, what then is the solution? I would argue that, whereas it remains necessary to mitigate compliance risks, a more structured and coherent approach is necessary. As previously discussed, banks are faced with challenges like the increasing globalization, issues with the corporate governance of complex institutions, the continuously changing understanding of what constitutes sound operational management, changing laws and the ongoing evolution of products. At the same time, the requirements and best practices imposed by legislators, supervisors and international standard setting-bodies are not necessarily attuned to each other. Those of you who work for an internationally active bank will recognize the difficulties that this brings to day-to-day practice. One important step towards solving these difficulties will be to bring these requirements and best practices together. This entails monitoring the implications of these requirements and best practices and putting effort in finding workable solutions and where possible to improve the consistency of standards already available. In my mind, this will be one of the bigger challenges for the supervisory and legislative community for the upcoming years. But you know that we are working hard here, amongst others through the BCBS Accord Implementation Group and the Core Principles Liaison Group. In the end such effort will as a result also entail new challenges for the banks themselves. It is widely realised that implementing the new Basel Accord is a huge burden on financial institutions, not only because of the complexity of the materials, but also because of the sheer size of the implementation project. The development and implementation of a consistent international compliance framework, might well be a challenge of equal size. New policies have to be written, approved and implemented, procedures have to be developed, IT-systems (e.g. automated systems to facilitate transaction filtering and monitoring) have to be installed, staff members have to be trained and control measures have to be put in place to detect and correct deficiencies. The amount of work done by ABN AMRO in response to the Cease and Desist Order resulted in comprehensive and extensive plans. This is illustrative of the effort that might well be the desired benchmark for the entire financial industry. Closing remarks I have highlighted the challenges that banks are facing today with respect to compliance and the compliance function amidst the ongoing increasing globalization, issues with the corporate governance of complex institutions, the continuously changing understanding of what constitutes sound risk management, changing laws and regulations, a continuous evolution of financial products, and a determination of governments and regulators to fight money laundering, terrorist financing and other illegal financial transactions. Therefore I expect that the importance of “compliance” will continue to grow exponentially. At this moment, multiple requirements and best practices with regard to compliance have already been issued. Nevertheless, it is my view that creating a “best in class” compliance framework by integrating these requirements and best practices should become a main priority, both for regulators and the industry. I realize that this will not be easy, but I am convinced that this is the best way forward. Par. 724 of the new Capital Accord. Par. 732 of the new Capital Accord. Par. 742 of the new Capital Accord. | netherlands bank | 2,006 | 3 |
Formal opening address by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the 14th International Conference of Banking Supervisors, Mérida, Mexico, 4 October 2006. | Nout Wellink: Global banking supervision in a changing financial environment Formal opening address by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the 14th International Conference of Banking Supervisors, Mérida, Mexico, 4 October 2006. * * * Introduction Good morning. It is an honour and a privilege for me to officially open the proceedings of the 14th International Conference of Banking Supervisors. This is my first formal address as Chairman of the Basel Committee on Banking Supervision, and I can’t imagine a more appropriate venue for my first speech than here with my colleagues from the international banking supervisory community. In addition, this year’s ICBS is the first to be held in Latin America, and I’m very pleased that we have at long last gathered in this rapidly growing and dynamic region. Since we gather at the ICBS to bring together our varied views and experiences, it is appropriate that we are here in the beautiful city of Mérida, which reflects the diverse influences of Europe, the Caribbean and the local Mayan culture. I would especially like to extend my sincerest thanks to Jonathan Davis and his staff at the Mexican National Banking and Securities Commission for their warm and generous hospitality. Not only have they put together what I expect will be a very thought-provoking programme of speakers and working groups, but they have also arranged a fascinating programme of events to better acquaint us with the colourful history and culture of Mexico and its Yucatán region. Before I begin, let me acknowledge one of our colleagues who was supposed to be joining us here. As you are no doubt aware, Andrei Kozlov, first deputy chairman of the Central Bank of Russia, was recently and tragically slain. We will remember Mr Kozlov for his tireless efforts to promote the safety, soundness and integrity of the banking system. His death is a great loss to the international supervisory community. In my remarks this morning, I would like to touch on several key themes. First, I will briefly review the work that has taken place since we last gathered two years ago in Madrid. I would then like to share some thoughts on developments in financial markets and the banking sector, and on how these developments influence the types of issues that both supervisors and the industry face. Finally, I will end with thoughts on the future agenda of the Basel Committee. In particular, I will emphasise our commitment to Basel II implementation, the need to monitor and assess the broad impact of the new capital standard, and the importance in all our work of minimising any unwarranted burden on the industry. Octavio Paz, the Nobel Prize winning Mexican poet and author, once said that “wisdom lies neither in fixity nor in change, but in the dialectic between the two”. As I will discuss shortly, we are in a time of rapid change, and we must continue to adapt. But at the same time, we must not lose sight of the fundamental elements of banking supervision. I believe that, as supervisors, we need to evolve to keep pace with changing developments, while also making sure that we retain the basic lessons that have served us well over the years. My hope going forward is that we all benefit from the wisdom of striking the correct balance between change and stability. Recent supervisory developments As I think ahead, I am greatly encouraged that the Committee’s recent work – under the steady guidance of my predecessor, Jaime Caruana – demonstrates an awareness of the need to strike this balance. Supervisors face an ever growing challenge of devising appropriate prudential structures for a financial industry that is in a constant state of change. In recent years, for example, we have witnessed an ongoing revolution in banks’ risk management practices. More and more, banks are taking a firm-wide approach to risk management that considers a broader array of risks, across a wider range of product lines and regions. Risk managers have become increasingly more disciplined in their approaches, harnessing both technology and advanced quantitative techniques in the process. Such changes require that supervisors design flexible standards and regulations that ensure a safe and sound banking system while still allowing for continued innovation in bank practices. The Basel II framework is designed to achieve this balance. It represents a fundamental paradigm shift in how we think about capital regulation. The advanced approaches to credit and operational risk rely on banks’ own assessments of risk as inputs to capital calculations, a recognition that banks are best positioned to understand and measure the risks that they face. In addition, because the quantitative and qualitative parameters for using the advanced approaches are intended as a baseline of sound practices, they can accommodate continued innovation by firms. And since the advanced approaches are driven by rigorous internal processes for risk measurement and management, they are clearly well suited for today’s sophisticated global banks. Indeed, the results of our fifth Quantitative Impact Study reveal that virtually every global bank intends to implement one of the advanced approaches. In combination with the role assigned to supervisory review and market discipline, these features of the new framework represent a more forward-looking approach to capital regulation, with the flexibility to evolve over time. A similar approach is evident in the new capital rules for certain exposures in the trading book, published in July 2005. Among other things, these rules update the trading book capital framework to better reflect the growth in traded credit products. The rules directly recognise the realities and complexities of today’s markets, and demonstrate that, even in the face of such complexity, greater harmonisation of regulations across sectors is possible. The Basel Committee has also strengthened its collaboration with banking supervisors throughout the world. This cooperation is particularly important for the success of Basel II, which raises many challenging questions regarding the roles and responsibilities of home and host supervisors. As one example, the Basel Committee’s recent paper on Home-host information sharing for effective Basel II implementation was developed jointly with a group of supervisors from a range of other countries. Likewise, 19 countries from outside the Committee submitted data to the fifth Quantitative Impact Study, allowing for a fuller understanding of the likely impact of the new framework on overall capital levels. Our commitment to working closely with non-member countries on Basel II implementation is also evident in their representation in the technical subgroups of the Accord Implementation Group. The Basel Committee also worked closely with supervisors from around the world on the updates to the Core Principles for Effective Banking Supervision. In what was truly a global effort, we have all succeeded in designing a practical yet flexible framework. It recognises not only the changes in financial markets and supervisory practices since the Core Principles were first published in 1997, but also that these changes have not occurred evenly across jurisdictions. The outcome of our effort, I believe, will allow for the application of the Principles to less sophisticated financial systems, without sacrificing their relevance for assessments of more complex systems. International accounting and auditing standards have also evolved rapidly in recent years. As supervisors, we are keenly interested in ensuring that banks’ accounting practices promote sound risk management practices, reinforce the safety and soundness of the banking system, and support market discipline through transparency. Where objectives of accounting standard setters diverge from those of bank supervisors, supervisors may have to put in place additional safeguards. Likewise, when audit reliability is called into question, supervisors may need to take steps to encourage greater reliability. Given these interests, the Basel Committee has taken an active role in the debate on changes to the framework for international accounting standards and promoting stronger global auditing oversight. As we look back on our accomplishments since we last assembled, I believe we have much to be proud of. In our completion of the Basel II rules, our attention to Basel II implementation issues, and our updates to the Core Principles, we have pursued approaches that have the flexibility to accommodate the continued evolution of bank and supervisory practices. We have also recognised the critical contributions that the broader supervisory community, the industry and other standardsetting bodies can and must make. All these efforts amount to significant contributions to ensuring the robustness of the financial system in the face of any future shocks. Evolving financial markets and emerging risks At the same time, however, the pace of innovation in financial markets shows no sign of slowing. Thus, even as we look back, we must look forward to ensure that our work remains appropriately focused on the most relevant risks. In this process, an important first step is considering market developments that affect how we view risk in the banking sector. This is the second topic of my remarks this morning. The role of banks is changing. As we know, banks have historically been the primary source of financial intermediation in most economies, with the loans they originated serving as their primary assets. Now, however, banks increasingly originate loans and other types of credit instruments with the intent of securitising them and selling them to other market participants. While it may be the case that banks in the end hold fewer credits on their balance sheets, I believe that it would be wrong to say that banks now play a less important role in credit markets. Banks, as well as securities firms, are at the centre of a new risk intermediation landscape that is increasingly based on traded products. In this new landscape, banks and securities firms are actively involved in origination, securitisation and active management of credit exposures. This shift to capital markets-based distribution of risk has been accompanied by increased velocity in intermediation, aided by new technologies that allow for greater automation and standardisation. And the greater role of capital markets in intermediation also implies that many of the risks once held by banks are now held by other types of market participants. The greater reliance on capital markets in credit origination and distribution has also served to unlock the creative potential of market participants. We see this, for example, in products that not only bundle loans with similar characteristics prior to sale, but also then structure the resulting securities into tranches with different risk profiles. We have also witnessed explosive growth in over-the-counter derivative products that give exposure to, and provide hedging vehicles for, a growing array of new and increasingly complex risks. To give some sense of the volume of this activity, the International Swaps and Derivatives Association recently estimated that the gross notional amount of outstanding credit derivatives was $26 trillion, a growth of over 50% in just six months. While I believe that these changes have made the banking system more resilient, these developments also pose a range of risks that both supervisors and the industry need to monitor closely. In a very broad sense, many of the challenges that we face stem from the mismatch between rapid market innovation and risk management infrastructure. The rapid growth in the markets for new financial products, and the entry of a diversity of participants into these markets, frequently strain the capacity of banks to manage the associated risks. If not addressed promptly and appropriately, these circumstances can have significant consequences for financial market stability. It is therefore imperative that we explore the extent to which the management of risks such as counterparty credit risk, market risk, liquidity risk and operational risk evolve in the face of market innovation. Globalisation is another important trend in the banking industry. A combination of liberalisation of financial markets over the past two decades and business opportunities in rapidly growing economies has led to an increasing proportion of global bank activities in foreign countries. This is particularly the case in capital markets, but also in areas such as retail where the presence of global banks in local markets continues to grow. As a result of cross-border mergers and acquisitions, an increasing number of banking markets now have a significant foreign bank presence. In general, I would argue that the scale of foreign banks operating in emerging markets allows them to bring expertise and financial resources that might not otherwise be available. They can also introduce more sophisticated risk management tools that may have been developed for the larger financial group. While these benefits are significant, the scale of foreign banks’ presence can have implications for host countries. For example, a local financial system could be disproportionately dependent on the safety and soundness of a small handful of foreign banks. This has potentially significant implications for how banks in these markets are supervised. It is one of the great challenges of our work that as many banks’ operations and risk management frameworks become more global, the supervisory structure remains national. Thus, as we work to address the issues I have highlighted, supervisors must also solve problems of cross-border information sharing and coordination, and clearly define those areas where supervisory responsibilities overlap and those where they diverge. Our recent updates to the Basel Core Principles show that we have been up to these challenges. The process of updating the Principles was a truly global supervisory effort and demonstrated our capacity to cooperate and seek a common understanding on many important issues. And the result – a global standard whose local application can be scaled in proportion to local risks and financial market realities – demonstrates our ability to work effectively within the constraints imposed by using national structures to supervise global institutions. Future work of the Basel Committee Given the developments that I’ve just cited, where do we go from here? How do we strike the appropriate balance between change and stability? My third topic this morning is to share some ideas on where I see the importance of work in the supervisory community over the next several years. I will focus my remarks on three key areas: our commitment to Basel II implementation; the importance of assessing and monitoring the impact of Basel II; and the need for proportionality in supervisory efforts relative to underlying risks in order to minimise the regulatory burden on the industry whenever possible. Basel II implementation Let me begin with Basel II implementation, which remains the key item on the Committee’s agenda. As I mentioned at the outset, Basel II represents a fundamental paradigm shift in the supervisory approach to capital regulation. This new approach is entirely necessary if capital standards are to keep pace with rapid innovation in financial products as well as in risk measurement and management techniques, and the ever increasing complexity of firms’ risk profiles. As such, the new framework is absolutely critical to the health and stability of the banking system. Given the importance of Basel II, I am pleased to report that implementation is fully under way. For example, implementing legislation or regulation is either in place or in process in markets such as the European Union and Japan. Likewise, supervisory agencies in the United States recently issued their notice of proposed rulemaking. Meanwhile, banks are continuing their discussions with supervisors on their specific Basel II plans, in many cases with a goal of implementation next year. Let me not, though, gloss over the difficulties involved in successful implementation. For example, it is clear that home-host issues remain among the most challenging for both supervisors and the industry. In addressing these issues, we should strive to achieve as much cross-border consistency as possible on key elements of the framework. At the same time, we should also recognise that both home and host supervisors have legitimate interests that need to be met and national implementation will vary in relation to local needs. Indeed, the tension inherent in applying a global standard within national supervisory regimes will never fully dissipate. Issues must often be resolved on a case by case basis, seeking pragmatic solutions that recognise the limits of what can be accomplished. Going forward, we must extract lessons and principles from specific cases and apply them back to our overall Basel II work. This is an iterative process, and one that will help to maximise consistency in implementation across banks and jurisdictions. In this regard, the Committee’s Accord Implementation Group, or AIG, is working to share information and thereby promote greater consistency in implementation across countries. As we address the challenges of Basel II implementation, we must remember that Basel II is more than a one-off exercise in getting the details and the numbers right. More than anything, it is a flexible framework that supports innovation over time, and provides appropriate incentives for improvements to risk management, supervision and disclosure. Basel II is as much about this long-term process, and the beneficial dialogue it has spurred between banks and supervisors, as it is about the more microlevel details of implementation. It provides the medium for interaction with the industry on a number of complex issues, and for thinking about how risk management and supervisory practices are likely to evolve over time. I encourage all of us not to lose sight of this important aspect of Basel II. The impact of Basel II I would also like to address the importance of understanding the impact of Basel II on banks and markets. Many banks, and market participants more broadly, have voiced concerns that the new framework could have unintended consequences on banks’ risk-taking and capital allocation in both the short and the long term. These consequences could occur across different dimensions, for example firm size, risk profile and jurisdiction. There could also be consequences for banks’ activities relative to those of securities firms. The Committee has been sensitive to the potential impacts of Basel II throughout its development, and this will not change as we move into implementation. I believe that shorter-term consequences, such as those related to so-called “gap year” issues arising from different implementation dates, will ultimately resolve themselves as these gaps disappear over time. This will be easier if there is constructive dialogue during this transitional period with the industry and among supervisors from jurisdictions with varying implementation dates about how best to address these short-term challenges. Some of the longer-term consequences, however, may be more difficult to predict but in many instances are likely to be the natural result of a more risk-sensitive framework. So as a first step in any discussion of longer-term consequences of Basel II, supervisors and banks should distinguish between those that reflect the closer alignment of regulatory and economic capital, and those that are indeed unintended and undesirable. Indeed, where regulatory and economic capital are more closely aligned, I expect that this will have a levelling effect on the playing field by eliminating any competitive distortions caused by Basel I. In addition, as is currently the case, I expect that banks’ decisions will be driven more strongly by assessments of risk and return than by regulatory capital considerations. Nevertheless, we must closely monitor and assess the impact of Basel II to mitigate the possibility of any competitive distortions. Failure to do so would undermine much of what is innovative and beneficial in the new framework. While I do not currently expect that it will be necessary, the Committee remains prepared to revisit aspects of the rules where there is clear evidence during the coming transition years of unintended consequences for risk-taking and capital allocation. We must also be attuned to the risk that these consequences can result from inconsistent application across banks or sectors, particularly for rules related to risk assessment and quantification. This is an area where the AIG and its subgroups will continue to actively exchange information on observed industry and national supervisory practices. I would like to highlight what I believe is a major accomplishment in this regard. Earlier in my remarks I mentioned the new trading book rules, which were developed jointly with our colleagues from the International Organization of Securities Commissions. Through this cooperative effort, we have developed a common framework for the convergence of capital requirements for banks and securities firms, which is a significant step towards providing a more level playing field. Proportionality of supervisory efforts As an important guiding principle for future supervisory areas of focus, we need to ensure that the scope and scale of any work we undertake is commensurate with the risks we seek to address. The realities of today’s banking industry and financial markets argue for more measured and flexible approaches. In an environment of continuous innovation and growing competition within and across sectors, it is important that regulators assess the appropriate balance between formal regulatory responses, enhancements to supervisory tools, industry solutions and market discipline. In the years to come, it is inevitable that the Committee will choose to develop guidance aimed at strengthening supervisory practices or highlighting necessary improvements to banks’ risk management. However, I anticipate that there will be many more instances where we decide to limit our work to stocktaking exercises and information exchange, or defer work altogether so that industry and national supervisory initiatives have the time and flexibility to run their course. As we consider the trade-offs of these types of approaches, we will continue to seek industry input on the intersection of market developments, the robustness of risk management practices, and the adequacy of supervision and regulations. In doing so, we will be able to build on the excellent dialogue that has existed around Basel II. Guided by this principle of proportionality, I would like to explore some broad aspects of the Committee’s agenda. These include cross-border information sharing, banks’ risk management practices, supervisory techniques and cross-sector coordination. My goal is not to provide specific details on potential projects, but to give you some sense of how the Committee perceives its role in the international supervisory community. Cross-border information sharing Looking first at information sharing, one of the main challenges I see going forward relates to the tension, if you will, between regulatory structures and market realities. A trend that we see is that banks increasingly manage risk on a global basis. This poses a challenge to us as supervisors since we generally operate within national regulatory structures (for very sound reasons, I might add). Supervisors will need to depend ever more on information provided by their colleagues in other jurisdictions, and will need to set up the appropriate mechanisms for doing so in ways that do not impose a burden on one another, or on the industry. In particular, we need to consider how supervisory information sharing and coordination can be deepened and broadened. Risk management practices We will also need to stay abreast of the latest developments in risk management and be attentive to the possibility that these developments may, as they have on occasions in the past, lag innovations in financial products and markets. Where such lags between financial innovations and risk management practices arise, the Committee will consider the merits of issuing guidance that conveys to banks and supervisors the sound practices that institutions should be following. Moreover, there is significant value in supervisors providing the industry with transparency about the range of practices they see in areas where financial innovation and risk management practices are evolving rapidly. For example, I think the Committee might usefully explore industry practices in areas such as counterparty credit risk, liquidity risk management and techniques for assessing economic capital. We will also continue our important work in the accounting sphere, to ensure that accounting and sound risk management practices are properly aligned. Moreover, ongoing changes in the accounting framework can have important implications for valuations, capital, and disclosure practices, and the Committee will continue to monitor developments in this area closely. Supervisory techniques The sharing of information on emerging supervisory practices will remain a fundamental role of the Basel Committee. It is not uncommon for national supervisors to pursue different approaches when adapting to changes in industry practices and market structures. Given the dynamic nature of the financial industry, diversity in supervisory practices is to be expected, and even encouraged in instances where our methods and processes continue to evolve. As best supervisory practices emerge, however, we have a strong interest in ensuring that these practices are clearly articulated and widely disseminated. Doing so will help to raise the level of global supervision, reduce any competitive distortions resulting from differing practices, and ultimately contribute to the resilience of the financial system. Cross-sector coordination In these and other efforts, it is equally important that we work closely with our fellow supervisors in the securities and insurance sectors, as firms in the three sectors increasingly compete across a range of products and markets. I have already mentioned our joint work with IOSCO on the trading book, and I am encouraged that securities regulators remain involved in our continued exploration of trading book issues, an area of growing importance as credit products become increasingly and actively traded. We will also continue to work closely with securities regulators and insurance supervisors under the auspices of the Joint Forum, which focuses on issues common to the three sectors, including the supervision of financial conglomerates and areas such as risk concentrations and management of complex retail products. Enhancing dialogue In all of our work, one of my key goals as Basel Committee Chairman is to maintain and enhance the dialogue with the wider supervisory community. For example, I earlier discussed the growth of crossborder banking and the challenges this poses for both home and host supervisors. This makes it essential that the Committee have a keen understanding of these challenges from both a home and a host supervisor perspective. In recent years, the Committee has strengthened its outreach through, for example, more frequent meetings with chairs of regional groups of banking supervisors and with the Committee’s Core Principles Liaison Group, which includes representatives from 16 non-G10 countries. This dialogue has been absolutely essential and must continue and be strengthened. Concluding thoughts In closing, as I mentioned earlier in my remarks, over the past several years we have tried to design flexible, principles-based standards that foster greater resilience in the banking sector while allowing for continued innovation on the part of banks. Looking at the pace of innovation in financial markets, the changing role of banks and the more globally interlinked banking industry, we must continue to respond in kind. Going forward, I expect the Committee will continue moving full speed ahead with Basel II implementation, assessing the impact of Basel II, and maintaining a sense of proportionality so as not to overly burden the industry and ourselves. Moreover, while we will probably continue to issue supervisory guidance as necessary in the future, we will also focus on some of the “basics” such as cross-border information sharing, understanding bank risk management practices and supervisory techniques, cross-sector coordination, and dialogue with the industry and among bank supervisors. In adapting to a changing world, we must not lose sight of the basic supervisory tools that have served us so well over the years. We should continue to encourage the development of sophisticated tools for better risk management, but we should also continue to emphasise simple but vitally important concepts such as sound corporate governance. We should strive to understand the increasingly complex quantitative models that banks increasingly rely upon, but not lose sight of the importance of sound judgment on the part of bankers as well as supervisors. I hope that you find the next several days in Mérida enlightening, challenging, energising and even, dare I say, fun. Thank you very much, and I look forward to exchanging views not just during this ICBS, but over the coming years as well. | netherlands bank | 2,006 | 10 |
Remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the High Level Meeting on the Implementation of Basel II in Asia and Other Regional Supervi. Priorities, Hong Kong, 11 December 2006. | Nout Wellink: Goals and strategies of the Basel Committee Remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the High Level Meeting on the Implementation of Basel II in Asia and Other Regional Supervisory Priorities, Hong Kong, 11 December 2006. * I. * * Introduction Thank you very much for the opportunity to address this important meeting on the implementation of Basel II in Asia and other regional supervisory priorities. I would like to thank the Hong Kong Monetary Authority for hosting this event, and congratulate the FSI and EMEAP on putting together such an impressive conference program. Hong Kong is a dynamic city in this rapidly growing region, so I can think of no better place to discuss the changes that are taking place in banking and supervision. What I would like to do this morning is talk briefly about the goals of the Basel Committee, outline the strategy and work program the Committee has in place to achieve those goals, and then provide some concluding thoughts. II. Goals of the Committee As the new Chairman of the Basel Committee, I think it is appropriate at this time for me to step back and consider the broad goals and strategies of the Committee. I would like to start by sharing with you today the Committee’s objectives as I see them. In my view, the Committee has three broad objectives. One, to provide a forum for dialogue and information exchange among supervisors. Two, to promote improvements in bank risk management practices and the framework for banking supervision. And three, to promote mechanisms for pragmatic implementation of the principles developed by the Committee. Turning to the first objective, a core goal of the Committee has always been to provide a forum for dialogue and information exchange. This helps to promote supervisory co-operation, greater consistency, and a level playing field for an increasingly global banking industry. Information sharing and dialogue also has a much broader aim, however. That is to provide the Committee with the context and perspective needed to develop policies and practices that most effectively promote a robust banking and financial system. The second objective of the Committee is perhaps most visible to the broader community. With the insight gained from information sharing about developments in risk management, supervision and financial markets, the Committee promotes improvements in these areas. In this regard, the Committee seeks to develop and promote proportionate responses to the issues identified using a range of tools. This may include undertaking further fundamental research, preparing range-of-practice papers, or where necessary developing new policies or guidance. Third, as you know, the policy guidance developed and promoted by the Basel Committee is based on consensus rather than on formal international legal agreements. An important objective of the Committee therefore is to promote credible, practical and flexible mechanisms to achieve effective policy implementation in a wide range of countries. The successful implementation of international policies requires processes and mechanisms that engage non-Committee supervisors, other sectors and the industry throughout the lifecycle of any initiative. With those objectives in mind, I would now like to discuss how the Committee’s strategy is working towards achieving those goals. III. The Committee’s strategy and work program The Committee’s strategy has four interrelated and reinforcing elements. The first element of the strategy is to maintain a strong capital foundation. That strong foundation is enhanced by the Basel II Framework, which many countries are now in the process of implementing. Secondly, the Committee reinforces the strong capital foundation by promoting other infrastructure needed for sound supervision. Thirdly, the Committee develops policy responses that are proportionate and flexible. Fourthly, the Committee is deepening and expanding its outreach to non-Committee supervisors, to other sectors, and to the industry. Strong capital foundation It should not come as a big surprise to you that implementation of the Basel II Framework is one of the highest priorities on our current work program. Integrating an effective approach to supervision, incentives for banks to improve their risk management and measurement, and risk-based capital requirements are fundamental objectives of Basel II. By definition, we don’t know where the next economic or financial shock will come from. Our focus, therefore, is on the important role of capital as a key shock-absorber for individual banks, and for the banking system more generally, no matter what the next shock entails. The implementation of Basel II reflects the reality that simple risk measures, such as those embodied in Basel I are, for the largest and most complex banking organisations, no longer very meaningful. A strong capital foundation requires a risk-sensitive capital framework that is flexible to adapt to innovation. Moreover, it should promote improvements in bank risk management and supervisory practices, and enhance transparency and market discipline. The three pillars of Basel II have been developed with those goals in mind. I would also like to emphasise that the choices that individual countries make with respect to the timing of implementation of Basel II, and the menu of options available in Basel II, should consider the development of their banking and supervisory systems, and financial markets. This leads me to my next point – the importance of other supporting infrastructure. Other supporting infrastructure For risk management and supervision to be effective and efficient, it is not sufficient to just have a sound capital framework. The second element of the Committee’s strategy is to get the basic supporting infrastructure in place. The development of the Core Principles for Effective Banking Supervision, the Committee’s liaison with international accounting bodies, and the Committee’s work on cross-sectoral bodies such as the Joint Forum are examples of our efforts to promote the fundamental infrastructure needed for a sound banking system and for effective supervision. Building the foundations for effective supervision and promoting the prudence and integrity of financial accounts are an integral part of the Committee’s current work. A sound system of accounting and provisioning underpins the integrity of risk measures, capital adequacy and meaningful market discipline. Moreover, as many of you here would know too well, it is not enough to just focus our attention on the implications of our policies for banks as the traditional lines between the various financial sectors become less clear. It is therefore important to understand the implications of market developments and supervisory changes on non-bank financial institutions and financial markets more generally. Supervision is not all about sophisticated modelling approaches. Rather it is about understanding the risks that a bank faces and promoting better management of those risks. Used appropriately, advanced modelling approaches can help a bank to refine and sharpen its ability to measure, monitor and control risk. Used inappropriately however, and without an understanding of the limitations and assumptions built into such models, the costs may be greater than the benefits. In this respect, I view the infrastructure supporting the capital foundation as vitally important. An initiative that the Committee will begin work on is the so-called “definition of capital”. Over the past decade we have witnessed significant advances in the way banks manage their economic capital, as well as the development of new and innovative capital instruments. The definition of capital topic highlights the importance of the supporting legal and accounting infrastructure, and the need to understand market dynamics within and across jurisdictions. At this stage, the Committee’s work in this area will focus on a stocktaking of the issues. Proportionate policy and flexible frameworks The third element of the Committee’s strategy is to promote proportionate policy responses, and to develop flexible policy frameworks. The Committee promotes a range of supervisory methods and advocates proportionality in supervisory approaches. The supervisory tools may include better regulation, supervisory guidance, or range-of-practice papers. In addition, in some cases, industry-led solutions may be the best approach. To respond to the accelerating pace of financial innovation and globalisation we need flexible frameworks. Both the Core Principles and Basel II are examples of global standards that were developed for local application. Both initiatives are flexible and responsive to innovation. For example, Basel II provides a menu of options to suit institutions with a range of complexity. Moreover, the more advanced approaches are based on the modelling approaches developed by advanced banks – allowing regulatory and banking models to develop together. Over the past ten years, we have observed significant changes in international capital flows, greater reliance on market funding in many jurisdictions, and banks becoming more active buyers and sellers of complex financial instruments. In light of the central role that banks play in providing liquidity, I believe that liquidity risk management is an area where it would be appropriate for the Committee to do some exploratory work. I believe there is much that can be gained from sharing information on supervisory approaches to assessing liquidity, and bank tools for managing liquidity, particularly during stress scenarios. In this and all cases, I expect that the Committee’s response will be proportionate to the risks identified, and that the policy tools that the Committee employs will be designed to achieve the maximum benefit for the least cost. I also expect the Committee will consult widely in the process of developing its views on the issues and then deliberating on possible responses. Proactive outreach This brings me to the fourth element of the Committee’s strategy, which is to engage in proactive outreach. This encompasses outreach to non-Committee countries, to the industry and to other sectors. The Committee’s dialogue with non-Committee member countries is an extremely important element of its strategy. This stems from the need to promote the development of sound supervisory practices in developing markets and to accommodate the growing importance and sophistication of non-Committee member banks, supervisors and markets. In addition, it is critical that we address home-host coordination issues that arise with the growth of cross-border banking. These trends, and the resulting need for dialogue, are quite clear when we look at the growing and changing financial landscape and the increasing trend towards market liberalisation in the Asian region. As an indication of the importance the Committee places on its outreach strategy, at its October meeting in Merida the Committee agreed to the establishment of the International Liaison Group (ILG). This group will replace the Core Principles Liaison Group, which with the completion of the revised Core Principles had completed its mandate. The new ILG will report directly to the Committee, and allow for broad supervisory dialogue on a range of issues. The ILG will provide a platform for non-member countries to contribute to new Committee initiatives early in the process, and to develop new proposals. The ILG will also initiate its own work streams on issues that are of interest to the broad supervisory community. I should also highlight the important relationship the Committee has with the FSI, which provides an outstanding program of training events and tools for supervisors around the globe. Members of the Committee and its Secretariat have been actively involved in FSI events since its founding, and we see this as a key element of outreach and dialogue to the wider supervisory community. By engaging in dialogue at a range of levels - within the supervisory community, with the industry, with representatives from other sectors, and also with other interested parties - the Committee aims to identify and address the most important risk issues. This process of filtering issues may lead the Committee to consider new initiatives from time to time. However, in most cases the exchange of information and ideas on a given topic, and making more transparent to industry the range of practices we see in a rapidly developing area, may be the most important outcomes. IV. Concluding thoughts I would like to conclude by summarising the main themes of my talk. The committee’s goals are, in my view, to provide a forum for information sharing, to promote improvements in risk management and banking supervision, and to promote mechanisms that facilitate consistent local implementation of global policies and principles. The Committee has a multi-faceted strategy to achieve its goals, which is developed within the context of developments in international banking and financial markets. The strategy and work program that the Committee has in place are built around the cornerstone of a strong capital framework. This is supported by other fundamental infrastructure, which includes strong accounting; the Core Principles for Effective Banking Supervision and cross sector collaboration. Proportionality and flexibility are overarching themes that permeate our policy work. Finally, the Committee’s strategy of proactive outreach and dialogue is critical to the long-run success of the work undertaken today. Thank you. | netherlands bank | 2,006 | 12 |
Remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the GARP 2007 8th Annual Risk Management Convention and Exhibition, New York, 27 February 2007. | Nout Wellink: Risk management & financial stability – Basel II & beyond Remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the GARP 2007 8th Annual Risk Management Convention & Exhibition, New York, 27 February 2007. * * * Introduction I am very pleased to be here in New York this morning to talk about risk management in the context of a rapidly changing financial environment. Many would argue that the greatest challenges for risk managers and supervisors arise during economic downturns and periods of financial stress. However, current benign and favourable conditions can present other challenges. We are facing a period of rapid innovation in financial markets, growing competition, and fading history that is relevant to how stress could play out in the future. In my remarks today, I would like to present a framework to think about the changing risk landscape for banks, as well as some practical steps for risk managers and supervisors that flow from this analysis. Specifically, I will first talk about the changing business model under which banks are operating. I will then discuss the new types of risk that this business model presents for banks and how traditional measures of risk and capital are becoming less relevant in this context. Finally, I will present some thoughts on what banks and supervisors can do to improve core financial institutions’ resilience to stressed market conditions. I should note that my remarks today benefit from the excellent exchanges of information that occur among banking supervisors at the Basel Committee on Banking Supervision, as well as other bodies like the Joint Forum of banking, insurance and securities supervisors. They are also informed by the insights that supervisors are deriving from the development and implementation of the Basel II capital framework. In an environment where banks and securities firms have a growing share of their activities outside of their home countries, exchanging information on emerging risks and possible supervisory responses is increasingly important. Changing business model of banking As a result of significant financial product innovation and advances in technology, the role of banks as the ultimate holders of credit assets has become less important. At the same time, however, the global banking institutions, together with a handful of securities firms, are now at the centre of the credit intermediation process. These institutions originate and underwrite the majority of credit assets. They tend to distribute them to various classes of investors through syndication, securitisation, and credit derivative technologies. Using similar technologies, they also actively manage their residual exposures. In many cases, financial institutions may retain and manage the more complex and potentially less liquid risks, for which they are ultimately rewarded. We are therefore witnessing a fundamental change in the business of banking from buy-and-hold strategies to so-called ‘originate-to-distribute’ models. While this change presents opportunities and challenges for risk managers and supervisors, it also serves as a useful framework for thinking about the changing risks at banks and other financial institutions. This shift in business models has been propelled by the rapid innovation in financial instruments, in particular the interaction of the credit derivatives markets with the rapid growth of securitisation technology. It has also been influenced by the rapid growth of the institutional investor base. There are many new players to whom risk can be distributed, such as hedge funds, loan funds, funds-of-funds, in-house hedge funds and mutual funds. In particular, we are witnessing a rapid growth in investor appetite to take on new forms of credit risk. These developments have created many opportunities to improve the way financial institutions manage their risk exposures and reduce their vulnerabilities to traditional types of credit stresses. Risks are now more widely distributed outside the banking system. There are more tools to manage risk concentrations. Risks, and how they are priced, have become more transparent. As a result, deteriorating credit exposures can be managed more actively at an earlier stage. New risks and risk management challenges The transformation of banks’ business models has yielded substantial benefits. However, the move to originate-to-distribute models also provides a useful framework for examining new types of risks that banks face and for highlighting some of the shortcomings of more traditional measures to manage them. By traditional measures, I mean simple balance sheet ratios of capital adequacy, historical measures of potential losses on loan portfolios, or value-at-risk-based risk measures in the trading book. The originate-to-distribute business models depend on several key characteristics: • First, a growing reliance on liquid markets; • Second, a healthy risk appetite among various types of investors, in particular those taking on the more risky portions of structured credit assets; • And third, a diverse investor base to whom risk is being distributed. Ultimately, what we are concerned about is the ability to transfer or actively manage the various risks that core intermediaries face, not just under favourable market conditions, but also during periods when financial market, credit and liquidity conditions are less benign. When seen through this prism, there are a number of new risks that are not captured through traditional measures. In particular, I would highlight the following: • First, a rapid growth of trading book assets relative to traditional banking book assets and a fundamental shift in the types of risks retained in the trading book, in particular those arising from structured credit products. This is a natural consequence of the improvement in financial technology we are seeing, which enables more and more assets to be priced and traded. • Second, the growth of the trading book is, in turn, producing a rapid growth in counterparty credit exposures relative to traditional credit exposures. As with market risk exposures, these counterparty exposures are becoming increasingly complex and difficult to measure. • Third, the valuation of increasingly complex products presents yet another challenge. Many of these products have not been tested under periods of stressed liquidity, which could have a significant impact on valuations. • Fourth, the use of traditional approaches by many firms to assess their vulnerability to funding liquidity risk. These approaches may not take into account the growing reliance on active markets to manage the firm’s liquidity in an environment that is increasingly capital-markets driven. Both the Basel Committee and the industry are currently exploring issues relating to the management and supervision of funding liquidity. • Finally, the degree of risk transfer that is actually achieved through credit risk mitigation and securitisation techniques requires greater scrutiny. In particular, how well do these risk transfers hold up under stress? To what extent will risk be put back to firms if counterparties were to default, if investors were to demand compensation for losses, or if investor risk appetites were to shift abruptly? Practical areas of focus for risk managers and supervisors Trying to predict how all these risks will play out in practice can be demanding since we have little historical experience to guide us. Growth in credit markets, synthetic securitisations, new market players and new risk management techniques have largely taken place over the past five years, that is, after the last credit downturn. I expect we will only experience a true period of stress when we have the combined impact of a credit downturn, a major shift in risk appetites and a withdrawal of market liquidity. Firms have been challenged to develop more comprehensive stress tests that cut across risk types and business lines in a true downturn environment. Stress tests that are produced on a regular basis are most evolved in the market risk area. Regular credit risk stress tests tend to be conducted primarily at the level of business lines. More comprehensive firm-wide credit stresses and scenarios often tend to be more ad-hoc. Finally, the manner in which different risk types interact under stress conditions is still at the frontier of risk management. I believe, however, that there are a number of additional practical steps that banks and supervisors can take to improve their understanding of financial intermediaries’ resilience to stress. Here again, the changes we are seeing from the originate-to-distribute models can come to our aid in structuring our thinking. In the case of banking institutions, this could entail an assessment of where pressure points might arise under the new business models if risk appetites were to reverse and liquidity conditions to deteriorate. This does not necessarily require a prediction of the magnitude of deterioration, but rather a relative assessment of where the greatest pressure points may emerge. Building on the earlier discussion, such areas might include: • The inability to distribute exposures in various types of securitisation and underwriting pipelines, and the need for a deeper understanding of the risks along various points of the distribution process; • Challenges around obtaining valuations for more structured positions and certain types of collateral; • The growth of concentrations under stress as borrowers draw down traditional lines of credit, conduits require additional support and trading counterparties demand additional financing. In the extreme, concentrations could arise by taking back positions if counterparties default; • And finally, the ability to collect adequate margin in relation to risk through the cycle (as discussed in the so-called “Corrigan report” produced by the Counterparty Risk Management Policy Group). Conducting such analyses under the umbrella of the originate-to-distribute model provides a common denominator across what might otherwise be an unrelated set of risks and control points. Firms might also ask themselves where they have the capacity to improve controls on their own versus where they must rely on cooperation across the industry, either because of shared infrastructures or due to competitive issues. Bank supervisors can reinforce these efforts through an assessment of firms’ risk management approaches and how these would perform should risk appetites and market liquidity conditions reverse (whatever the cause). Given the cross-border nature of banking institutions, there is significant value in supervisors sharing information about the quality of firms’ risk management systems in relation to such a scenario. There also is value in sharing across sectors where we see product lines and business lines cutting across institutional lines. Finally, let me discuss how Basel II fits into this picture. Banks and supervisors are spending a lot of time and resources preparing for the practical implementation of the framework, including the management of a variety of home-host issues. Basel II also provides a structured framework for firms and supervisors to assess the robustness of risk management in the originate-to-distribute market environment. A more in-depth discussion of this issue is something I will take up in a future speech, but let me end with a few concrete examples about how the Basel II framework can focus dialogue in this area: • First, Basel II requires that firms develop more robust frameworks for capturing less liquid products and rapidly growing credit risk in the trading book. • Second, the Basel II framework permits firms to use their own models to measure counterparty credit risk exposures. This process can focus on how firms capture some of the more complex credit risks arising from structured credit and equity derivatives. Under Pillar 2, supervisors can assess how these risks are reflected in economic capital models. Moreover, the framework only allows the recognition of portfolio margining models if they are sufficiently robust from a legal and risk management standpoint. • Third, Basel II establishes benchmarks for recognising risk transfer and mitigation in credit derivatives and securitisation structures. These provide a framework for supervisors to assess the degree of risk transfer and mitigation under both normal and more stressed market liquidity conditions. • Fourth, Basel II seeks to advance comprehensive stress testing frameworks and provides a clear benchmark for what stress testing is intended to achieve. For banks, this means demonstrating to themselves and to supervisors that they hold an adequate cushion of capital in good times to carry them through a significant credit downturn. • Finally, under Basel II, firms must take a close look at the robustness of their economic capital models. For example, it requires banks and supervisors to discuss assumptions regarding diversification benefits, within and across business lines and risk types. Conclusions To conclude, there is a great deal of uncertainty around the nature of risks in the markets, the adequacy of risk premia and what might trigger the next stress scenario. At the same time, I think there is a lot that banks and supervisors can do in practice to better prepare for the inevitable next downturn. By assessing how the business of banks has changed through the prism of the originate-todistribute models, banks and supervisors can focus their efforts on strengthening risk management in areas that present the greatest vulnerabilities to a deteriorating market liquidity scenario, as well as on those risks that are not well addressed using more traditional risk metrics. Moreover, there is significant value in the industry and supervisors sharing insights on issues and concerns around this type of a scenario. Finally, Basel II provides a structured framework for discussing some of the new risks we are seeing and creating incentives to better measure and manage those risks. Thank you very much, and I wish you an interesting and enlightening conference. | netherlands bank | 2,007 | 2 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Annual General Meeting of the Foreign Bankers Association, Amsterdam, 15 May 2007. | Nout Wellink: A changing financial landscape – two of the key challenges facing supervisors in Europe Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Annual General Meeting of the Foreign Bankers Association, Amsterdam, 15 May 2007. * * * It is a great pleasure to speak here, at the Annual General Meeting of the Foreign Bankers Association (FBA). The FBA’s mission statement is “to protect and promote the interests of foreign banks operating in the Netherlands”. Looking at recent developments, I think it is fair to say that your mission will become a whole lot bigger, and, for that matter, so will DNB’s interest in the soundness of foreign banks operating in this country. As both DNB and the FBA strive for a robust and efficient financial system, the rapidly changing financial landscape offers us opportunities as well as challenges and uncertainties. Addressing these in a market-friendly way is essential, yet certainly not easy, and from time to time even mind-bending. Fortunately, we – supervisors and market participants – are in this together. I would like to address two of the key challenges we presently face. One of these challenges is to ensure an effective and efficient framework for the supervision of cross-border financial institutions. Given that financial integration in Europe and beyond will continue, it is essential that supervisory structures, which traditionally have been organized along national lines, remain viable in the longer run. Another challenge relates to the growing role of unregulated players such as hedge funds and private equity in the financial sector. Hedge funds and private equity have enriched the financial system. At the same time, these unregulated players are rapidly growing and, with that their activities are getting more relevant from a systemic point of view. Before going into these important challenges and their implications for supervision, let me first sketch the major developments in the financial system in the recent past. Changing financial landscape The European financial landscape has changed to a great extent over the past years. Indeed, numerous measures have been taken to deregulate and liberalize the financial sector, although much remains to be done. The need for these changes is evident: a market-oriented and liberal financial sector fosters an efficient allocation of scarce resources and thereby promotes economic prosperity. In addition, the financial sector has witnessed rapid technological innovations, facilitating an increase in new services and products and a growing sophistication in the way financial institutions manage risks. Deregulation, liberalization and technological innovation have greatly changed the financial system. Four key interrelated trends can be distinguished. • First, the traditional demarcation between banks and other financial institutions has blurred. Large and complex financial institutions are the most evident example of the increasing interwovenness within the financial system. • Second, financial institutions themselves have become increasingly market-dependent. Financial innovations, such as credit risk transfer and derivatives, enable financial institutions to manage and spread their risks more effectively. Although risk-sharing has come at the expense of transparency, risks today are now more widely spread to those willing and hopefully able to bear them. • Third, financial institutions are moving more easily across national boundaries. They have increasingly embarked on international operations and cross-border mergers and acquisitions, so becoming more integrated in other countries. In light of recent events surrounding ABN AMRO, this process seems set to accelerate. This is not only reflected in the growing share of banks’ foreign operations, but also in the expansion of institutional investors’ holdings of foreign paper. Interbank markets, derivatives markets and payment systems are becoming more internationally integrated too. • Finally, the financial system has become more complex, partly because of the rapidly increasing role of unregulated financial entities. Regulated institutions are now more exposed to hedge funds and private equity, while these new players also foster the transfer of risks inside and outside the financial sector. Problems in these unregulated industries can have a larger potential impact on the regulated financial system than before. Prompted by the first two trends – the blurring of financial products and markets and the increasing market-orientation of financial institutions – the set up of financial supervision has already been reorganized in many countries. Nowadays, the majority of Europe's supervisors operates on a crosssectoral basis, and in an increasingly risk-oriented manner. In this respect, supervisors have taken a big step towards delivering more effective and more risk-based supervision. However, what constitutes an adequate regulatory response to the last two trends – the cross-border consolidation of financial intermediaries and the expansion of unregulated parts of the financial sector – is still an open question. Let me elaborate on these two challenges, starting with how to ensure effective and efficient supervision of cross-border financial institutions in Europe. Ensuring effective and efficient supervision in Europe The internationalization of financial services in Europe is steadily progressing, even though some degree of national segmentation remains. Having said this, it is a fact that both the number and the value of cross-border mergers and acquisitions is rising and, as mentioned, will continue further; at least there is absolutely no reason to assume that the rise in cross-border mergers and acquisitions will abate any time soon. A direct result of these cross-border deals is that the share of foreign banks in domestic European markets has increased substantially, from 20% of total assets in 1999 to 26% in 2005. There are several catalysts for the internationalization of European financials, most notably their growth opportunities. Indeed, international expansion is one of the most attractive growth opportunities for the profitable, capital rich European banks. With the ongoing integration of European financial institutions and markets, the conduct of financial supervision in Europe has moved beyond its primarily national orientation. Supervisory rules and regulations are progressively internationally harmonized – Basel II is in this respect a leading example. Of course, the implementation of these rules is predominantly performed at the level of national supervisors. The practical consequences of this discrepancy are interesting. Let us look at, say, an internationally active bank with subsidiaries in ten other EU countries. Such a bank has to deal with at least one home supervisor and ten foreign supervisors. Although all these supervisors apply the same general, internationally agreed standards, they may impose their own specific requirements, for example with regard to a firm’s internal control system. The process of financial integration across Europe thus suggests we should keep thinking about whether the model underlying financial supervision in Europe remains adequate. Given that financial integration and consolidation in Europe is desirable and will continue, it is essential that supervisory structures remain viable. I therefore believe that further steps are needed to achieve more convergence of supervisory practices in Europe. National supervisors are already moving, albeit slowly, towards more convergence of their supervisory practices. This is supported by the Approval Procedures for Basel II-Model Validation under the Capital Requirements Directive, Art. 129. However, a single European supervisor should not be considered a panacea for the cross-border challenges being faced by Europe’s supervisors. I do not need to remind you that many European banks with large cross-border activities have their largest exposures outside the EU – predominantly in North and South America – rather than within the EU. Besides, large institutional differences exist between European countries. Legal frameworks, deposit guarantee schemes and even aspects of fiscal regimes must be harmonized before substantial integration of supervision can be realized. One can imagine the technical and political complexity of such a process. A major step forward in the convergence of supervision in Europe can be achieved through the Lead Supervisor model. As you will know, the Lead Supervisor model was launched by the European Financial Services Roundtable in 2003/2004. Under this model, the home supervisor is made responsible for supervision of an entire financial firm, including its foreign subsidiaries, while recognizing the need for an important role for the host supervisor. Indeed, in my view the Lead Supervisor model requires a close working relationship between the host and the home supervisors so as to achieve effective supervision. The home supervisor, referred to as the lead supervisor, is given final authority to set the reporting requirements for the entire group, to coordinate the validation of its internal models at the group and local levels, as well as the planning of on-site bank inspection regimes, and to co-ordinate the authorisation process. The concept of Lead Supervision promotes greater efficiency. Moreover, the Lead Supervisor model also fits in with the continuous integration – or perhaps I should say globalization – of the financial sector. After all, Europe is part of the global financial market, and many large financial players, notably also in the Netherlands, have expanded far beyond the European frontiers. DNB believes the Lead Supervisor model can properly support the interests of market participants, which should be carefully weighed when deciding upon the future architecture of financial supervision in Europe. An illustration of how the Lead Supervisor model can work is the preliminary high level agreement between DNB and the United Kingdom Financial Services Authority (FSA) regarding the supervisory consequences of a possible merger between ABN AMRO and Barclays. In this specific case, we have been able to come to good, pragmatic and transparent agreements. It has been agreed that decisions will be taken on a consensus basis where material issues affecting the combined group are concerned. In the unlikely event that the supervisors do not agree, the lead supervisor, the FSA, will have the final power of decision making. Addressing the rise of hedge funds A second challenge facing supervisors today is to deal with concerns that unregulated parties such as hedge funds and private equity constitute a potential source of systemic risk. Before I discuss these concerns, let me stress that both hedge funds and private equity have enriched the financial system in many ways. Hedge funds provide liquidity and price discovery in many markets and have fostered financial innovation, so facilitating the distribution of risk within the financial system. Private equity mobilizes risk-bearing capital for investments in companies and generally helps to sharpen a company’s strategic goals. As such, it is beyond dispute that hedge funds and private equity contribute to the functioning of the economy. In what follows, I am restricting myself to hedge funds. For three reasons there are concerns that hedge funds may exert a destabilizing influence: • The first concern is the potential impact on regulated firms of a sudden collapse of highly leveraged hedge funds. Banks and other regulated financial institutions are heavily involved in investing and extending credit to hedge funds. This exposure implies that large losses at one such institution could have knock-on effects for institutions closer to the heart of the financial system. In times of market stress, such effects may even threaten the stability of the financial system, as illustrated by the LTCM case in 1998. There is no certainty that such an event will not happen again. • The second concern relates to market dynamics associated with the potential for large and concentrated positions or "crowded trades" that can seriously amplify market pressures. Crowded trades can arise when hedge fund managers take similar investment positions on a large scale. Especially in combination with high leverage, this concentration could contribute to price instability if market conditions force hedge funds to unwind their positions simultaneously. • A third concern relates to the intense form of shareholder activism associated with some hedge funds. The prominent role of shareholders today is a direct result of two developments; the first is the deregulating measures that have been taken in recent years by regulators. The second development concerns the changing corporate governance structure at private firms, including the relaxation of protection constructions. Amid the ensuing public debate, regulators and supervisors are being called upon to assess the risks associated with shareholder activism, such as the potential violation of market integrity and uncompromising behaviour with the sole aim of maximizing shareholder value. Particularly the latter may have broader financial stability implications in so far as a single-minded pursuit of shareholder maximization may in some cases undermine the stability of, and public confidence in, a financial institution, such as a bank. Such institutions do after all also provide a public good, which should be taken into account when deciding upon the future strategy, and which explains why they are subject to supervision. These examples illustrate that hedge funds are generally beneficial but may under certain circumstances have a destabilizing influence. Therefore, the call is on those responsible for safeguarding financial stability to ensure that checks and balances are in place to limit the risks these entities pose, while avoiding restrictive measures that may prevent them from playing their beneficial role in today’s markets. So far, the common view amongst supervisors is that the first concern posed by hedge funds is best addressed through indirect supervision, via their regulated counterparties. For that reason, many of the regulatory initiatives since the near-collapse of LTCM were, and still are, aimed at improving the counterparty risk management practices at regulated institutions. Effective risk management depends, however, on reliable and timely information. Supervisors have therefore also made recommendations to bolster market discipline and improve information flow between market participants. In fact, much has been achieved to date in containing hedge fund related macro prudential risks. Yet, in a continuously changing financial environment there is no room for complacency. New categories of financial products have rendered the credit relationship between regulated institutions and hedge funds more challenging. In addition, the recent protracted period of abundant liquidity and low volatility has increased the exposure of hedge funds to riskier assets. Finally, the attractiveness of doing business with hedge funds is a constant temptation for counterparties to relax their conditions, such as the haircuts applied to collateral. Hence, there is a continuous need to assess ongoing market developments and address any weaknesses in counterparty risk management and market discipline. Indirect supervision, although essential, will not mitigate all the risks associated with hedge funds. For instance, given the importance of hedge funds in some markets, any abrupt liquidation of their positions could have implications for market stability. In addition, indirect supervision may not be in a position to address the concerns related to shareholder activism I mentioned earlier. In order to address these concerns, additional measures may have to be considered. I hasten to add, however, that tight regulation of hedge funds – such as we know for banks – is undesirable. In order to preserve the beneficial role that hedge funds play in today’s market, I would prefer a lighter approach. Greater, market-driven transparency could provide markets and firms with a better sense of the build-up of large, concentrated positions or crowded trades. Of course, I also recognize that there are limits to providing data, if only given the speed at which hedge funds’ positions change. Secondly, there should be better access to information on shareholder positions and strategies, including those of hedge funds. Such an approach could limit risks of market integrity and behaviour that does not consider the stability of financial firms and the financial system as a whole as a precondition. Improved disclosure along these lines could be linked to the supervisory reporting requirement on shareholding in financial firms, for which the threshold could be lowered. Finally, an additional option is to register the operating managers of hedge funds. It should be kept in mind, however, that these managers are often already registered elsewhere and operate internationally, making such registration on a national level less useful. In a nutshell, hedge funds have enriched our financial system, but they also pose some systemic concerns. The job of the supervisors is to ensure that appropriate checks and balances are in place. Further transparency and disclosure could be helpful in facilitating this process, as it would enhance market surveillance. Conclusion I spoke to you about recent trends in the financial industry and the challenges these pose to supervisors. I believe that a further convergence of financial supervision in Europe is desirable and indeed already progressing. In this respect, as DNB believes that the interests of market participants should be carefully weighted when deciding upon the architecture of European supervision, the Lead Supervisor model is a possibility. Regarding hedge funds, I stress that indirect supervision is a necessary but not sufficient condition for mitigating the risks they could pose to financial stability. For that reason, further transparency and disclosure by hedge funds is essential in limiting risks of market integrity and uncompromising behaviour that potentially could damage the stability of financial firms. In addressing these important challenges, co-operation amongst market participants and supervisors is key. Thank you for your attention. | netherlands bank | 2,007 | 5 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Nieuwegein Business Center, Studievereniging ECU '92, Nieuwegein, 31 May 2007. | Nout Wellink: Economic and Monetary Union at eight – achievements and challenges Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Nieuwegein Business Center, Studievereniging ECU '92, Nieuwegein, 31 May 2007. * * * Introduction Eight years after its establishment, it is sometimes forgotten what a monumental achievement Economic and Monetary Union actually is. In the early nineties, many people believed it would never happen. Others speculated that if it were to happen, it would soon fall apart. These doomsayers were wrong. Monetary Union happened and it happened smoothly, bringing huge benefits to the people who share the euro. With this in mind, I will today resist the temptation to predict the future of Monetary Union. Instead, I will touch upon the benefits of having the Monetary Union and the key challenges it still faces. By taking up these challenges, I am positive its future can be shaped into a more prosperous one. The achievements of EMU Let me first go into the economic benefits of the Monetary Union. The euro has brought about substantial improvements in the macroeconomic policy framework. Most notable is that the ECB has managed to deliver low and stable inflation. Although countries like Germany and the Netherlands also enjoyed low inflation before the adoption of the euro, the ECB has been able to “export” that benefit to other countries, such as Italy and Spain. This has been greatly facilitated by the ECB´s independence and its mandate to safeguard price stability. As a result, annual consumer price increases in the euro area have been kept around 2 percent over the past 7 years. The ECB has also succeeded in anchoring stable and low inflation expectations, as indicated by consumer surveys and inflation-indexed bonds. This is a major achievement for a young central bank, in particular considering the shocks the euro area faced such as sharp rises in oil prices. Along with lower inflation, interest rates have fallen dramatically. Globalisation has definitely played a role, but the credibility of the ECB has also contributed to lower interest rate levels. It takes two to tango: macroeconomic stability in a monetary union cannot be guaranteed without sound fiscal policies. The Stability and Growth Pact aims to ensure prudent fiscal policy over the economic cycle. In the medium and long run, the Pact also promotes sustainability of public finances. If we look at the cyclical-adjusted fiscal balance over time, we see an impressive improvement in the run up to the euro. Between 1995 and 1999, the average public sector deficit fell from 4.5 to 1.5 percent of GDP. In the following years this deficit worsened again, to a low-point of 2.8 percent of GDP in 2002. The good news is that this bottom lies at a much better level than the troughs in the 1980s and 1990s. As a consequence, the increasing trend in the debt-to-GDP ratio, which rose to almost 75 percent of GDP in 1997, has been reversed and declined to 69 percent of GDP in 2006. While this performance is not impressive against the backdrop of lower interest rates, it does suggest that with the arrival of the euro the worsening in public finances has come to a halt. Besides supporting macroeconomic stability, Monetary Union has been a catalyst for integration. The euro has eliminated exchange rate risks within the euro area and has increased price transparency across borders. These factors have led to significant positive effects on trade within the euro area. A popular empirical model to analyse trade flows is the so-called gravity model. It is a straightforward application of the Newtonian model of gravity from physics. Translated to economics, bilateral trade tends to increase with the size of the countries concerned and to decrease with their mutual distance. Figuratively speaking, distances have become smaller between member states by the elimination of exchange rate risk and the reduction of transactions costs. Studies using this method estimate a positive growth effect on trade of 5 to 10 percent 1 . Another indication of increased trade within the Monetary R. Baldwin (2006), The euro’s trade effects, European Central Bank Working Paper No. 594, March 2006. Union is the substantial decline in the differences of traded-good prices across member states. These have dropped to a level akin to regional price differences in the US 2 . But Monetary Union has left it greatest mark on European financial markets. Traditionally, the efficiency of these markets has been hampered by costs associated with the use of multiple currencies. Given the large volumes traded in financial markets, even small transaction costs can produce substantial distortions. The euro has reduced those transaction costs and has improved the efficiency of European financial markets. For example, euro area cross-border holdings of bonds have increased strongly – from about 10 percent at the end of the 1990s to 60 percent in 2006 3 . This suggests that investors are increasingly diversifying their portfolios across the euro area. Together with financial innovation, the euro has increased market liquidity and the opportunity for risk sharing. The bond market’s depth has recently increased to 11 trillion dollar, outnumbering the size of euro area’s GDP. Admittedly, the corporate bond market in the euro area is still substantially smaller than in the US, as European firms traditionally rely more on bank financing. However, firms on this side of the Atlantic increasingly make use of debt securities. Between 1998 and 2006, the value of outstanding bonds in terms of GDP has doubled, while it increased “merely” 60 percent in the US 4 . More efficient and deeper financial markets benefit companies through lower borrowing costs. The challenges for EMU As we speak, the euro area is undergoing an upturn. Economic figures have been better than expected. In 2006, GDP grew by 2.9 percent, outstripping the United States for the first time in 5 years. Unemployment has fallen to 7.5 percent in 2006, the lowest level in 15 years. While the recovery reflects a cyclical upswing, these figures also suggest that structural reforms in the past are starting to pay off. However, as Henry Kissinger once said: “each success only buys an admission ticket to a more difficult problem”. Monetary Union’s problem is twofold: weak public finances and subdued per-capita-income growth. Things have improved, but I am convinced we can do much better. Without aiming to be exhaustive, I will mention a few steps that enable countries to tackle these issues and to further capitalise on the advantages of the single currency. Creating sustainable fiscal positions A first challenge will be to bring public finances on a sustainable footing. In periods of buoyant revenue growth, there is often a tendency to overestimate the strength of the underlying budgetary position. That is partially because economists can only tell you tomorrow why things predicted yesterday didn’t happen today. If spending is allowed to increase on a structural basis, but higher revenues turn out to be transitory, the budgetary position starts to deteriorate as soon as economic conditions turn nasty. This was exactly the mistake made by some countries in the beginning of this decade. Let’s not repeat that mistake. Countries with sizeable deficits and public debts should use the current windfall in tax revenues to consolidate. Sound public finances are also crucial for dealing with the costs due to population ageing. While living longer is good news, public expenditures in the euro area are projected to increase by up to 10 percent of GDP by 2050 if the implications of ageing are not addressed 5 . Action is therefore needed. By lowering public debt more financial room is created for less favourable democratic times. But governments should also reduce the burden of ageing itself by, for example, reforming public pay-asyou-go pension schemes. Germany and the UK have recently announced a gradual rise in the statutory retirement age to 67 and 68. As this measure appears quite effective to absorb an increasing life expectancy 6 , other European countries should follow this example. J.H. Rogers (2007), Monetary Union, Price Level Convergence, and Inflation: How Close is Europe to the United States?, Journal of Monetary Economics, 54 (2007) 785-796, and Faber and Stokman (2005), Europese convergentie in vogelvlucht, Economische Statistische Berichten, 128-130. ECB (2007), Financial Integration in Europe, March 2007. BIS (2007), BIS Quarterly Review, March 2007. Economic Policy Committee (2006), The impact of ageing populations on public spending, November 2006. CPB (2006), Ageing and the sustainability of Dutch public finances, March 2006. Improving labour markets Fiscal consolidation is more likely to succeed if it is accompanied by structural reforms that lift the potential growth path. One obvious candidate is the labour market. The average participation rate in the euro area still relatively low. This is most striking for workers aged between 55 and 64, where the rate is just two-third of the figure in the US. It is often argued that this is because Europeans are keen on leisure. But financial incentives play a large role in people’s decision to either work or not. For example, empirical studies show that labour supply is responsive to the tax rate on labour. This suggests that if we want to increase economic wellbeing, improving financial incentives could be of help. Labour force participation could be stimulated by further lowering marginal taxes on labour. According to the OECD, the average marginal tax rate on labour in the euro area is high and it hovers around 15 percent points above the rate in the US 7 . Female participation could be supported by providing adequate childcare facilities. Euro area’s labour markets could also use some extra flexibility. The OECD indicated that rigid employment protection and generous unemployment benefits have barely changed over the last years. In 2005, the average replacement rate of unemployment benefits 8 in the euro area was more than 20 percent higher than the OECD average 9 . Improving labour market dynamics involves making employment protection less stringent and reducing the length of unemployment benefits. Through this, employees will get a stronger incentive to seek a job, while firms will find it more attractive to hire people. Fostering service market competition and a friendly business environment Increasing competition in service markets is another condition for higher economic growth. A lack of competition harms productivity growth by limiting efficient production and reducing the incentive to innovate. “Necessity is the mother of innovation”, Veblen once said. I think he is right. When there is pressure from contenders, one tends to perform better than without competition. Much headway has been made in raising competition in product markets. Also in some service sectors there has been progress. Noteworthy in this regard is the opening up of the telecommunication sector in the late 1990s. However, differences in permits, regulations and national monopolies continue to hinder cross-border competition in a number of service sectors, such as mail and electricity. This is particularly regrettable, given that services represent 70 percent of GDP and employment in the euro area. That also illustrates the importance of the European Service Directive. While this Directive has been watered-down compared to the Commission’s original proposal, it still has benefits. It has been calculated that consumption in the EU can rise by 0.3-0.7 percent permanently due to the Directive . I agree, this does not sound spectacular, but it only entails the static effect of increasing trade opportunities. If the dynamic effects from increased competition are taken into account, the number is expected to be higher. Air travel offers an example of what can happen. Due to liberalisation and competition, air travel within the EU has come within reach of tens of millions of people, often at lower fares than 20 years ago. In view of these benefits, it is important that countries bring their legislation in line with the Directive over the next years. Enhancing cross-border competition one thing, creating an entrepreneur-friendly environment is another. This includes lowering the costs and constraints imposed by the public sector on existing and start-up firms. According to the World Bank, in 2005 the average cost of starting a business with up to 50 employees in the euro area is estimated to be 10 times higher than in the US. That is, if entrepreneurs have not given up starting a business in the meantime, as it takes on average 27 days to set up a new business in the euro area, compared to just 5 in the US 11 . I always had respect for entrepreneurs, but it’s getting larger in view of the red tape they have to cut through. In this respect, I fully underscore the Marginal tax on labour consists of income tax, employee and employer social contributions as a percentage of total labour costs of average worker. The average replacement rate is measured by the average unemployment benefits relative to the average income for three different family situations (single, dependent spouse and working spouse) A. Bassanini and R. Duval (2006), Employment patterns in OECD countries: reassessing the role of policies and institutions, OECD Working Paper No. 486, June 2006. CPB (2006), The trade-induced effect of the Service Directive and the country of origin principle, CPB document 108, February 2006. World Bank (2006), World Development Indicators, Business Environment database. current EU Commission initiative for measuring the cost of existing legislation and reducing the administrative burden on companies with 25 percent by 2012. Stimulating further financial market integration Economic growth can get an additional boost by more financial market integration. Clearly more needs to be done in the equity market. While slowly increasing, only a quarter of the equity portfolio of euro area residents consists of equity issued in another euro area country. Home-bias might be one reason for lagging integration; high costs for cross-border transactions are another. This partly reflects the lack of integration in market infrastructure for equities. Settlement of equities in Europe is divided over 19 different systems compared to only two in the US 12 .Since the introduction of the euro, consolidation in this sector has failed to take place and barriers continue to hold back cross-border trade. This hampers competition, keeps transaction costs high and weakens the opportunity for risk sharing. If the market fails to produce satisfying results, than it is up to the public sector to act. Against this background, the ECB has recently launched its proposal for a single securities settlement platform. The huge economies of scale it aims to produce should create scope for lower transaction costs and a more efficient allocation of savings and investment. Another area where further integration is warranted is the retail banking sector. The cost of opening a bank account and the cost of transferring money from it widely differs between euro area countries. National discrepancies in legislation, technical standards and procedures are obviously major impediments to further integration. Fortunately, the right initiatives are underway. It already started in 2001, with the Regulation on cross border payments in euro. Better known as the Bolkestein Regulation. This Regulation paved the way for the Single Euro Payments Area. An ambitious initiative, where European citizens should by 2010 be able to make payments throughout the euro area from their bank account as easily and safely as in their own country today. By creating a pan-European infrastructure and identical payment tools, all payments in the euro area essentially become domestic payments. 15 years ago this goal was beyond imagination. Now it appears within reach. Concluding remarks To conclude, the euro has seen a number of successes: the introduction of a new currency for more than 310 million people, price stability, low interest rates and progress in the integration of the goods and financial markets. These achievements are remarkable, as they have been realised in a short period of time and in a unique political context. Indeed, Europe is the world’s laboratory: we created the first supranational entity based on a sense of solidarity rather than coercion. Of course it is not all plain sailing. In the fields of public finances and the internal market work remains to be done to reap the full benefits of the euro. It is therefore important to remain ambitious in the near future. Not ambitious to be, but ambitious to do. How Monetary Union will evolve in the future is hard to predict. But if the past 8 years offer a compass for the future, I am optimistic we find the right answers to our current challenges. G. Tumpel-Gugerell (2007), The competitiveness of European financial markets: an economic framework for effective policy making, speech at Washington Economic Policy Conference, 12 March 2007. | netherlands bank | 2,007 | 6 |
Remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at "Risk Capital 2007" Conference, Paris, 27 June 2007. | Nout Wellink: Basel II and financial institution resiliency Remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the “Risk Capital 2007” conference, Paris, 27 June 2007. * * * Introduction I am pleased to join you today to speak about Basel II and financial institution resiliency. I would first like to commend the conference organisers for putting together such a comprehensive programme of events this week. I am grateful for the opportunity to discuss the Basel II Framework and how it was designed to help make banks more resilient in the face of turbulent waters and constantly shifting currents. Resilience comes from the Latin word for “rebound”, which implies change from the status quo and change is the only constant in the business of banking. Banks sometimes need to adjust to unexpected and unwanted shocks, though change also arises in a more positive way, such as innovation. Today I will focus on our changing financial landscape and how the work of the Basel Committee and, most notably, the Basel II framework helps firms and financial systems to become more resilient to these changes. From my perspective, financial resiliency has three distinct elements. First, it includes the existence and promotion of sound economic and financial policies. The second element is a resilient financial market infrastructure underpinning the system, which includes sound payment systems, robust exchanges, prudent accounting standards and sensible governance standards. Third, it is essential to have robust and resilient core firms at the centre of the financial system operating on safe and sound risk management practices. A sound global capital adequacy framework is critical to ensure the robustness and resilience of these firms. It is on this third dimension that Basel II plays an important role and on which I will focus my remarks. Basel II – general We are witnessing a rapidly changing financial environment, which in some cases represents a sea change from traditional practices. We have seen significant advances in technology and financial product innovation that have reshaped the role played by banks in the credit process. An example is the shift in business models. Core institutions are moving away from traditional buy-and-hold strategies to an originate-to-distribute or market-based model. Changes such as these create new challenges – as well as new opportunities – for bankers as well as for supervisors. Innovation has led to new techniques and tools for managing credit portfolios and this has been accompanied by increased complexity. A regulatory framework based on a simple risk weight scheme has become less and less effective in assessing an appropriate level of regulatory capital against these new, complex risk exposures. Basel II – Pillar 1 The Basel Committee’s response has been to capitalise on the improvements in banks’ risk management systems to better address the complexity and innovation that we see today. This is reflected in the first pillar of the framework that relates to minimum capital requirements. In order to meet the challenges, the Committee leverages off the core building blocks of banks’ risk management systems, namely the probability of default, loss given default and exposure at default. These are concepts that are integral to the risk management systems developed by large banks. By utilising these concepts, Basel II provides a more meaningful signal between risk taking and capital. This, in turn, reinforces sound risk measurement techniques and the framework is sufficiently flexible to accommodate new techniques and products. There are many aspects of Basel II that were drawn from modern risk management techniques and industry best practice. Banks themselves have indicated that Basel II has produced improvements in their risk management processes by spurring innovative work in several important areas. Let me give you a few concrete examples to illustrate this. First, under Basel II, we have seen substantial advances in operational risk measurement and management, particularly with respect to complex risk transfer arrangements. Since the Basel II discussions began in the late 1990s, there has been a tremendous increase in research on operational risk, including the forms it can take, the ways in which it arises, measurement methods and techniques to mitigate the risk. As a result, the industry has witnessed a surge of innovation and development in these areas. Second, with respect to stressed conditions, Basel II seeks to advance comprehensive stress testing frameworks and risk management practices more generally. Strong risk management is a critical component of a bank’s ability to withstand shocks. The Basel II framework requires that stress scenarios capture the effects of a downturn on market and credit risks, as well as on liquidity. Such an improved firm-wide approach to risk assessment is essential to ensuring that banks have a sufficient capital buffer that will carry them through difficult periods. Third, Basel II better assesses the risk inherent in arrangements using evolving technologies, such as securitisation and credit derivatives, that are used to buy and sell credit risk. This is clearly evident in the originate-to-distribute model. Basel II provides a framework that allows supervisors to focus discussions with banks on the robustness of their risk measurement and management of the complex financial instruments that are typically used in this model. Basel II also establishes benchmarks for recognising risk transfer and mitigation in securitisation and credit derivatives structures. It sets a boundary between the point at which a firm transfers risk and actually retains the risk. These enable supervisors to assess the degree of risk transfer and mitigation under both normal and stressed market conditions. And finally, Basel II requires that firms strengthen their frameworks for assessing appropriate capital for the trading book. This has taken on increasing importance given the rapid growth of trading book assets relative to the banking book. For example – the Basel Committee – in consultation with the industry – continues to work on developing a framework for better capturing the default risk associated with credit exposures in the trading book. In addition, Basel II permits firms to use their own models to measure counterparty credit risk exposures. This risk arises, for example, in OTC derivatives, which are becoming increasingly complex and more difficult to measure. This approach is closely aligned with industry best practice as well as the underlying economic risks of these activities. Basel II has also paved the way for improvements in other, less visible ways. One example is Basel II’s greater focus on firms’ risk management infrastructure. For instance, the Framework requires fundamental improvement in the data supporting PD, LGD, and EAD estimates that underpin economic and regulatory capital assessments over an economic cycle. This has spurred improvements in areas such as data collection and management information systems. These advances, along with the incentives to improve risk management practices, will support further innovation and improvement in risk management and economic capital modelling. Pillar 2 Let me now turn to the second pillar – the supervisory review process. Pillar 2 really starts with you, the banks. First and foremost, responsibility lies with bank management for developing an internal capital assessment process and setting capital targets that are commensurate with the bank’s risk profile and control environment. A sound risk management process is the basis for an effective assessment of the adequacy of a bank’s capital. And bank management bears the primary responsibility for ensuring that the bank maintains adequate capital to support the risks beyond the minimum requirements. Excessive participation by supervisors in a bank's capital adequacy assessment process or firms' over-reliance on supervisory review of their assessments are both counter to Basel II’s objectives and raise the risk of moral hazard. The better banks measure and manage their risks, the more comfortable supervisors and the market will become with respect to their Pillar 1 processes, as well as the amount of overall capital that Pillar 2 indicates is appropriate. This is not a compliance exercise! Senior management and boards of directors need to lead the process and ensure that their institutions establish robust internal systems that capture all material risks for their institution in a rigorous manner. Management should make certain that the economic substance of risk exposures is fully recognised and incorporated into the bank’s systems. This is extremely important, particularly in the instance of securitisation and other complex risk transfer arrangements where the risks retained by the firm are more difficult to measure. These estimates of risk must translate into robust capital assessments that can be validated by banks and supervisors. When supervisors assess economic capital, they should leverage off of banks’ systems. Supervisors need to understand the global perspective within which banks operate. Local approaches may be warranted, but we need to ensure that local deviations are proportionate and that the costs do not outweigh the prudential benefits. To achieve the full benefits of Pillar 2, supervisors need to avoid falling into the trap of establishing a check-list approach to supervision. It is not in anyone’s interest to engage in a tick-the-box compliance exercise. Let me stress this - Basel II goes beyond merely just meeting the letter of the rules. The framework is more about a risk-focused approach to capital and risk management. I understand that for banks and supervisors to realise the full potential of Basel II, more work must be done on home-host issues. With respect to Pillar 1, we have resolved a number of concerns and have come quite a long way. The same vigour and energy needs to be applied to the home-host issues related to Pillar 2. I am confident that with the development of the home-host principles, increased use of the supervisory colleges and further dialogue with the industry we will make progress on the outstanding issues. Many of these Pillar 2 issues, such as diversification, are particularly challenging and supervisors need to work with the industry to resolve them. I expect that over time bankers and supervisors will engage in a dialogue around Pillar 2 that ultimately will turn out to be one of the most important benefits coming out of the implementation of Basel II. For instance, I have already heard from a number of banks about the fruitful discussions of how credit risk mitigation is reflected in their risk models and about the robustness of risk measures for complex structured products. I have also heard discussions about how diversification is treated in risk management systems and how the dialogue surrounding credit risk stress testing is becoming more focused. Pillar 3 Since the release of the Basel II framework, most of the focus has been on the first two pillars but we should not forget the third – and certainly not the least – of the three pillars. Market discipline is made possible by effective disclosure requirements and is a critical complement to the other two pillars of Basel II. Indeed, in the light of recent and rapid financial innovation, state of the art disclosure needs to keep up. Basel II seeks to raise the bar on the quality of disclosures, especially related to more complex credit risk intermediation activities, covering areas such as counterparty risk, securitisation and credit risk mitigants. It provides clearer industry benchmarks and its required qualitative disclosures will allow banks to put their quantitative disclosures into context and help explain their approach to risk management. To help advance the use of market discipline, Pillar 3 disclosures are, in many instances, required to utilise an advanced Pillar 1 approach, such as the internal ratings-based approach or the recognition of securitisation. This will help the industry move forward collectively. Further, Pillar 3 disclosures will enhance discipline around risk measures since banks must show the actual outcomes versus estimates. An example of this is the required disclosure of actual losses compared with estimated losses in the preceding period for each IRB portfolio, combined with qualitative information to explain the outcomes. However, challenges remain. There needs to be more discussion with a broader group of institutions to discuss their views regarding Pillar 3. In particular, banks have expressed their concern about the potential for misinterpretation of the purportedly complex disclosures by investors and the market in general. Another concern relates to potential inconsistencies and differences across banks and the unclear signal this may send to the users of such disclosures. Clearly, broad dialogue on this topic involving supervisors, bankers and market participants is necessary to prevent any unintended consequences. A strong understanding by the market of Pillars 1 and 2 will make Pillar 3 more understandable and market discipline a more reliable tool for supervisors and the market. Before I conclude I would like to say a few words about the costs associated with Basel II’s implementation and compliance, particularly costs related to information technology and human resources. Clearly, a shift in capital regulation as fundamental as Basel II entails significant transition costs for both banks and supervisors. However, even in the absence of Basel II, well managed financial institutions would have continued to update and improve their IT systems and risk management practices simply to keep pace with the evolving marketplace. Basel II has pushed firms further than they may have gone on their own. In addition, Basel II confers other benefits, including greater operational efficiencies, better capital allocation and greater shareholder value through the use of improved risk models and reporting capabilities. One might reasonably expect such improvements to lead to more consistent profits and reduced volatility of credit losses as a result of consistent risk spreading, more effective deployment of capital, and the ability to make better business decisions. Conclusion I would like to close by reiterating the importance of Basel II in support of financial resiliency, especially in this age of rapid change and innovation. Basel II encourages better measurement and management of risk exposures and the treatment of complex financial instruments. It seeks to advance the practice of stress testing as well as other risk management techniques. Under Pillar 2, banks take the lead in developing internal risk management processes that support robust estimates of regulatory and economic capital. Through enhanced transparency and market discipline, Pillar 3 will become more important because of increasing intermediation of risk through the capital markets. Both banks and supervisors need to take a long-term perspective when considering the benefits of Basel II. Regulatory capital, risk management and risk-based supervision are aligned in a more consistent manner that can accommodate financial innovation. This capital framework is a long-term investment that if done properly will lay the foundation for further evolution. It is through strong coordination among supervisors and with you – the industry – that we can realise the full potential of the Basel II framework. Thank you. | netherlands bank | 2,007 | 6 |
Speech by Dr Nout Wellink, President of the Netherlands Bank & Chairman of the Basel Committee on Bkg. Supervision, at the 2007 Money & Bkg. Conf. "Monetary Policy Under Uncertainty", hosted by the Central Bank of Argentina, Buenos Aires, 18 June 2007. | Nout Wellink: No globalisation without innovation Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the 2007 Money and Banking Conference "Monetary Policy Under Uncertainty", hosted by the Central Bank of Argentina, Buenos Aires, 4 June 2007. * * * Introduction I grew up in a small Dutch village. Although it was not in a polder, to me the world seemed flat. It took several years before I saw mountains for the first time and realised that the world is not flat. The generation of my grandchildren misses this kind of experience. Flying long-distance at early age is no longer exceptional in the more prosperous parts of the world. The world has changed dramatically in the course of decades. Information technology has brought us many new opportunities, in particular mobility of people, goods and ideas. I’ll discuss technological progress, and what it means for the macro economy in general, and for monetary policy in particular. Globalisation is driven by technological change There are at least four manifestations of technological change that have dramatically reshaped the world over the past decades: • What we see in major cities are people from all over the world. What lies behind this is cheap and fast air traffic. Competition is a driving force. So is technology, which makes air transportation more efficient, and management skills that allow for splitting up the market in high yielding business-class tickets and low cost fares. • What we see are cheap imports from China everywhere in the Western world. What lies behind this are low transportation costs thanks to the cargo container. The cargo container can move non-fragile goods for about 1% of retail value to anywhere in the world. In the precontainer era, shipping costs used to be between 10 and 20% of retail value. 1 Apart from low transportation costs, additional factors are needed to explain the surge in Asian products in Western markets. In particular the catch-up of Asian economies is creating new trading opportunities. • What we see is offshoring of labour-intensive production to low-wage countries. What lies behind this is that new technologies allow the production process to be unbundled. Production sites are located far from target markets, both in manufacturing and in the service industry. The share of offshored inputs in GDP can reach up to12%, as in Canada and the Netherlands. 2 • What we see is low-skilled labour in the West feeling a cold wind of competition from cheap labour from Asia and Central and Eastern Europe . At the same time, wages for high-skilled labour are on the increase. What lies behind this is skill-biased technology. Automation lowers demand for low-skilled workers, since computers offer a substitute. But computers can also amplify natural advantages of high-skilled labour, as complements to labour. A talented professional can serve a much larger customer base due to new ICT opportunities. Financial engineering and management skills also tend to favour high-skilled labour. These are just examples, illustrating that there would be no global economy without new technology. Technology has always been the driving force for change. This was the case when the invention of the printing press in the 15th century boosted the diffusion of ideas; and it is still the case in today’s world, where ideas are spreading much faster than twenty years ago thanks to the internet. J. Bradford DeLong (2006) The box that changed the world, Project Syndicate. IMF (Spring 2007) World Economic Outlook. Macro-economic consequences Technological change has brought the world prosperity. In recent years, output growth has been at levels not seen since the early 70s. Not just Western economies are growing fast. China and India are integrating in the world economy at full speed. China’s average productivity growth over the last ten years was close to 10%. Average productivity growth in emerging and developing countries has also increased, to 5% last year. 3 Despite a recent pick-up, productivity growth in Latin America is lagging that in other emerging markets. Although technology is a source of welfare, it can also have negative side-effects. For instance, the unprecedented speed at which ideas are passed between people is a key achievement of the ICT revolution. But it also allows bad ideas to travel fast, such as religious fundamentalism. I feel some sympathy for those who fear rapid technological change. But whether we like it or not, we can’t stop technological progress. Like toothpaste, once it’s out of the tube, it is hard to get it back in again. The challenge is to make sure that new technologies bring change for the better. There are winners and losers from technological change, at least in relative terms. The developing world at large is benefiting from recent developments. However, some areas are losing out. On the losing end are areas that lack connections to the container-handling network and the internet. This applies to areas that lack crucial infrastructure, be it reliable electricity and roads, or the rule of law. In the Western world, job security has diminished, not just for blue-collar workers. These days, services in ICT and other high-tech sectors are offshored to low-income countries. But the number of offshored jobs is still very modest compared to the total number of jobs lost and created. In the Netherlands, roughly 9.000 jobs are offshored each year, whereas the annual number of job destruction and creation is above 800.000. 4 Since the ICT revolution is skill-biased, it favours highover low-skilled labour. Fortunately, higher income inequality between high- and low-skilled workers does not necessarily imply that low-skilled workers are worse off. The IMF has shown that recent trends have increased the size of the pie. Cheaper inputs have lifted output and overall labour compensation by about 6% in real terms in advanced economies over the last 25 years. 5 And all consumers benefit from lower prices. To keep labour market effects in check, employability is a key policy issue. Flexible employees can adapt to new circumstances that technology brings about. Governments can offer a helping hand by improving education, and by providing a social security system that encourages people to move from one job to another. In some countries, social security schemes may be so generous that they deter efforts to seek new employment. But the slogan “the lower, the better” goes much too far. In Latin America, for instance, social security schemes alleviate income inequality. If the benefits of economic growth are widely shared, support for economic reform can be expected to be broader than otherwise. Monetary policy The challenge for monetary policy is to adapt to the new environment. Fortunately, central banks have much more room for manoeuvre now than they had when Arthur Burns was appointed as Fed Chairman by President Richard Nixon back in 1970 with the words: [quote] “I respect his independence; however, I hope that independently he will conclude that my views are the ones that should be followed” [unquote]. Also downward pressure on inflation by cheap imports from low-income countries has made central bankers’ life in the Western world a bit easier than in the past. Prices for clothes and big ticket items such as cars and personal computers have declined. Computers became a lot cheaper if one takes into account quality improvements. The overall downward pressure on inflation has allowed for lower monetary policy interest rates, at least in the short term. In the longer term, the real equilibrium interest rate might rise. This would be the case if the world would have moved to a permanently higher trend rate of productivity growth. The jury is still out on Productivity is measured as real GDP divided by working age population. Source: IMF (Spring 2007) World Economic Outlook. Numbers are averages over 2001-2005. Source: Dutch Ministry of Economic Affairs (2005) Visie op verplaatsing. IMF (Spring 2007) World Economic Outlook. whether this is true. Other things equal, a higher real equilibrium interest rate implies that monetary policy interest rates also have to move to a higher level, consistent with the new equilibrium. So, a major issue is to determine the trend rate of productivity growth. From a monetary policy point of view the question can be rephrased as: What is the level of growth at which the economy can operate without generating higher inflation? It is always difficult to determine the speed limits of an economy, but in times of change this is even more challenging. One development makes it particularly hard. That is the move from an industrial to a post-industrial society. In the 1950s, 30% of the US labour force was employed in manufacturing. Now the number is 10%. We have moved to a service oriented society. In the service industry, capacity utilisation cannot be measured by counting idle capacity in factories. Besides, productivity growth can only be estimated in an imprecise way. Usually, total factor productivity is used as the key measure. It is determined as a residual: productivity growth is the increase in value added that cannot be explained by the volume of inputs used. This measure is very rough. All in all, potential output and its growth rate is more difficult to determine than it was in an industrial economy. Uncertainty about potential output translates into uncertainty about the output gap between potential and actual output. It has always been tricky to base monetary policy on output gaps. Research by Orphanides suggests that the Great Inflation was to a large extent due to mismeasurement of potential output and the output gap. 6 It appears virtually impossible to determine output gaps in real time. They can only be measured in a reliable way ex post, with the benefit of hindsight. “Life can only be understood backwards, but it must be lived forewards” as the Danish philosopher Kierkegaard said. This is certainly true for monetary policy, with its medium term objectives. How to cope with this? I’ve learnt a couple of things since I thought the world was flat. One is that the objectives of monetary policy should be modest. Fine-tuning economic growth has always been a too ambitious goal in a world with long and variable lags in monetary transmission. A clear focus on low and stable inflation can safeguard central banks against the temptation of activism. Given current uncertainties, monetary authorities must be particularly cautious in interpreting the output gap. They have to remain firm in reaction to actual inflation and other relatively reliable indicators of inflation risks, such as excessive wage growth. As a side remark, I add that, in theory, capital account liberalisation and trade openness warrant a sharper focus of monetary policy on price stability rather than output stabilisation. 7 International capital mobility, as well as broader access to financial markets, creates new opportunities for households to smooth consumption over the years. Free international trade allows for specialisation in domestic production. As a result, it might be possible to disentangle consumption and production to a higher extent than in the past. In other words, households can cushion changes in production without intervention by the central bank. I would like to conclude with a warning. A focus on price stability is more complicated than it sounds. Low and stable consumer price inflation is no reason for complacency. In spite of consumer price stability, asset price inflation may signal underlying imbalances, such as an overoptimistic risk assessment by financial market participants that keeps long-term interest rates at unwarranted low levels. Monetary policymakers must be forward-looking, and assess possible divergences between real and nominal factors in the area of monetary aggregates, credit and asset markets. How this should be done in practice is a difficult question that deserves further elaboration. I won’t answer it now. Time is running out. Sometimes it is better to stop before one has finished. Athanasios Orphanides (2003) The quest for prosperity without inflation, Journal of Monetary Economics, Vol. 50, nr. 3. Assaf Razin and Prakash Loungani (2006) Globalization and equilibrium inflation-output tradeoffs, NBER Working Paper nr. 11641. | netherlands bank | 2,007 | 6 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Roosevelt Academy, Middelburg, 1 June 2007. | Nout Wellink: Microfinance – small loans, big differences Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Roosevelt Academy, Middelburg, 1 June 2007. * * * Today is special. You represent the very first graduation year of the Roosevelt Academy, and undoubtedly there awaits a bright future for you all wherein chances of success will abound. Clearly your accomplishment also signals the big achievement by the Academy and its faculty members. Today, I wish to talk to you about another success story, namely that of microcredit. The UN designated 2005 the International Year of Microcredit. The aim was “building inclusive financial sectors and strengthening the powerful, but often untapped, entrepreneurial spirit existing in communities around the world.” The Year of Microcredit has proved highly successful. It has raised awareness around the globe about the importance of microfinance in fighting poverty and empowering the poor by enhancing higher incomes and more jobs. In other words, microfinance can promote economic and social inclusion. Permit me to address the issue of microfinance in greater depth. “Microfinance” generally stands for financial services for the poor. Microfinance is important because well over three billion people do not have access to basic financial services such as credit, savings accounts and insurance. Microfinance can offer such basic financial services, which is of prime importance to these people. These financial services are provided by so-called "microfinance institutions" (MFIs) or "microlenders", which are simply generic terms for the estimated 10,000 diverse entities such as commercial banks, NGOs, credit unions, finance companies etc. While from now on I will have microcredit in mind when referring to microfinance in general, please keep in mind that microfinance services are much broader and also include insurance, deposit taking and sometimes even pensions. However, the most important element of microfinance today is still micro credit. Let me therefore begin by explaining what microcredit is, how it works and whether it helps poor people to improve their living standards. Thereafter I will discuss the market for microcredit. In particular, I will focus on initiatives that have been taken in the Netherlands. With pride I can say that the Netherlands is amongst the frontrunners when it comes to developing and supporting new initiatives in the field of microfinance. The fact that Her Royal Highness princess Maxima was a member of the Advisors Group to the United Nations International Year of Microcredit 2005 has undoubtedly contributed to the growing involvement of the Dutch in microfinance. And, she continues her work as a member of the UN Advisory Group on Inclusive Financial Sectors. Finally, by way of a conclusion I will identify some challenges for the future. Microcredit – what is it? Microcredit is the extension of very small loans (micro loans) to the unemployed, to poor entrepreneurs and to others living in poverty who are not considered bankable. These individuals typically lack collateral, steady employment and a verifiable credit history. Therefore they cannot meet even minimal qualifications to gain access to traditional credit. Microcredit is a financial innovation which originated in developing countries where it has successfully enabled extremely impoverished people (mostly women) to engage in self-employment projects that allow them to generate income and to begin to build wealth and ultimately to exit poverty. Thanks to the success of micro credit, many people in the traditional banking industry have begun to realize that these microcredit borrowers can be seen as pre-bankable. Microcredit is gaining credibility in the mainstream finance industry. Many traditional large finance organizations are now considering microcredit projects as a new source of future growth. How does microcredit work? As you all know, microfinance has been invented by Nobel Prize laureate Muhammad Yunus, who was here last year when he received the Four Freedoms Award by the Roosevelt Foundation. In the 1970’s Professor Yunus was working at the Chitttagong University in Bangladesh. At that time, he started experimenting with providing small loans to the people in the villages surrounding the university. In 1976 he started the now famous Grameen Bank with help from the government. The goal was simple: providing small loans to the very poor. Regular banks would not provide such loans because they considered them too risky – poor people typically lack collateral – and too costly. The small scale of the loans and high monitoring costs for each individual loan typically increase operational costs. An interesting feature of Grameen bank’s initial lending methodology is that loans were provided to groups rather than to individuals. Let me briefly illustrate how some of those first schemes worked in practice. Two members of a five-person group receive their loans first. If all instalments are paid on time, the initial loans are followed four to six weeks later by loans to two other members. After another four to six weeks, the remaining member, known as the group chairperson, receives his or her loan – of course provided all goes well. In the beginning the group was typically seen as a source of solidarity. For example, when one member could not repay the loan, the group chairman could help out. In this way the credit record of the defaulted borrower would remain clean, and thereby also that of the group as a whole. Over time, formal sanctions by the bank became more common. If one or more group members failed to repay, all group members would be cut off from future loans. The incentive to help each other out in times of need, but also to check on each others repayment record, became stronger through this joint liability system. In practice the group lending methodology functioned well, as repayment rates were generally high. Group lending is not only beneficial for the poor people as they gain access to credit, it is also an advantage for the microfinance institution that is providing the loans. Part of the responsibilities of the microfinance institution, such as monitoring loans and enforcing repayments, are taken care of through the group’s own checks and balances. In this way the operational costs of microfinance have reduced and it becomes possible to give poor people loans that would otherwise not be available or at least would not be available at such low interest rates. The group lending methodology thus increases social capital and efficiency. Effect on poverty and economic development With innovative concepts such as group lending it is possible to give poor people access to credit. An obvious next question is: what does this credit do for them? Can people actually improve their living standards with the help of micro credit? There are basically two ways to answer this question. The first way is to look at the data and the available scientific studies and carefully assess the results. This is how central bankers typically approach economic questions. The second way is to pack your bags, hop on an airplane, and see for your self how microcredit affects the lives of people in developing countries. Let’s start with the second approach, which is not so common for central bankers, but undoubtedly no less illuminating. My personal experience with microfinance in Ghana has been very positive. And this holds for many observers who have witnessed the activities of microfinance institutions on the ground. But is microcredit really an effective means to alleviate poverty? Are the high expectations justified and can we establish a clear causality between microfinance and higher socio-economic welfare? To answer this question, we have to go beyond personal experience and also look at the data and results of the available scientific studies. However, there has been surprisingly little scientific work on the effectiveness of microfinance programs. According to some experts this may be explained by the fact that many donors who finance microfinance institutions are focussed on reaching as many poor people as possible. Evaluating programmes is often seen as a waste of time and money – and let me say that from a practical point of view such a perception is understandable. But, from a broader policy point of view, it is important to know which concepts work best and which concepts are less effective. Careful experimentation with sound control groups may provide such insights. Another explanation for the limited degree of scientific evaluation is lack of data. Often there are simply not enough data available to study the effectiveness of microfinance. Moreover, the available data may be of limited use because, for example, accounting definitions differ between institutions in the microfinance industry. I therefore welcome recent initiatives, for example by the World Bank, to improve the quality of reliable data to increase our current knowledge. With these shortcomings in mind, the available studies provide a rather positive picture of microfinance and confirm my personal observations. It turns out that microcredit helps people to increase their income through entrepreneurial activities. The effects are often larger for women than for men and seem to diminish if the size of the loan increases. This latter result suggests that the smallest loans can actually make the biggest difference! And that women remain an important target group. The market for microcredit and initiatives in the Netherlands The prospect for the microcredit industry in general is strong. The market is growing rapidly and supply can hardly keep up with demand. It is estimated that only 4 percent of global demand for microfinance services is being met. Note that the potential global microfinance market is worth roughly $300 billion, although estimates vary widely. Also, with the growing development of the microfinance sector, sources of funding for MFIs have diversified. Official donors are no longer the primary source, as tens of microfinance funds and more and more private sector investors are also offering capital to MFIs and are rapidly commercialising microfinance. These investors are typically private-sector funding arms of donors and socially motivated, privately-managed investment funds financed by public and private capital. Although both types of investors generally take a commercial approach in the rigor of their investment analysis and monitoring, they are not always fully commercial in the sense of trying to maximise profit. The Dutch involvement in microfinance has not been left to chance. On the contrary, already in 1997 the first effort was made to co-ordinate microfinance activities by several co-financing agencies (Cordaid, Hivos, Interchurch Organisation for Development Co-operation and Novib) and their main funder the Ministry of Foreign Affairs. With the growing involvement of other private and commercial organisations in microfinance there was a need to include a larger and more diverse group of actors in this initiative. So, in January 2003 thirteen organisations agreed to formalise their efforts to co-ordinate and work together. They jointly established the Netherlands Platform for Microfinance. Dutch organisations that support the microfinance sectors in developing countries through investments or subsidies can join. Since its establishment the Platform has grown to comprise fifteen organisations. To give you some idea of what the Platform does: in 2005 the Platform invested over Eur 360 million in the form of loans, equity investments, guarantees, seed capital and subsidies; this is up more than 50% from the Eur 225 million in 2004! These investments reached more than 550 organisations in 78 countries that offer financial services to poor people, ranging from community-based organisations, cooperatives, non-governmental organisations, banks and other financial institutions. A large share of this money has been invested in Latin America, followed by Asia, Central and Eastern Europe. Surprisingly, Africa has the lowest share (around 12%). The West still seems to lack the commitment to truly help this continent forward. The distribution over the four regions has by and large remained steady over the last three years. This reflects the fact that in general microfinance markets have matured, especially in Latin America, compared to the development of the sector on the African continent. But, although the market for microfinance is growing and more and more organisations are supporting this development, there remain important challenges for the future. Challenges for the future – by way of conclusion If we truly wish to succeed in providing microfinance services to the poor on a large scale, further contributions are desperately needed. This is not only an issue of financing. Regulators and governments, in particular, need to develop legal and regulatory frameworks for microfinance, consumer protection, and financial infrastructure. Also prudential supervisors – and as a prudential supervisor myself I find this very important – can contribute to the growth of microfinance by defining clear criteria for microfinance institutions. This pertains in particular to institutions that wish to take deposits from the public or expand their services cross sectorally. And, last but not least, perhaps you yourselves as successful graduates of the Roosevelt Academy can also make a contribution to the success of microfinance, as future investors, entrepreneurs, or simply by telling others in your environment about the potential of microfinance. The latter can actually prove to be very effective, as you undoubtedly have a bright future as the next generation of influential professionals in our society. | netherlands bank | 2,007 | 6 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at Hoofdkantoor Shell, Den Haag, 26 June 2007. | Nout Wellink: Challenges and opportunities for corporate pension fund management Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at Hoofdkantoor Shell, Den Haag, 26 June 2007. * * * The organizers have asked me to contribute to this seminar in honour of Peter Bronkhorst, who is stepping down as Managing Director of the Shell Asset Management Corporation. In view of Peter’s outstanding contributions to the Dutch pension business in general, and to that of Shell in particular, I decided to agree to this request. An additional reason, of course, is that this is an excellent opportunity to address a prominent group of asset managers. Although it is tempting to resort to breezy lightheartedness on a festive occasion such as today, I have opted for substance, as Peter Bronkhorst is widely known as a man of content and professionalism. Given today’s theme – Challenges and Opportunities for Corporate Pension Fund Management – I would like to discuss some challenges that pension funds have recently encountered. More specifically, I would like to explore how company pension funds have dealt with these challenges in the Netherlands and in the US. In this respect, it is interesting to compare the Dutch corporate pension industry with its American equivalent, as they have chosen different routes to cope with the increasing burden of aging: whereas the Americans have individualized their pension system to a large extent, collectivity was preserved in the Netherlands. In evaluating these different routes, I will emphasize four key messages. First, I will argue that a clear separation between a sponsor and its pension fund is a desirable feature of any pension system. Second, I will point at the added value of collective pension plans over individual ones. Third, I will argue that this collective nature saddles pension fund asset managers with an important social mandate. And fourth, I will also point at an opportunity in the pension delivery market, which I challenge you to seize. Comparison of the Dutch and American pension system Since most of us are more familiar with the Dutch pension system, I will start with a brief overview of the American system. The US pension system is characterized by a relatively small governmentimposed pay-as-you-go system. This benefit constitutes only 45 percent of total retirement income in the US. Here, the Netherlands and the US are comparable. Indeed, the Dutch state pension scheme is also fairly small, as it provides the average employee with about 50 percent of his total pension benefit. At the same time, about 55 percent of total US retirement benefits is provided through a funded system. In the Netherlands, too, funded pensions are fairly popular, constituting about 50 percent of total retirement benefits. Notwithstanding these similarities, there are also differences. In particular, pension benefit replacement rates differ widely between the two countries: whereas the US have an average pension replacement rate of 51 percent, this rate amounts close to 84 percent in the Netherlands. Also, US pension funds have shifted much more risk towards their participants while the Dutch pension system provides its participants with a relatively high degree of certainty on the expected pension benefits. Within the class of funded US pension benefits, we primarily need to distinguish between two cases. First, there are the traditional company-linked defined benefit pension schemes, which are losing popularity for reasons which I will set out later. The decline of these defined benefit pension schemes has been reflected in a rise of the so-called 401(k) plans. These pension plans, which are named after a section of the US tax law, are individual saving plans that allow workers to save for their retirement under a favourable tax regime. The tax incentive is derived from the deferral of taxes on pension savings and returns. Under such a plan, the employee chooses to transfer a certain portion of his wage to a 401(k) account, from which he can draw after retirement. These 401(k) plans are typically of a defined contribution nature and at times depend heavily on the investment capabilities of the individual concerned. The benefits of legal separation between sponsor and pension fund Traditional US company pension plans clearly resemble Dutch company pension plans. Both are collective in nature, both invest pension assets on their participants’ behalf, and both provide a defined pension benefit. However, the legal setting in which these company pension funds have to operate, varies between the two countries. In the US, company pension funds are rarely financially separate from the sponsor company, so that pension assets are ill-protected against employer bankruptcy. The Dutch system, on the other hand, is characterized by legal separation between the sponsor and the pension fund, so that bankruptcy of the sponsor does not necessarily have fatal consequences for the fund. To me, this legal separation between sponsor and pension fund has two crucial advantages. First, it excludes insidious conflicts of interest. After all, if the sponsor and the pension fund are not separated, it is not entirely clear for whose benefit a pension fund is run. For shareholders or participants? In this respect, experience in the US has shown that in some cases pension fund surpluses were channelled back to the sponsor, while deficits were borne by pension fund participants via premium increases or entitlement cuts. This criticism admittedly also applies to the behaviour of some Dutch pension funds in the 1990s. But the new Financial Assessment Framework, which became active as of January 1st, 2007, has made the situation more balanced by explicitly spelling out the modalities under which contribution holidays can take place. Second, a crucial advantage of the legal separation between a sponsor and its pension fund is that not all the employees’ eggs are put in a single basket. In the absence of such a separation, the system creates concentration risk for employees as it makes both their human and financial capital dependent upon one and the same firm. Consequently, if a firm were so unfortunate as to go bankrupt, its employees would lose not just their jobs, but their pension entitlements as well. This concern is increasingly problematic in modern dynamic economies where company lifetimes are decreasing. With the introduction of new accounting rules, which require companies explicitly to report their pension liabilities on their balance sheets, many companies discovered that they had actually been transformed into asset managers and life insurers, at great distance from their core business. For example, with pension liabilities amounting up to $11 billion, General Motor’s pension obligations roughly equalled its market capitalization, which amounted to $12 billion at the end of 2005. In fact, some US companies (including some airline companies) had to renege on their pension promises by entering into Chapter 11 insolvency protection. Via this route, they were able to transfer their pension obligations to the pension benefit guarantee corporation and to continue their business, with lower implied pension benefits for retirees. These considerations lead to the first important message I would like to emphasize today, namely that the separation between a sponsor and its pension fund should be a key feature of any pension system, to be fervently preserved and promoted. By contrast, in the US the aforementioned problems are mitigated in another way. There, companies introduced individual 401(k) plans, which do not appear on their balance sheets as a liability. This switch has the advantage that employees’ pension assets are no longer exposed to employer bankruptcy; on the downside, however, benefits are now of a defined contribution nature. The risks are then placed squarely on participants’ shoulders. In this respect, a further development of risk-pricing would help gain deeper insight into risk differences between pension systems. This brings me to a second key issue in the design of corporate pension plans: how to decide on investment policy and who should bear the residual risks? Investment policy and responsibility Let me put this more bluntly: is a shift to defined contribution schemes the optimal way to reduce pension risks for employers? I doubt it. In 401(k) plans, the individual decides what part of his wage he wishes to transfer to his 401(k) account. Moreover, notwithstanding recent initiatives that offer participants responsible investment-packages as a default, the majority of the plans still give contributors a substantial say in the investment policy. This all means that many 401(k) plans rely heavily upon individual responsibility as well as financial literacy. However, not everyone is able to understand the complex world of pension finance, as the average employee is not as well educated in finance as you all probably are. Let me clarify this by asking two basic questions, which were also put to a large group of American workers: • Suppose you have €100 in a savings account and the interest rate is 2 percent per year. After five years, how much do you think that you would have in the account if you left the money to grow: more than, less than, or exactly €102? • Now imagine that the interest rate on your savings account is 1 percent per year and inflation 2 percent per year. Would you then be able to buy more than, exactly the same as, or less than today with the money in the account? It may come as a surprise to you, but research has shown that over 50 percent of US pension plan participants could not answer these two simple questions correctly. And add to this, as pension-expert David Blake noted more than once, that 50 percent of the individuals does not even know what 50 percent is! Moreover, the man in the street is not an expert on risk diversification: in for example the well-known Enron case, employees had invested 60 percent of their 401(k) assets in Enron stock. On average about one-fifth of all 401(k) assets are invested in own company stock. Although this is understandable since an employee is always relatively confident of his own firm’s prospect, this again leads to the undesirable situation where human and financial capital are tied to the wellbeing of one and the same firm. Additionally, under 401(k) plans, it is up to participants to decide what amount to reserve for pension purposes. Here, the problem is that the typical 401(k) participant seems to have commitment problems: estimates indicate that the typical 401(k) participant approaching retirement has saved less than $50,000, instead of the $300,000 he would have accumulated under a defined benefit system. Procrastination behaviour – based on thoughts such as “I will start saving tomorrow” – as well as limited rationality seem to abound. Given these examples, my second main message is that since individuals only seem to be rational up to a point, there is considerable value in preserving the collective nature of our system. In such a system, participants automatically contribute enough towards their old age financing while professional asset managers make sure that the contributions are well invested from a risk-return perspective. This ensures that every individual is provided with a reasonable pension benefit after retirement. Moreover, collective pension systems are cost efficient, as they exploit economies of scale, and enable intergenerational risk-sharing which is welfare-enhancing to risk-averse individuals. My third main message, which follows from my second, is that you should all realize that the collective nature of our system brings important fiduciary responsibilities for you as pension fund asset managers. Keep in mind that compulsory participation implies that participants are not free to choose which pension fund to join, unless they move to another company or industry. In this way, your power to raise contributions is very similar to the government’s power of taxation, from which one normally also cannot escape. Consequently, you bear an important social responsibility – even more so than “ordinary” companies. Therefore, pension fund management requires good governance as well as transparency to allow pension plan participants to see what is being done with their money on their behalf. In addition, the compulsory nature of participation implies that you should not only look at private returns, but also try to take social returns into account, as society as a whole has given you the mandate to raise your funds. In this light, I applaud the recent initiatives that discourage socially irresponsible investments. My final message is more of a provocation to you all. In most western countries, pension systems have already been individualized to some degree as part of the shift from defined benefit towards defined contribution systems. To a lesser degree, this has also occurred in the Netherlands, with the introduction of conditional indexation and life course arrangements. In this context, I foresee market opportunities for new pension products that are tailored to individuals, but maintain the benefits of collectivity. This involves both assisting individuals with complex choices and making risk pooling instruments more readily available. Peter Bronkhorst Having stated these messages, I finally turn to today’s overarching theme: Peter Bronkhorst’s retirement. From my story, one may infer that I believe that a good asset manager should be both prudent and astute. Peter Bronkhorst possesses both these characteristics. This is also reflected in the performance of Shell’s pension fund. During Peter’s period of office, Shell’s pension fund portfolio out-performed that of most other Dutch pension funds: as noted in its yearly report, Shell’s pension portfolio earned an average annual rate of return of 6.8 percent over the period from 2001 to 2005, when Peter led the predecessor of SAMCo, as compared to 4.5 percent for the average Dutch pension fund over the same period. In Peter’s last year, 2006, I am told that SAMCo even realized a rate of return equal to 17% – about 7 percentage points higher than the average Dutch pension fund. That is what I would call a generous farewell gift! But Peter’s strong track record was not only established in the upswing. In fact, Peter guided Shell’s pension portfolio through the perfect storm that hit the financial markets in 2001. Peter’s investment policy enabled the Shell pension fund to compensate its participants fully for inflation in all years he was in charge. Besides this, Peter deserves merits for bundling Shell’s pension assets in the Netherlands. This is favourable for the Shell pension fund itself as research has shown that there are substantial economies of scale in pension fund provision. Apparently, the Dutch entity was the better place to deliver these economies of scale. In this context, bundling these activities in the Netherlands also brings positive externalities to the Dutch economy as it preserves and creates high-skilled employment in our country. In this way, it seems to me that Peter has fulfilled his social mandate in an exemplary fashion. Finally, one of my colleague-directors at the Dutch Central Bank – Dirk Witteveen, who as pension supervisor got to know Peter Bronkhorst fairly well – praises Peter for the binding role he fulfilled between social partners and pension funds when the sector was in disarray in the wake of the 2001 financial market storm. During this period, Peter kept a constructive, open attitude that contributed to agreement on the necessary adjustment measures. With the recovery of the Dutch pension system now well-established, this all seems like long ago, but we wouldn’t be sitting so comfortably now if it hadn’t been for the necessary measures taken and for Peter’s contribution to implement them. Conclusion I am coming to the end of my speech. I have stressed four important interconnected messages, relevant for the future world of pension finance. First of all, I believe that we should preserve and promote a clear separation between a sponsor and its pension fund. Second, I have pointed out the added value which collective pension arrangements have over individual ones by protecting pension plan participants against their own shortcomings, by exploiting economies of scale, and by enabling intergenerational risk-sharing. Third, I have emphasized that asset managers need to realise that their fiduciary mandate saddles them with important social responsibilities. Last, I challenge you to come up with pension products that are tailored to individual preferences, but are also able to maintain the benefits of collectivity. I congratulate Peter Bronkhorst on the excellent job he has done in these respects. The flipside is that I regret his stepping down from a prominent position in the pension industry. As a real – and therefore internationally oriented – Dutchman, Peter was often able to build bridges, even in intense debates. Now time has come for you, Peter, to harvest, as a pensioner, the fruits of the seeds you have sown. I wish you all the best in the future. | netherlands bank | 2,007 | 7 |
Speech by Dr Nout Wellink, Pres. of the Netherlands Bank & Chairman of the BCBS, at the Conference "Towards sustainable European competitiveness: the role of business" org. in commemoration of INSEAD's upcoming 50th anniversary, Amsterdam, 8 June 2007. | Nout Wellink: European competitiveness – where do we stand and where do we go? Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Conference “Towards sustainable European competitiveness: the role of business” organized in commemoration of INSEAD´s upcoming 50th anniversary by its Dutch alumni association, Amsterdam, 8 June 2007. * * * Introduction Let me start with some personal remarks. In the past few weeks, I visited successively Dublin, Tblisi, Athens and Buenos Aires. And as you probably know, I meet twice a month with my European colleagues at the ECB in Frankfurt. And as you probably don’t know, I will become 65 next year and thus entitled to public pension benefits (AOW), although my term as president expires only in 2011. This is how my professional life looks like nowadays in a world marked by globalization, European integration and aging. However, these three trends are not only relevant for central bankers, they are relevant for everyone. Today, I will speak about the impact of globalisation, European integration and aging on European competitiveness. Globalisation Globalisation strengthens the interrelationships between national economies. Let me illustrate this by China’s economic development. The rise of China gives an enormous supply shock to the world economy. Currently, 16% of total world production is made in China, which was only 4% in the beginning of the 80s. After the European Union and the US, China is now the third largest economy in the world. China’s economic development is noticeable for every European citizen. For example, electronics and textiles have become much cheaper due to cheap Chinese production. Inflated prices of raw materials and oil are a flip side of China’s explosive growth. Everyone who regularly refuels his car, can agree on this. On balance, Chinese economic development has been beneficial for Europe. For instance, Dutch families have saved on average 300 euros per year due to cheap Chinese imports, according to a recent estimate by the Netherlands Bureau for Economic Policy Analysis (CPB) 1 . China’s economic development certainly has an impact on European economies, but there are large differences across Europe. China has a comparative advantage in producing and exporting cloths, shoes, toys and consumer electronics. A country like the Netherlands has a comparative advantage in producing and exporting flowers, dairy products and food. Hence, the Netherlands currently has only limited competition from China in its export markets. However, a country like Italy, which is specialized in shoes and clothing, is confronted with severe competition from China. Consequently, Italy will have to restructure its shoes and clothing industries, something the Netherlands already did by the end of the 60s. A key question for the future is whether Europe can sustain global competition with countries like China. The development of labour productivity is an important determinant of the competitive position. In this respect, it is worrisome that the growth of European labour productivity has been lagging behind its main competitors in the past years 2 , although recently there seems to be a pick-up in trend productivity growth. Possible explanations for the low productivity growth in Europe are the lack of technological progress and an unfavourable business environment 3 . Let me take a closer look at both. Concerning technological progress, there is evidence that Europe’s relative weak productivity growth can at least partly be explained by its low research-and-development efforts. In the US and Japan, CPB (2006), China and the Dutch Economy; Stylised facts and prospects, CPB Document 127. While annual productivity growth recently decelerated from 2.4% (1970-1995) to 1.3% (1995-2004) in the euro area, it accelerated from 1.3% to 2.4% in the US. Source: European Commission (2007), Annual report on the euro area. Source: ECB (2005), Competitiveness and the export performance of the euro area, Occasional Paper no. 30. R&D-expenditures 4 in total manufacturing are about 50% higher than in the euro area. A second factor which might explain our weak productivity growth, is the education of the European population. Over the last decades we have seen an increase in the level of educational attainment. But to create a knowledge-based European powerhouse, we need to unlock universities’ potential. In a global context European universities are currently no match for American universities 5 . More competition between academic institutions, selective entrance exams and allowing more freedom in funding could spark a move to high-quality academic research. This is one of the things Europe needs to become “the most competitive and dynamic knowledge-driven economy” as laid down in the Lisbon agenda. Concerning the overall business environment, there is evidence that Europe is in a less favourable position than its main competitors. Surveys among European businessmen suggest that this holds in particular for the tax system, labour regulations and the administrative burden. The average marginal tax rate on labour in the euro area is high and hovers around 15 percent points above the rate in the US 6 . Labour regulations such as employment protection legislation hinder job-to-job mobility in Europe. As a result, workers in the EU stay in the same job for more than 10 years on average, compared to less than 7 years in the US 7 . Concerning the administrative burden, the average cost of starting a business with up to 50 employees in the euro area is estimated to be 10 times higher than in the US, according to the World Bank. That is, if entrepreneurs have not given up starting a business in the meantime, as it takes on average 27 days to set up a new business in the euro area, compared to just 5 in the US 8 . I always had respect for entrepreneurs, but it’s getting larger in view of the red tape they have to cut through. Some reforms have recently been undertaken, both at the national and the European level. For example, personal tax wedges have been reduced and employment protection legislation has been relaxed in some European countries. And I fully support the current EU Commission initiative for measuring the cost of existing legislation and reducing the administrative burden on companies with 25 percent by 2012. Furthermore, the adoption of the European Services Directive by the European Parliament in 2006 will contribute to a level playing field in the services sector. This will foster competition in the services sector, which is needed given the lacking productivity performance. However, although these reforms are a step in the right direction, more reforms are needed to improve productivity growth in Europe. Aging Europe is aging more than for instance the US and China. Let me give you some figures to illustrate this. Currently there are on average 23 retirees for every 100 workers in Europe, in 2050 this will be 48. In the same period, this so-called old-age dependency ratio will increase to 34 in the US, and to 39 in China 9 . Thus, the relative share of workers in the population of Europe will be smaller than in the US and China in the coming decades. This will threaten Europe’s competitive position. Although all European countries are aging, there are large differences across Europe. For instance, Italy is aging more rapidly than the Netherlands. Concerning aging in the Netherlands, let me have a closer look at the two underlying demographic trends. First of all, we have fewer children. Until the mid 60s, Dutch women gave birth to approximately three children during their lives. After having fallen to 1.5 children in the mid 80s, this figure is now projected to be only 1.75 children in the coming decades. Secondly, we live longer. At the time the public pension scheme (AOW) was introduced (1957), the average remaining life expectancy at age 65 was less than 15 years. Nowadays, new AOWbeneficiaries expect to receive AOW-benefits for more than 18 years on average. R&D-expenditures divided by value added. P. Kalaitzidakis, T. P. Mamuneas and T. Stengos (2001), Ranking of Academic Journals and Institutions in Economics, October 2001. Source: OECD. Marginal tax on labour consists of income tax, employee and employer social contributions as a percentage of total labour costs of average worker. Turmann, A. (2004), A new European agenda for labour mobility, CEPS Task Force Report. World Bank (2006), World Development Indicators, Business Environment database. Source: UN (2006), World Population Prospects: the 2006 Revision. From an economic point of view, both demographic trends are basically good news. Having fewer children reduces the scarcity of finite natural resources, which has a positive effect on individual welfare. Living longer partly mitigates this effect as individuals use more finite natural resources the longer they live. However, living longer also increases an individual’s potential earning capacity over their lifetime. Reaping the potential economic gains from living longer requires adjustments, in particular with respect to education and retirement. Let me take a closer look at both. Living and working longer requires more attention for education both when young and old. Young people should be properly educated and the number of school drop outs should be reduced. Older people need to get additional education during their careers to keep pace with the latest technological developments. In this respect, it is good to note that this concept of life-long learning is one of the leading principles of education at INSEAD. Living and working longer also requires an increase in retirement ages. Until recently, most European countries never increased their statutory retirement ages despite the increased longevity of their population. This threatens the sustainability of the pay-as-you-go financed European public pension schemes. Germany and the UK have recently announced a gradual increase in the statutory pension age to 67 and 68 respectively. Other European countries should also increase retirement ages in response to longevity developments if they want to keep a sound public pension scheme. Given the prospect of dramatically increasing old-age dependency ratios, it is now definitely time to act. Moreover, gradual adjustments in the pension ages are much easier to deal with than large increases at once. Doing nothing implies either a dramatic future fall in public pension benefits such as AOW to avoid tax increases or a dramatic future increase in the tax burden to preserve pension benefits. The latter would have severe consequences for Europe’s competitive position. European integration In a globalizing world economy, European integration can help to preserve Europe’s competitiveness. Being the largest economic block in the world, a united Europe is more capable in defending its economic interests than a divided Europe. This applies for instance to the trade negotiations in the World Trade Organisation. More importantly, European integration has fostered the competitiveness of European companies, in particular by the creation of the internal market. This has made European companies better prepared for global competition. The euro is another important example of how European integration can foster Europe’s competitiveness. Being a strong and stable currency, the euro is not as subject to exchange rate fluctuations as the individual European currencies used to be in the past. This reduces the economic uncertainty for European exporters. A precondition for successful European integration is a proper governance structure to facilitate smooth decision making. This holds especially after the enlargement of the European Union to 27 Member States. Besides fostering democracy and transparency, the recently rejected European Constitution was aimed at improving decision making in the European Union. Surveys among the European public suggest that the resistance against the Constitution does not stem from the proposed changes itself, but from the process followed, which was considered as proceeding too fast and too unknown for the public. In this respect, the term “Constitution” might be misleading as it suggests the creation of a single European State. In my view, the rejection of the draft Constitution in France and the Netherlands demonstrated the need for a deeper dialogue with the public about European integration. In this respect, I fully support the recent attempts to draft a shorter and simpler version of the draft Constitution, maintaining its main components. Despite the rejection of the draft Constitution, there is no need for pessimism concerning European integration. In the past, European integration has also halted from time to time before proceeding to the next landmark. Let me remind you of the crises with the European Monetary System in the early 90s. These crises did not prevent Europe from completing the process of monetary unification by the creation of the euro. It is as Willy Brandt once said: “The history of the EU is the history of its crises”. Concluding remarks Let me conclude. Globalisation, European integration and aging do not stop after this conference. The question is whether Europe is able to deal with it in such a way that its competitiveness is safeguarded. Although there is certainly a need to adjust as I have just sketched, we shouldn’t be too pessimistic about the ability of Europe to accomplish this. In the past, Europeans proved themselves to be more than capable of adjusting to new circumstances. | netherlands bank | 2,007 | 7 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the symposium "Demographic ageing: a broader view", Science center NEMO, Amsterdam, 11 October 2007. | Nout Wellink: The labour market in 2040 – greyer but full of vitality Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the symposium “Demographic ageing: a broader view”, Science center NEMO, Amsterdam, 11 October 2007. * * * Imagine: it is the year 2040. Those who turn 32 this year will then be 65 and so are now halfway there. Demographic ageing will have reached its pinnacle in 2040. More than 4 million Dutch people will then be older than 65, working out at a quarter of the population, whereas that age group now makes up less than 15%. For every person over-65, there will be just two compatriots aged between 20 and 65 1 . In such a greying society, our cities and towns will look quite different to now. Amsterdam city centre is likely to be a largely pedestrian zone, allowing for wider footpaths. Political pressure will have forced the monument conservation authority to relax its rules. Large groups of older people in the city will have been obliged to remove thresholds, install stair lifts and knock through walls. The two universities in the capital will have been forced to merge because of the smaller inflow of new students. Only a handful of the many places of entertainment around Rembrant Square will still remain, but the classical performances at the Concertgebouw and the Muziektheater aan ’t IJ will be sold out every night. Subsidies for museums may even have been scrapped owing to the overwhelming increase in visitor numbers. And here, in NEMO, where today’s children make their first discoveries in the area of science and technology, there may be a shopping mall with stores full of books, golfing equipment, spectacles, hobby accessories, fine chocolates and garden tools. Of course this is mere speculation. Time will tell what life will really be like in 2040. But it’s a sure thing that the older people of the future will have a major influence. Today we are looking at the economic consequences of population ageing. I want to talk to you about the impact of ageing on the labour market and how we can prepare ourselves for it. Labour force in 2040 For a start, the average worker in 2040 will be older than at present and so have more work experience. Owing to the rise in the number of pensioners, he will have fewer competitors in the labour market, unless there is a spectacular rise in birth or immigration rates. Because work will become scarcer, but also because of the trend rise in labour productivity, his disposable income is likely to be far higher than it is now. But population ageing will absorb a huge share of the employees’ rise in income if the current schemes continue unchanged. To illustrate, if we assume that income in 2040 has risen by 60% [at, say, 1.4% per year], more than a quarter of this rise in income will be “eaten-up” by higher contributions and taxes for the state old age pension 2 . Some sectors will be faced by bigger changes in the labour market than others. At present, older workers are overrepresented in education and health care. Shortages could arise in these sectors if there is no increase in the inflow of young employees. In education, this is These figures were derived from the population forecast 2006-2050 published by Statistics Netherlands. If the grey pressure doubled, and all other circumstances remained unchanged, the burden of contributions and taxes related to the state old age pensions would also double, from 9% at present to 18% in 2040. That means that net disposable income would not rise by 60%, but by 44%. already expected to lead to problems in the short term 3 . In the longer run, the effects will be mitigated by the decline in the number of schoolgoing children. An added problem for health care is that population ageing will generate greater demand. Working conditions in the health care sector merit extra attention if we are to avert staff shortages in the future. Retirement age Looking at the labour market in 2040, we cannot skirt problematic pension issues. The number of pensioners will increase, because the group of people reaching retirement age is expanding while life expectancy has risen too. The latter is a great achievement, of course. In 1960, 40-year-old men had an average life expectancy of more than 74 years, compared to just above 78 in 2008. The life expectancy for 40-year-old women has risen by five years, to something over 82. And there has also been a significant gain in the number of years lived without the need for intensive health care 4 . The price we pay for this progress is that bottlenecks may arise in the funding of the state old age pensions and supplementary pension schemes. We can of course absorb these by either raising contributions, or by letting benefits fall behind them. But such measures hit people directly in their pockets, and I think that better solutions are available to improve the sustainability of the pension system. One of these is to widen the contribution base through greater labour participation. There is still scope for widening participation in the Netherlands, notably among women, youths from ethnic minorities, people with occupational disabilities and, most definitely, among older workers themselves. Population ageing apart, higher participation is a good thing in itself. Our prosperity will benefit from the optimum deployment of available workers. Moreover, older people are staying active for longer, thanks to the higher life expectancy and good health care. They look after their grandchildren, perform voluntary work and play a full part in society. An obvious path is to stimulate older people to use their active attitude to life to stay on longer in the workplace. This would also reinforce the solidarity between working and non-working people. But let’s not go too far. Employees in sectors such as construction, the fire brigade and the army have often started working at a very young age. It would not be reasonable to expect these groups to work for more than 50 years of their lives, whereas people in less demanding positions are hard pressed to work for 40 years. Especially as these jobs are physically taxing. The collective labour agreements for such physically-taxing occupations generally arrange for pension funding that enables employees to stop work before reaching the statutory retirement age. That is understandable, and may continue on broadly the same lines as far as I am concerned. It is difficult to exactly determine what percentage of the labour force hold physically-taxing jobs, but in all likelihood, it would be reasonable and possible for the greater part of the labour force to prolong their careers. An additional factor is the structural decline in the share of physically-taxing jobs owing to the diminishing share of industry in our economy. This employment shift to services set in many years ago, but is still ongoing. In 1980, industry still accounted for 15% of employment, but this share has now dwindled to less than 10% 5 . The share of construction in our economy remained stable over this period at around 5.5%. In education, the percentage of employees aged 55-64 is 19.2%, whereas the average rate is 11.8%. In addition, in its report Vergrijzing en vervanging (Ageing and Replacement), the Council for Work and Income expects bottlenecks in education in the short term. The Rapportage Ouderen 2006 (Report on Older People 2006) by the Ministry of Health, Welfare and Sport, shows that in 2003 the so-termed life expectancy without physical impairments of a 65-year-old man was 77.3 years, compared to 75 in 1989. For 65-year-old women, these figures were 77.4 and 74.1 respectively. “Less welfare growth in the service economy”, DNB Quarterly Bulletin, September 2005. Will staying on in the workplace alleviate the impact of ageing on the labour market? Yes, most definitely! For employers, it means that labour supply will not decrease as rapidly, making it easier for them to fill vacancies. And the bigger the working section of the population, the better the labour market for both employers and employees because of the lighter marginal tax burden. If more people continue working, not just until they turn 65 but afterwards too, and delay drawing the state old age pension, there would be less state old age pension claimants and more potential contributors. The level of contribution for the working part of the population would then be lower. So it works both ways. Older people themselves benefit from prolonging their working lives as a means of safeguarding the sustainability of the pension system. For they enjoy higher disposable income. Retaining older workers The reality is that labour participation among those aged between 55 and 64 is relatively low 6 . And participation among the over-65s is negligible, the reason being the various legal and socio-cultural impediments discouraging older people from working for longer than they generally do now. A major obstacle is that many collective labour agreements provide for termination of employment on reaching 65. It is subsequently quite unappealing – for both employer and employee – to enter into a new contract. Having reached retirement age, the employee has much less financial incentive to work, because he is then entitled to a state old age pension as well as his supplementary pension benefits. For the employer, entering into an employment contract with someone over 65 represents a risk, seeing as he is obliged to offer all his employees occupational disability insurance. The employer may choose to place this risk with the Employee Insurance Administration Agency or to run it himself, possibly by taking out private insurance. If cheaper in their case, employers generally choose the latter option. This choice applies for their entire payroll. But a problem is that insurers do not provide occupational disability insurance for employees over 65. So it is up to employers to carry the risk of occupational disability for these employees. Moreover, the risk of an employee becoming sick increases as he gets older. Since the Sickness Benefits Act obliges employers to continue paying sick employees for two years, this could be very costly for employers. The statutory retirement age thus constitutes an obstacle for older workers and their employers, even though prolonging working lives would be of general benefit. Germany has opted for gradually raising the retirement age from 65 to 67 as of 2012. During the first twelve years, Germany will raise the retirement age by one month a year, and in the six following years by two months a year, completing the process by 2030. So German employees will have the opportunity to prepare for a later retirement age, and no one will have to carry on working unexpectedly. We could likewise raise the retirement age in the Netherlands stepby-step to, say, 67 too. This would make it easier and more rewarding to stay on in the workplace. But it is vital to encourage older workers to continue working, even before the retirement age of 65. Because too many people are now taking early retirement without being prompted by the physically-taxing nature of their job. With this in mind, the government has already voiced its desire to partly fund the state old age pension by taxing older people’s incomes. In itself, the idea of funding state pensions from public resources seems a good idea: older people would then help carry the collective burden of population ageing. All other things being equal, it would allow for a reduction in general tax rates, and it is also expected to boost total labour participation. Moreover, the funding of state pensions from public resources forms a direct According to Eurostat figures, average labour participation among people aged 55-64 in 2006 was 50.5%, whereas it was 77.1% for those aged 15-65. incentive to older workers to keep working. However, the impact of this inducement will be contained, because the change in funding will mainly affect the more well-off pensioners. Research by De Nederlandsche Bank 7 has shown that when it comes to choosing their own retirement date, this group is less sensitive to changes in their pension wealth. Besides the said income effect, the move to finance state pensions from public resources also has a substitution effect: the positive effect that continuing to work would have on the level of a pension would be less if this pension were subject to tax. However, our research shows that, on balance, funding state pensions from public resources would stimulate older workers to stay on. In addition to funding state pensions from public resources, there are conceivable measures to reward older workers for continuing to work. In part, the current system already contains such features. Owing to the fixed accrual of pensions, the years leading up to the age of 65 are relatively lucrative. And the earned income tax credit is higher for employees over 57. Nonetheless, this now gives older workers who prolong their careers no more than EUR 500 a year. One possibility would be an incentive in the form of a considerable hike in this earned income tax credit. Helping older people find work Besides older people who are already employed, there are of course those who have lost their job through, say, a reorganisation. Many of them would like to keep working but find it difficult to find a new job. In this respect, we need to look at older workers’ salary and productivity. Older workers are often more expensive than their younger colleagues, because their salary has increased over the years. However, their expertise is often less up-to-date. In part, the wider experience of older workers makes up for their perhaps outdated expertise. However, this experience often proves to be most useful for the organisation in which it was acquired. It is also difficult for employers to assess the precise nature of experience gained in other enterprises. To what extent do the tasks and corporate culture resemble those in their own company? How much responsibility did the job applicant actually hold? How well did he perform? All too often there is no satisfactory response to such questions, prompting employers to choose the safer option of a younger, cheaper candidate. [This means that older job seekers have often been job hunting for some time when they file job applications. Existing prejudices about older people, generous severance payments and overestimation of their own employability make it harder to find work. The longer older people seek work, the worse their labour market position becomes.] To enable older workers to actually stay in the workplace, it is hence not enough to gradually raise retirement age and increase financial incentives. Employers and employees will need to make a joint effort. Employees will need to continue developing their skills to strengthen their labour market position. And employers will have to be prepared to give older workers a chance. For it is in their own interest to quickly fill vacancies and to take on good employees. Importantly, employers should realise that older workers are indeed able to acquire new knowledge and skills. And that they can win commitment from a motivated employee who they are likely to retain in service for longer than a job-hopping employee in their twenties or thirties. Bruinshoofd, Allard en Sybille Grob (2006), Do changes in pension incentives affect retirement? A stated preferences approach to Dutch retirement considerations, DNB Working Paper no. 115. | netherlands bank | 2,007 | 10 |
Remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the GARP 2008 9th Annual Risk Management Convention & Exhibition, New York, 27 February 2008. | Nout Wellink: Recent market turmoil – implications for supervisors and risk managers Remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the GARP 2008 9th Annual Risk Management Convention & Exhibition, New York, 27 February 2008. * * * Introduction I am pleased to join you today to speak about the recent financial market turmoil and the concrete responses of the Basel Committee. The mission of the Basel Committee is to improve the quality of banking supervision worldwide and to promote strong risk management practices at banks. This morning I would like to discuss some of our recent initiatives with you. Issues and lessons for risk managers and bank supervisors Let me begin by first focusing on some of the key issues that were identified during this recent turmoil and the lessons – in some cases painful ones – experienced by risk managers and supervisors. Quite frankly, some of the lessons learnt from the turmoil point to the importance of risk management fundamentals. While the triggers and transmission of risk always take on new faces, it is the basics that remain the same – complex structured products provide a stark example of this. From the perspective of bank supervisors, I believe there were three fundamental shortcomings that contributed to and amplified the turmoil. These fundamentals can be found in all parts of the credit intermediation process. The first of these relates to the origination of credits. Here, the industry failed to consistently employ sound underwriting standards. In many cases, firms also neglected to define prudent firm-wide risk limits on these exposures. Second, risk management and measurement capabilities did not keep pace with rapid financial innovation and the evolution to market-based credit intermediation. Third, certain aspects of regulation, supervision and market transparency failed to reflect financial market developments and therefore contributed to weak practices at banks. These are areas where future practical improvements must be made. Underwriting standards As you know, the trigger for the turbulence was subprime mortgage lending, much of which took place outside the regulated banking sector. A large part of this lending was based on weak underwriting standards. Weak underwriting has long been the bane of banks and banking systems; the difference in this case was the rapid and global transmission of risk through the use of securitisation. Problems at banks are all too often caused by the failure to adhere to basic risk management principles, especially when new products and markets come into play. In many cases, this is due to the pressures that firms face to increase market share, combined with unrealistic expectations about growth and performance prospects. But no matter how much risk exposures get sliced, diced and distributed among financial market participants, financial innovation cannot mask poor underwriting. At the same time, the additional complexity, opacity and leverage resulting from certain structured products and offbalance sheet vehicles further magnified the problem, as it has not been sufficiently clear where the ultimate risk lies. This brings me to my second point. Risk management infrastructure and financial innovation Indeed, the second fundamental shortcoming is the wide disparity between the rapid pace of financial innovation and the risk management infrastructure on which this innovation was built. When I spoke at last year’s GARP conference, I noted that the linkages between the various segments of the credit markets and financial institutions had been fundamentally altered. This is mainly due to increased market-based credit intermediation, or the originateto-distribute model. Historic or statistical measures of risk and exposure, such as value-at-risk, past loss experiences and name concentration in the traditional banking book have proved inadequate when assessing relationships in the originate-to-distribute model and how they may perform under stress. In fact, the use of these and other historic measures resulted in a massive understatement of stressed losses, which were far below the actual losses experienced to date. As I suggested at last year’s conference, the greater reliance on securitisation and other risk transfer mechanisms means that banks are more vulnerable to exposures building up or returning to the balance sheet when market liquidity seizes up. In addition, increased reliance on market liquidity means that problems in financial markets can adversely – and very quickly – affect banks’ funding liquidity. However, for those institutions that stress test funding capabilities, many only assumed a firm-specific event. The problems arising from poor underwriting were compounded by failures to manage firmwide concentrations. Many firms were unaware of their overall exposure to subprime mortgages and related structured products, such as CDOs, whose repayment depend on such mortgages. These concentrations went far beyond traditional loan portfolio exposures and included CDOs and mortgage-backed securities held in the trading book; liquidity facilities extended to conduits; reputational exposures to sponsored SIVs; and counterparty exposures to the monoline sector. In addition to failing to understand their firm-wide concentrations, many institutions could not readily nor easily aggregate their subprime exposure sector when the crisis arose. This points to the need for greater investment in firm wide risk management and measurement capabilities. Sound regulation, supervision and transparency Finally, there were shortcomings in regulation, supervision and market transparency. It is important to point out that this crisis has played out under Basel I, which was instrumental in raising the level of bank capital in the late 1980s and through the 90s. However, the framework became outdated and could not adequately capture the types of risks that banks face in today’s increasingly market-based credit intermediation environment. As a result, offbalance sheet exposures as well as operational, legal and reputational risks were not appropriately identified and measured. Moreover, liquidity supervision and regulation have failed to keep up with banks’ changing risk profiles and growing vulnerability to market-based shocks. All in all, these issues underscore the need for Basel II and the necessity to continuously improve the framework. Recent difficulties also highlighted the lack of transparency due to insufficient disclosure. CDOs of asset-backed securities are a particularly striking example. I must add, however, the turmoil also made clear that investors did not make full use of available information and placed excessive reliance on external ratings. Taken together, these factors resulted in banks and investors assuming excessive risk and concentration to the subprime sector – either directly or indirectly through structured products based on subprime mortgages. Work programme of the Basel Committee From the Basel Committee’s perspective, the previous analysis points to a number of concrete measures that banks and supervisors must take. These measures should improve firms’ resilience to market-based shocks and help strengthen confidence in core financial institutions. I will address three of these initiatives the Committee is working to complete, which are: 1) implementation of and further improvements to Basel II; 2) enhancing global standards for liquidity risk management and supervision; and 3) strengthening other risk management practices, particularly with respect to stress testing and valuations. 1) Basel II Let me now say a few words about each of these initiatives, and I will start by underscoring the importance of Basel II. In developing the Framework, the Committee sought to provide better incentives for banks to capture exposures to structured credit activities, both on- and off-balance sheet, including ABCP conduits. The three pillars of the framework were designed to better reflect banks’ evolving risk profiles, while building in cushions for uncertainty and forward looking risks. The implementation of the Basel II framework hence remains a high priority. At the same time however, we have identified some areas within the improved Basel II framework that need to be strengthened to reflect the lessons of recent events. These relate to the Pillar 1 capital treatment of certain securitisations of complex products where the vast majority of losses in the banking sector have occurred. In Pillar 2 of the framework, we need to make sure that banks perform adequate stress tests and hold capital for uncertainties related to exposures coming back to the balance sheet for legal, reputational or liquidity reasons. And we need to build on the Pillar 3 disclosure requirements of the framework to strengthen banks’ transparency around exposures to structured credit products and securitised assets, including banks’ involvement as sponsors. I also want to emphasise the importance of strong capital supporting trading book exposures. For the largest global banks, balance sheet assets have more than doubled between 2000 and 2006. Much of this growth relates to trading assets. Indeed, the vast majority of bank losses have been on retained trading exposures, particularly highly rated CDOs and leveraged lending. As supervisors, we need to make sure that the capital underpinning the trading book is commensurate with the risks that firms face. We therefore are supplementing the current VAR-based framework with a capital charge for credit default risk in the trading book. Moreover, to address the shortcomings of VAR, it is critical that banks have rigorous stress testing and scenario analysis that translate into prudent risk taking and limits along with strong capital. 2) Liquidity risk Our second initiative relates to liquidity risk management and liquidity risk supervision. It goes without saying that over the past months, national supervisors have been closely monitoring the liquidity situation of their banking sectors and individual banking institutions to ensure that they enhance their resiliency to stress. The Committee is engaged in a major effort to strengthen global standards for liquidity risk management and supervision. We have identified a range of common weaknesses in liquidity risk management, including stress testing, contingency funding plans, disclosure and the management of off-balance sheet exposures. We are working to translate these lessons into robust global standards for risk management and supervision. Practically, this involves a fundamental review of the Sound practices for managing liquidity in banking organisations, which the Committee developed in 2000. We plan to issue the enhanced sound practices for public comment this summer. Issuing sound guidance and standards is only the first step; implementation and follow-up is the second. After the Committee issues the updated sound practices later this year, it will be incumbent upon banks to properly implement them and for supervisors to follow up to ensure proper implementation and adherence. 3) Strengthening other risk management practices The third area to which the Basel Committee attaches high priority is the strengthening of other risk management practises. As I have indicated, there is a need to strengthen various aspects of firm-wide risk governance and management practices. Let me mention two specific areas, namely valuations and stress testing. Valuation practices for complex trading assets have been a destabilising factor over the course of the crisis. When markets for financial instruments do not function properly, it is difficult to determine a fair value. Also, market participants have had a notable lack of confidence in firms’ disclosure of exposures to structured products, processes for valuing positions, and the timely and accurate recognition of losses. This translated in a marked decline in financial firms’ share prices. Recent financial disclosures are helping improve the situation but more needs to be done. With close cooperation from risk managers and other professionals, the Committee is carefully analysing how to help put valuation practices on a sounder long term footing. This is a topic the Committee is deeply concerned with, given the growing share of exposures that have been subject to mark-to-market valuations and which then flow through to earnings and capital. Disciplined fair valuation practices and clear sound practices can help make firms more resilient to stress. But poor practices can create major vulnerabilities for individual banks and for the financial system. Furthermore, it also is critical that banks improve their firm wide stress testing practices. The turbulence has made clear that firms need to aggregate all exposures to a particular risk driver or related drivers and subject them to stress, also taking into account second round effects and the response of other market participants. This is particularly relevant since funding and market liquidity are increasingly linked. In addition, additional forward looking measures of risk must be applied when we see rapid growth in new products or markets, which have not been subject to an economic or financial market downturn. Firms must develop the governance and infrastructure to carry out rigorous stress tests that identify where the major vulnerabilities and firm-wide concentrations lie. And there needs to be a clear impact on risk taking and appetite. The Committee will be taking a close look at the lessons of the turmoil, how the current range of bank stress testing practices stacks up, and where we can strengthen the supervision around stress testing going forward. Conclusion In conclusion, the Basel Committee is focusing on practical and concrete efforts that will help strengthen risk management, regulation, supervision, market transparency for banking institutions. We have embarked on a focused and ambitious work agenda with clear deliverables. We also are contributing to the broader initiative of the Financial Stability Forum to address the issues resulting from the recent turmoil. Some of the Committee’s efforts will take time, but having a clear road map should improve market confidence even in the shorter term. The banking sector needs to have sufficient capital and liquidity buffers to absorb financial shocks and the uncertainties around how such shocks could play out in the future as the process of financial innovation continues. Risk managers need to continuously translate the basics of sound risk governance and management to rapidly changing environments. And importantly, regulators need to make sure that the infrastructure of supervision, regulation and transparency keeps pace with innovation and promotes appropriate incentives for sound risk management. There are no simple, quick fix measures that will prevent the next crisis. But I believe that the steps I have outlined will make the banking sector more resilient to the next set of shocks, whatever their source. Thank you. | netherlands bank | 2,008 | 2 |
Opening address by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Risk Minds Asia Conference - Basel II Implementation Summit, Singapore, 4 March 2008. | Nout Wellink: Basel II – market developments and financial institution resiliency Opening address by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Risk Minds Asia Conference – Basel II Implementation Summit, Singapore, 4 March 2008. * * * Introduction I am pleased to speak with you this morning about the Basel II capital framework in the context of recent market developments. As you know, most global banks are only beginning to implement the Basel II framework as of the beginning of this year. The financial turmoil therefore has been playing out under the Basel I capital regime. In my remarks today, I would like to discuss how the implementation of the Basel II framework provides an opportunity for banks and supervisors to strengthen the resilience of the banking system to financial and economic shocks. I will first discuss some key objectives of capital regulation. I will then discuss how the Basel II capital framework is better able to achieve these objectives in the face of rapid financial innovation. Next, I will discuss some lessons from the recent turmoil and their potential implications for Basel II going forward. Finally I will talk about the work of the Committee to supplement strong capital with improvements to global liquidity risk management and supervision. Objectives of capital regulation In assessing the implications of the recent turmoil, a key area of discussion has been the role of regulatory capital. It is clear that the capital regime plays a key role in shaping the incentives and constraints that banks face when managing their portfolio of risk exposures. In developing Basel II, the Basel Committee had a number of objectives in mind. One objective was to develop a more meaningful link between banks’ on- and off-balance sheet risk exposures, and the capital supporting them. Another was to strengthen the links between sound regulatory capital and risk-based supervision as a way to create incentives for strong risk management practices at banks. A third objective was to enhance market discipline through better information about banks’ risk profiles, risk measurement techniques and capital. And finally, the Committee sought to develop a framework that was adaptive to rapid financial innovation. The Basel I framework played an important role in raising capital levels across the banking system over the late 1980s and 90s. However, as recent events are demonstrating, it has increasingly failed to deliver on the four objectives I have listed. For example, the failure to capture off-balance sheet exposures to ABCP conduits and SIVs demonstrates the growing gap between banks’ rapidly evolving risk profiles and the regulatory capital framework. Changes introduced by Basel II How will Basel II do a better job delivering on the four capital objectives I have described to you? It does so by moving capital regulation to a better point on a spectrum of two extremes. On one end of the spectrum, we have Basel I-like regimes, which rely on rigid, externally imposed regulatory ratios which collapse under their own weight as rapid financial innovation and capital arbitrage proceed. The result is a breakdown in the link between risk and capital (as we have seen in the example of structured credit exposures). On the other end of the spectrum, we have full reliance on banks’ internal credit models. Here we run the risk of regulatory capital not putting appropriate constraints on banks’ risk taking, and as we all know, the role of regulatory capital is to impose limits on banks that do not manage themselves in a prudent way. Basel II falls in the middle of this spectrum by leveraging off and reinforcing the basic building blocks of sound credit risk management, but filtering these elements through a rigorous regulatory framework. In particular, I am talking about requiring banks to have sound internal ratings classification systems that decompose any exposure into its probability of default, loss given default and exposure at default, subject to stringent supervisory standards and internal controls. Moreover, these inputs are filtered through a regulatory framework where supervisors conservatively specify correlations within asset classes. Let me elaborate a bit more on how Basel II does a better job of capturing the types of risk that banks increasingly face. Some of the most important areas relevant to the current crisis are the following: • First, Basel II delivers greater risk differentiation. Banks that move from prime into subprime mortgage lending or that move from traditional corporate lending into leveraged lending will see an increase in their capital commensurate with the changing business strategy and risk profile. Under Basel I, all such exposures receive the same charge. • Second, off-balance sheet contractual exposures to SIVs and conduits will be brought into the fold and subject to regulatory capital, whatever the accounting treatment. • Third, there will be a much more risk sensitive treatment for securitisation exposures. This will create more neutral incentives between retaining an exposure on the balance sheet or distributing it in the market through securitisation. • Fourth, banks will have to develop more rigorous approaches to measure and manage their operational risk exposures and hold commensurate capital. • Fifth, banks will have to develop more rigorous methodologies for capturing counterparty credit exposures, including so-called wrong way risk. This is the risk that the exposure increases as the counterparty’s credit quality deteriorates, as we saw in the monoline sector. In addition, Basel II has in place a variety of safeguards, which also have the benefit of reinforcing supervisors’ objectives to strengthen risk management and market discipline. Let me say a few words about some of Basel II’s safeguards. • For example, banks will have to continuously improve the quality of their internal loss data. Basel II requires that banks have at least five years of data, including a downturn. Our quantitative impact study work showed that this will raise the bar from current practice at many banking institutions. • Another safety measure is the requirement for banks to estimate their recovery rates assuming a downturn in the credit cycle. This will reflect up front in capital that losses on liquidated collateral will be greater during stressful periods. • In order to use Basel II’s advanced approaches, banks will have to demonstrate robust data management and firm-wide aggregation capabilities. • The requirement for banks to perform stress tests of their on- and off-balance sheet exposures is an additional safeguard. Based in part on these stress tests, banks will need to demonstrate to supervisors that they have adequate capital cushions to manage through a down cycle. • Finally, banks will have to provide much better transparency to the market about the range of exposures they hold, including to securitisations and conduits. Taken together, these measures will introduce a more rigorous, forward looking perspective on the types of risks that banks could face in a downturn. They will require banks to factor these risks into minimum regulatory capital, internal capital planning and disclosures to the market. Supervisors will reinforce these disciplines by assessing banks’ risk management, measurement and capital before capital ratios fall below the minimum requirements. This will help change incentives to anticipate risks and potential losses and to hold commensurate capital ex ante. In sum, all these efforts recognise the fact that banks’ business models and associated risks have gotten increasingly complex, and that there is no longer one simple measure that can capture them and stand the test of financial innovation. Indeed, the framework, through its three pillars and various safeguards, provides multiple perspectives on a banks’ risk taking, ensuring that there is no over reliance on any one measure. Lessons from the recent turmoil and possible implications for Basel II My remarks so far should indicate to you that a number of the lessons for banks and supervisors will be addressed through the improved capital framework. Moreover, the framework puts regulators in a better position to reflect future lessons and change. So the first priority is for Basel Committee members and other jurisdictions to press ahead with this fundamentally important enhancement to capital regulation. The current Basel II framework, however, is not perfect. There are opportunities to reflect some of the new lessons within this more adaptive capital regime. Let me share with you some of the issues we have been discussing within the Basel Committee, as well as some of our current priorities. While we have a rigorous and ambitious work plan with clear timelines to make progress and deliver on these issues, I nevertheless want to caution you that this is still work in progress. I will say a few words about each of Basel II’s three pillars. In the first pillar, we are taking a look at the treatment of highly rated securitisation exposures, especially so-called CDOs of ABS. These securities have recently been the source of the greatest losses across the banking sector and they have an unusual feature: most of the time they perform very well, but when they start experiencing losses, these can build very rapidly, producing a real cliff effect. This explains the unprecedented downgrades we have seen on triple-A super senior tranches, which exceed anything we have seen in traditional corporate bonds. These structured securities are highly correlated with systematic risk. The Basel Committee will look at whether the capital charges for these types of exposures are calibrated appropriately in relation to their risks and complexity. The Committee also is pressing ahead with our work to introduce a credit default risk charge for the trading book. As you know, there has been a rapid growth of less liquid, credit sensitive products in banks’ trading books. These products include structured credit assets and leveraged lending. The VAR-based approach is insufficient for these types of exposures and needs to be supplemented with a default risk charge. In addition, it is critical that banks conduct rigorous Pillar 2 stress testing of their trading book exposures. They must factor in liquidity horizons and reflect these results in their risk limits, economic capital and concentration management strategies. Many structured credit products are tailored for individual investors and have a limited or no secondary market. The Basel II framework has guidelines for what should and should not go into the trading book and these need to be reviewed by banks. In the second pillar of the Basel framework, supervisors will be reinforcing the importance of banks’ stress testing practices. As I mentioned, Basel II already requires that banks conduct stress tests of their credit portfolios to validate the adequacy of their capital cushions at all points of the credit cycle. However we need to think more about the importance of banks’ conducting scenario analyses and stress tests of their contingent credit exposures, both contractual and non-contractual. These contingencies have implications for balance sheet growth and capital. As we have seen, many banks have taken significant exposures back on the balance sheet for reputation reasons. Being better prepared for such scenarios going forward can help make banks more resilient to stressful conditions. In Pillar 3, there are opportunities to further leverage off the types of disclosure required under Basel II. In particular, supervisors need to monitor the type of information that banks make available for structured credit products. The Committee will determine whether improvements are needed, particularly related to securitisations, conduits and the sponsorship of off-balance sheet vehicles. Strengthening liquidity risk management and supervision So far I have told you about the Basel Committee’s objectives in developing the Basel II framework and the lessons we have thus far learned from the recent turmoil, which – taken together – will forge a strong capital framework. But a strong capital base is one part of the puzzle – another is strong liquidity risk management and supervision. Banks with a weak capital base are vulnerable to liquidity problems during periods of financial market stress. However even banks with strong capital can experience liquidity problems if they do not manage this area well. Before the market turmoil began last summer, the Committee had already launched a work stream to assess the current state of liquidity risk management and supervision. However, as a result of the turmoil, we have accelerated this work. Last month we released our assessment of the weaknesses identified by the crisis and what we think needs to be done about it. We are now well along to completing a fundamental review of the global standards for liquidity risk management and supervision, which were issued by the Basel Committee in 2000. We plan to issue the new standards for public comment this coming July. Some of the key areas we will address include the need to enhance overall governance for liquidity risk management, integrating it more closely with other risk management disciplines. We will address the need to strengthen liquidity stress testing practices, including the capture of offbalance sheet contingent exposures. And we will focus on the importance of firms having in place rigorous contingency funding plans that reflect the possibility of major funding sources drying up for long periods of time. Finally, we will have guidance for strengthened supervision, banks’ reporting to supervisors and market disclosure. I am convinced this initiative will take liquidity risk management and supervision to a new level. However, I would also note the critical importance of rigorous follow up by supervisors on a continuous basis to ensure that these standards are implemented in practice. Conclusion The banking sector needs to have strong capital and liquidity buffers to absorb financial shocks and the uncertainties around how such shocks could play out in the future as the process of financial innovation continues. Basel II is an important next step to enhance bank resiliency. Moreover, it provides supervisors with a better framework within which to make enhancements in the future, as financial markets evolve. There are no simple measures that will capture the complex risks that global banks now face. We need multiple perspectives on risk, as provided under the three pillars of Basel II. Moreover, there is no substitute for strong risk management, liquidity management and supervision. Risk managers need to continuously translate the basics of sound risk governance and management to rapidly changing environments. And importantly, regulators need to make sure that the infrastructure of supervision, regulation and transparency keeps pace with innovation and promotes appropriate incentives for sound risk management. If we take these lessons forward, I believe that we will have a banking sector that is ever more resilient to the next set of shocks, whatever their source. Thank you. | netherlands bank | 2,008 | 3 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the inaugural event for the Willem F Duisenberg Fellowship, Amsterdam, 28 February 2008. | Nout Wellink: Wim Duisenberg's legacy as President of the Netherlands Bank Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the inaugural event for the Willem F Duisenberg Fellowship, Amsterdam, 28 February 2008. * * * I am honoured to be here today, at the inauguration of the Willem F. Duisenberg fellowship, and to have the opportunity to introduce to you Professor Tito Boeri, who will give the first Duisenberg lecture. DNB encourages the initiative to continue this successful fellowship, and we are privileged that it has been given the name of DNB’s former president Wim Duisenberg. I have many lively memories of Wim Duisenberg, some dating back more than 30 years. Today I would like to take a closer look at the period when Duisenberg was president of the Nederlandsche Bank, the years between 1982 and 1997. Viewing back, from the current period of financial turmoil, those years may seem remote and relatively quiet. However, there was some turmoil at that time as well, and I think that our experience of that time remains relevant today. When Duisenberg became president of DNB in the early 1980s, the world economy was in a bad shape. The Bretton Woods system of fixed exchange rates had collapsed and the world had been shocked by two oil crises. The advanced economies were entering a deep recession. In the Netherlands, the economy suffered from what became known as the “Dutch disease”. Essentially, it meant that we were living beyond our means, financed by the income from natural gas. As a consequence, the public sector expanded rapidly, including the social security system. Moreover, the wage share of national income exploded, and competitiveness of the Dutch business sector deteriorated. To top off all this, in 1982, inflation was very high, around 6%, the budget deficit was 9% of national income, and unemployment rate was almost 8%, more than doubled from two years earlier. Altogether, the economic situation was rather depressing, at the start of Duisenberg’s presidency. After the collapse of the Bretton Woods system in 1971, Dutch monetary policy remained directed at the exchange rate of the guilder. A strong currency was regarded as the best guarantee against imported inflation. Since Germany had a strong anti-inflation record, Dutch exchange rate policy amounted to keeping a stable exchange rate against the DM. The Netherlands was the first country to adopt this policy, and Duisenberg had already defended it strongly when he was Minister of Finance (73-77). During Duisenberg's entire presidency, the Netherlands was a participant in the ERM, the exchange rate mechanism of the European Union, that had started in 1979. Throughout the first turbulent phase of the ERM, until 1983, the guilder remained the strongest currency in the ERM. In 1983 the guilder was devalued for the second time, and last time ever. The devaluation in 1983 was against the advice of Duisenberg, and for years the loss of confidence by the financial markets was felt through higher interest rates. In the end, this episode strengthened Duisenberg in his resolve to defend the exchange rate, even if significant interest hikes were required. By acting like that, Duisenberg quickly restored credibility in the markets, and in the course of that proved that credibility is achieved by action, not by words. Still, politicians were not always convinced that the exchange rate had priority over the interest rate. In 1992, for example, another Minister of finance (Kok, in 1992) indicated that an interest rate increase was undesirable. Duisenberg took the unusual step not to follow Germany in raising the headline rate, but instead raised a less important rate (beleningsrente). It was accompanied by a press communiqué, indicating the Bank's dedication to fight inflation through a strong guilder. This illustrated Duisenberg's ability to avoid a public conflict about interest rates, a conflict that certainly had negatively affected the exchange rate. A major test of the ERM and the Dutch exchange rate policy, came in 1992 and 93, when speculative attacks caused several crises. In this phase the guilder-DM rate was the only exchange rate that was not under attack. The guilder-DM peg appeared to be the most credible and tightest bilateral exchange rate within the ERM. Looking back, this can only be explained by the credibility of Dutch exchange rate policy in the previous years. The process towards Economic and Monetary Union, which started in the 1970s, was in full progress during Duisenberg's presidency. In the 1980s capital markets gradually became less restricted, culminating in 1990, with the start of stage I of the EMU. On many occasions, Duisenberg explained that free capital flows were in the interest of The Netherlands. As a small, open economy, the Netherlands could only benefit from international cooperation, free trade and free capital markets. Duisenberg advocated the opinion that integration of monetary policy was the inevitable reply to this liberalization of European money and capital markets. Returning again to the start of Duisenberg's presidency, the high inflation and interest rates in that period had a serious effect on the real estate market. In the early 1980s several mortgage banks ran into trouble. In 1983 one of them, the Tilburgsche Hypotheekbank, became insolvent. This mortgage bank crisis was a serious test for the new prudential supervision regime of DNB, the Wtk of 1978. Duisenberg indicated firmly that supervision could only minimize the probability of failures, not exclude them. He showed that this tough policy line could be complemented by careful steering towards a private sector solution. Two of the mortgage banks could be rescued by other institutions, which benefited all stakeholders, including the creditors. Ultimately, 95% of the liabilities of the failed Tilburgsche Hypotheekbank could be paid off. Duisenberg took a clear stand with respect to budgetary policy. Starting with his first annual report, Duisenberg has always maintained that DNB would not support an expansionary budgetary policy that would result in unsustainable deficits. A view like that was not at all obvious in the 1970s and 80s. Between the second world war and the 1970s, Dutch economic policy had been of a Keynesian nature, with scope for activist, counter-cyclical budgetary stimulus. Early 1980s, the consensus view changed gradually towards a more restrictive budgetary policy. With patience and perseverance, Duisenberg continued to explain the adverse economic consequences of a high budget deficit. His main argument was the upward effect on interest rates, which reduced private investment and economic growth. Also, Duisenberg had the view that the Dutch welfare state could not be supported in the long run if budgetary policy would not change its course. Finally, Duisenberg argued, international coordination of economic policy required a budgetary situation that is under control and on a sustainable path. In a sense, he gave early arguments for the Stability and Growth Pact, that was signed in 1997. Duisenberg's view on economic policy was completed by respecting the crucial role of employers and employees in setting wages and labour costs. Next to stable exchange rates, low inflation and low capital market rates, wage moderation was central to improve the financial health of the private sector. That would lay the foundations for an improved investment climate, supporting labour demand. Here, the central bank had little more instruments than to use its weight and try to influence the private sector. The famous Wassenaar agreement of 1982, was supported by DNB, because it offered scope for restoring profitability of the business sector. At the end of Duisenberg's presidency, some concluded, rather optimistically, that a Dutch miracle had replaced the Dutch disease. The Dutch economy had experienced a successful recovery that can be ascribed to many factors: monetary and budgetary stability, as well as wage moderation and structural changes in labour and product markets. It is safe to say that Duisenberg contributed to all of these factors. When one would try to summarize the legacy of Duisenberg's DNB presidency, I think the first central theme is his aim for stability. He achieved that stability by a persistent policy and staying the course. Frequently, he had to defend this kind of policy line, for example regarding interest rate adjustments in view of the exchange rate. In Dutch he described this kind of policy as “stug”, translated as stiff or tough. “Stug” has the subtle connotation that he did not expect much initial cooperation in his policy line towards stability. Another central theme for Duisenberg was his relentless focus on the benefit of the Dutch society. This may sound self-evident for a policymaker, but Duisenberg interpreted this differently from a politician. He demonstrated that a central banker should look at the long term costs and benefits. To give an example, at the time when politicians were celebrating the proceeds of natural gas production – 6% of GDP in 1981 – Duisenberg stressed that this was only temporary and warned that painful adjustments would be necessary in the long term. The last central theme that characterizes Duisenberg's presidency is his European focus. With respect to economic policy, Duisenberg continuously stressed that an “Alleingang” would be catastrophic for the economic well-being of nations. An integrating world, with all its complexities and risks, required international cooperation and coordination. Duisenberg was aware as well, that a single monetary policy would not always match with local developments. His message is that the remaining channels to adapt to country-specific shocks should be safeguarded and strengthened. That is the main reason for his strong support for sustainable public finances and flexible labour markets. Duisenberg's strong support for international coordination, combined with his global view, earned him much support, and were highly valued when he was the first president of the European Central Bank. Let me now conclude, by introducing the speaker of today’s main lecture, Professor Tito Boeri. Professor Boeri has been appointed three months ago as the first Duisenberg Fellow. He is currently at Bocconi University in Milan, where he also acts as Director of the Fondazione Rodolfo Debenedetti. Professor Boeri is a research fellow at two outstanding international institutes for applied economic research: the Centre for Economic Policy Research (CEPR) in London and the IZA (Institut zur Zukunft der Arbeit) in Bonn. His main research topic is the labour market, but he has also published on immigration, social security, pension systems and transition economics. Professor Boeri has published in top-rated economic journals, while also having worked with organizations like the OECD, the European Commission, the International Monetary Fund, and the Italian Government. This indicates that Professor Boeri has the rare, but, in my opinion, invaluable mix of being both skilled in academic research and in applied, policy oriented activities. Today, we will have the opportunity to benefit from this, as he will speak, in the first Willem F. Duisenberg lecture, about “The disappearance of mass unemployment in Europe”. | netherlands bank | 2,008 | 3 |
Speech by Dr Nout Wellink, President of the Netherlands Bank & Chairman of the Basel Committee on Banking Supervision, at the International Symposium on "Globalisation, Inflation and Monetary Policy", organised by the Bank of France, Paris, 7 March 2008. | Nout Wellink: Financial globalisation, growth and asset prices Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the International Symposium on “Globalisation, Inflation and Monetary Policy”, organised by the Bank of France, Paris, 7 March 2008. * * * Financial globalization and financial innovation I have been asked to introduce the round table with a group of very distinguished panellists who will discuss the topic of “Financial globalisation, growth and asset prices”. I was pleased to see that the panellists, through their different fields of expertise, will be able to illuminate us with a broad range of ideas on this topic. Before giving them the floor, let me raise a few issues. Financial globalization, like most good things in life, has its doses of risks and challenges. The recent wave of financial globalization, which began in the mid 1980s, has been seen as a catalyst for financial innovation. We have witnessed borders opening for banks and other market players. As a result, global financial markets have become deeper and more diversified and financial products have become more complex. In response to these changes, supervisors and the industry have had to keep pace by adapting the regulatory structures. The Basel II framework in that sense is inherently flexible with its risk-based approach. Even so, as lessons from the turmoil become clearer, it may be necessary to fine-tune certain elements of Basel II. To make our work as central bankers even more interesting, financial globalization has changed the environment for monetary policy with the growth of cross-border financial flows and the transfer of risk across different jurisdictions. In response, central bankers have also taken a number of steps to adapt their strategies to support financial markets and price stability. Just to mention a recent example, the collective actions among central banks to facilitate liquidity provision in short-term money markets were an important initiative in this sense. But to what extent does increasing financial globalization affect the efficiency and stability of asset prices and economic performance in general? Financial globalization, growth and asset prices In the past years, as financial globalization and deeper financial markets became more prominent there was an improvement in the stability of the macroeconomic environment. Global inflation was contained, accompanied by a decline in the volatility of economic growth, exchange rates and interest rates leading to the so-called Great Moderation. 1 These factors contributed to improving market sentiment. Liquidity seemed plentiful and this perception had a strong influence on the behaviour of investors and their risk tolerance, which grew with the search for yield. Alternative asset classes began getting large injections of liquidity. Real estate, high risk credit products, private equity and art, for instance, saw their prices rise considerably, which increased the potential for financial bubbles. Capital flows to and from emerging markets have also been surging. In the past five years, emerging markets have seen capital inflows almost six fold, raising challenges for many economies. B. Bernanke in a speech given in 2004 indicated that among the explanations for the Great Moderation (the decline in economic volatility in the past years) were structural changes led by deeper financial markets, a more stable monetary policy and good luck. This environment contributed to a new trend in financial innovation, mainly through securitization and a change in banking strategy to the so called “originate-to-distribute model”. This model allowed banks to originate loans, pool credit risks and sell them on to investors. The securitization of mortgage loans became an important platform for the originate-to-distribute model. Initially, a problem that started in the US housing market, spread rapidly across borders and across other financial markets, particularly to where credit risk had been transferred but not exclusively. There continues to be a generalized uncertainty related to valuation losses of securitized products ($250-600 billion), the use of credit ratings, possible spillover effects to other financial institutions (including monoliners) and the overall impact of the turmoil on global economic growth. The recent developments in the US and in foreign financial markets are stimulating considerable review and analysis. Regulators, supervisors, central banks, accounting boards, rating agencies and academics are trying to distil lessons from the crisis. To help address and coordinate this endeavour, the Financial Stability Forum for instance, has set up a working group on Market and Institutional Resilience. This group has analyzed the causes of the market turbulence and proposes policy directions to strengthen financial resilience. The results of the report will be available in April 2008. The quality of financial globalization matters If markets remain fragmented, not all the fruits of financial globalization can be reaped. Consequently, we probably need to work more in a concerted fashion to enhance the quality of globalization. Let me address some lessons from the recent turmoil: • First, I would stress that complacency in risk management is often fertile soil for financial distress. Complacency spread through global markets has contributed to over-optimistic assumptions for market liquidity conditions and led to a great reliance in rating agencies. • Second, in the past, liquidity risk management had not been at the centre stage. Most improvements in liquidity risk management were tailored for each country. Today, there is consensus among supervisors and the banking industry that liquidity risk management needs to be upgraded to capture the implications of a more globalized financial system and the rapid growth in financial innovation. • Third, the originate-to-distribute model encountered several shortcomings: The suboptimal incentives in the chain of origination, acquisition and distribution led to a poor assessment of risks, based on the expectation that credit risk could be quickly transferred through securitization. Another important weakness was the inadequate information on products and the quality of underlying assets. Moreover, the model’s dependency on market liquidity made it extremely vulnerable. • Fourth, recent events that have led to changes in the implementation of monetary policy through open market operations. G10 central banks took coordinated measures to bring money market rates back down to target levels. • Finally, from our specific experience at the Dutch Central Bank, I must add that the combination of central bank and supervisor led to a successful internal communication structure and to timely interaction with the financial industry during recent events. Follow-up issues To conclude, the pace of financial developments has accelerated with financial globalization. Consequently, we must remain exceptionally alert and flexible to encounter adverse dynamics that may threaten financial or economic stability. In my opinion, developments that should be followed closely are the strengthening of risk management and the implementation of Basel II. There are other interesting issues to follow-up such as the role of sovereign wealth funds in a context of globalized financial markets. I trust that the panellists will focus on this and other interesting issues in the coming hours. | netherlands bank | 2,008 | 3 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the 36th Economics Conference 2008, held at the Austrian National Bank, Vienna, 28 April 2008. | Nout Wellink: Banking supervision in Europe – developments and challenges Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the 36th Economics Conference 2008, held at the Austrian National Bank, Vienna, 28 April 2008. * * * The banking system has gone through major changes over the past years. Underlying factors have been deregulation and liberalisation, as well as technological progress. Three main trends can be distinguished. • First, banks themselves have become increasingly market-dependent. That is, we have seen a transition from the traditional originate-to-hold banking model to the contemporary originate-to-distribute model. Financial innovations, such as securitisations and credit risk transfer, have enabled banks to disperse their risks to the capital markets. However, as the financial turmoil has clearly shown, the transfer of risks has in many cases been inadequate. The currently ongoing reintermediation process, which is hampered by a lack of market transparency, is putting strain on banks’ profits, capital and liquidity cushions. • Second, banks have increasingly embarked on international operations, primarily through subsidiary companies. As a direct result of a recent surge in cross-border banking mergers and acquisitions, the share of foreign banks in domestic European markets has increased substantially, from 26% of total assets in 2001 to 33% in 2006. Furthermore, the share of European banks’ claims on the rest of the world has also grown. • Third, the banking system has become more concentrated. Whereas the number of credit institutions in the European banking sector has declined, total assets have increased, signalling the emergence of larger institutions. As a direct result of numerous mergers and acquisitions, Europe’s largest banking groups have been growing in prominence. Between 2001 and 2005 the largest banking groups’ share in total EU banking-sector assets has risen substantially from 54% to 68%. As regards the first trend of more market-orientation of banks, the recent turmoil has revealed that the originate-to-distribute model needs to be strengthened. The Financial Stability Forum has made several recommendations in this respect. Market transparency and valuation should be enhanced; risk management practices should be strengthened, especially with regards to liquidity risk; and, more fundamentally, incentives along the securitisation chain must become properly aligned. So, major challenges lie ahead. Let me elaborate on how the implementation of Basel II will support the adjustment process. Basel II supporting banking system resilience As you know, Basel II has only been fully implemented in Europe since the beginning of this year. The US is rolling it out more slowly. Even so, there is already strong agreement that Basel II will improve incentives for risk management and market disclosure and enhance capital regulation and supervision. Let me point out some key enhancements relevant to the current crisis. Among other things, Basel II will deliver better risk differentiation. Banks that enter upon more risky lending practices will need to strengthen their capital base accordingly. Moreover, under the new capital regime all exposures will be subject to regulatory capital charges, whether on or off the balance sheet. Basel II will also create more neutral incentives between retaining exposures on the balance sheet and transferring them to the capital markets through securitisations. It will reinforce capital requirements for banks’ trading books, which are rapidly growing. And last, Basel II will enhance disclosures of banks’ risk profiles, notably with regard to structured credit and securitisation activities. Given that Basel II is a risk-sensitive framework, there is some concern that it may turn out to be too procyclical. However, to achieve more risk sensitivity in minimum capital, there has to be some fluctuation in that requirement over the cycle. The Basel Committee has tried to balance the objectives of risk sensitivity and capital adequacy over the cycle. For instance, banks are required to perform forward-looking stress tests to make sure that they hold enough cushions above the minimum. Basel II will also require much stronger firm-wide aggregation and management of risk exposures. And banks that take on more risk will be required to hold more capital in the first place, helping to prevent the build-up and underpricing of risk. We will also be tracking the framework over time and make any necessary adjustments based on our findings. So, it is safe to say that the Basel II framework is a major improvement. But it is not the ultimate answer to the financial markets problems of today and tomorrow. In December 2006, the Basel Committee had already identified “pressure points” and weak spots in the regulatory and supervisory regime that should be addressed. Fortunately, the framework is flexible enough to evolve over time. In light of recent developments, the Basel Committee has already begun to evaluate certain aspects of the framework. These include issues such as the securitisation of complex products, reputational risk and disclosure. But strong capital, though essential, is only one aspect of a stable banking and financial system. Sound risk management, strong supervision and robust liquidity cushions are also critical. The Basel Committee’s work agenda seeks to strengthen practice in these areas. It is in the process of finalising global sound practice standards for liquidity risk management and supervision. These will address many of the lessons learned from the market turmoil. The Committee will also work on stress testing, off-balance sheet management, and valuation practices. Furthermore it is enhancing market discipline through better disclosure. Ensuring effective and efficient cross-border banking supervision Let me now turn to two challenges related to the infrastructure of supervision in Europe, namely cross-border supervision and the interplay between central banks and supervisors. The former challenge follows from the internationalisation of the banking industry. Over the past decades, European banking groups have become increasingly international in character. Not only do they move more easily across national boundaries, they also organise themselves accordingly. Prompted by these developments, supervision has moved beyond its primarily national orientation. Indeed, supervisory rules and regulations are being progressively internationally harmonised – Basel II is in this respect a leading example. Nonetheless, internationally active banks are still confronted with a multitude of supervisors and regulators, which may impose their own specific national requirements. As the internationalisation of banks may be presumed to continue in the foreseeable future, further steps are needed to ensure effective and efficient cross-border banking supervision in Europe. While a more integrated pan-European supervisory structure is ultimately desirable, how to get there is far from clear. Indeed, legal frameworks, deposit guarantee schemes, fiscal regimes and national supervisory arrangements within the European Union are still very diverse. The European Council agreed in December 2007 on a Financial Supervision Roadmap. Important elements of this Roadmap are the introduction of a European dimension into the mandates of national supervisors and the improvement of the functioning of EU colleges of supervisors. Realistically, to promote more effective and efficient banking supervision in Europe in the near term, we should continue to build on the existing institutional structure. Accordingly, the challenge of cross-border banking supervision can be addressed in a two-step process. The first step is straightforward and can be taken swiftly. In line with the outcome of the latest informal ECOFIN and the recommendations by the Financial Stability Forum, so-called colleges of supervisors should be established for all major cross-border groups. These international colleges should include all relevant supervisors and would be created to enhance cooperation on ongoing supervisory issues. Existing supervisory committees such as CEBS should guard the coherence and consistency between the different colleges to preserve a level playing field for the industry as a whole. The second step towards more effective and efficient cross-border supervision concerns the decision-making process in colleges of supervisors. Whereas decision-making in existing examples of colleges is entirely on a consensus basis, I believe that the role of the lead supervisor or consolidated supervisor should be strengthened in order to avoid stalemates. Both for efficacy and efficiency reasons, decision making in colleges should resemble the clauses on internal model validation in the Capital Requirements Directive. These call on home and host supervisors to agree but ultimately, if consensus is not reached, allow the home supervisor to decide. Let me emphasise that the lead supervisor model requires a close working relationship between the host and the home supervisor, in which the host supervisor is taken seriously. In practice, a distinction could be made between general colleges with broad information sharing, and core colleges with high frequency meetings particularly during periods of stress. A formal mediation mechanism could be considered to provide host supervisors a way to appeal against decision-making by the college or the lead supervisor. Besides more effective supervision, lead supervision will also promote greater efficiency. The financial sector’s strong support for this supervisory model underscores this. Ensuring effective interplay between supervisors and central banks Besides effective and efficient cross-border supervision, another challenge is to ensure an effective interplay between banking supervisors and central banks. As European banks have clearly grown in prominence and wholesale markets have become closely integrated, problems at individual banks are more likely to have systemic effects. Consequently, it is difficult to draw a line, in practice, between the responsibility for systemic stability, including the function of lender-of-last-resort, and that for prudential supervision of large banks. Indeed, in today’s increasingly market-based financial system, disturbances are likely to affect core market mechanisms. In my view, there are two necessary conditions for effective cooperation between central banks and banking supervisors. First, a cooperative and open mindset is required. Second, close and continuous information sharing is necessary. For the execution of central bank functions, timely access to micro-prudential information on individual banks is relevant. In the financial turbulence, information on the liquidity arrangements of counterparties, their sources of funding, and on their financial position has proven to be essential to obtaining a clear picture of the liquidity pressures influencing banks. Conversely, the information central bankers have on the functioning of money and credit markets is indispensable for prudential supervisors when assessing the risks to individual banks. These two necessary conditions for effective cooperation between supervisors and central banks – cooperative and open mindsets and adequate information sharing – are most effectively met within “an institutional framework in which the Eurosystem’s responsibilities for monetary policy in the euro area are coupled with extensive supervisory responsibilities of NCB’s in domestic markets and with reinforced cooperation at a euro area-wide level”. The Twin Peaks model of financial supervision is fully in line with this 2001 conclusion of the Governing Council. Conclusion In conclusion, the financial market turmoil has underscored the importance of resilient, wellfunctioning banking systems. The implementation of Basel II will help banks and banking supervisors in achieving this. Regarding the infrastructure of supervision in Europe, I believe cross-border supervision needs to be strengthened. Indeed, a major step forward can be achieved through the lead supervisor model. In the lead supervisor model, an adequate representation of host country interests is crucial. Regarding the combination of prudential supervision and central banking, recent events have shown there are important synergies and reinforced the arguments for bringing both responsibilities as close as possible together. To ensure effective interplay between supervisors and central banks, a cooperative and open mindset is required, as well as adequate and timely information sharing. | netherlands bank | 2,008 | 4 |
Speech by Dr Nout Wellink, President of the Netherlands Bank & Chairman of the Basel Committee on Banking Supervision, at the Conference 'Integrating micro & macroeconomic perspectives on financial stability', University van Groningen, Groningen, 26 May 2008. | Nout Wellink: It’s the incentive, stupid! Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Conference “Integrating micro and macroeconomic perspectives on financial stability”, University van Groningen, Groningen, 26 May 2008. * * * Introduction 1. It is a great pleasure for me to deliver a speech at this conference on financial stability. Needless to say, this subject has hardly been more challenging than in recent times. But let me start on a positive note. Because of the market turbulence, many people seem to forget how the financial system has improved over the past decades. The system has developed and expanded, and its potential to facilitate efficient allocation in the economy has increased enormously. Financial services have become more accessible to broad categories of firms and households. And the possibilities to spread and manage risks have improved, which partly explains why the financial system has been able to absorb an accumulation of setbacks in recent years, including the burst of the dotcom bubble, the September 11 attacks and rising geopolitical tensions. If the financial system is the switchboard or operating system of the world economy, this switchboard has clearly become more powerful, allowing more transactions at a higher speed. 2. But higher speed and greater power also entail the possibility of more severe accidents, as illustrated in the past year. Looking at financial history, this is not surprising. Financial development over the past centuries has always been characterised by ups and downs. Typically, vulnerabilities like the ones we have seen recently can be traced to wrong incentives and a lack of checks and balances. In the rest of this speech, I will first discuss common patterns of past crisis episodes, emphasising the role of incentives. Against this background, I will then examine the current crisis. I will conclude by discussing policy implications and the recent recommendations of the Financial Stability Forum. Role of incentives: lessons from history 3. Although every financial crisis has its unique features, there are several recurrent themes. As Charles Kindleberger argues in his famous book “Manias, Panics and Crashes”, financial crises are typically the result of a prolonged accumulation of imbalances, preceded by some exogenous shock or structural change in the financial system. Examples are changes in the political environment, new regulation and financial innovation. These changes create new opportunities but also uncertainty and a lack of awareness about potential new risks – the socalled “unknown unknowns”. In such an environment, traditional checks and balances may become inadequate and easily lead to excessive risk 4. We have seen numerous examples where periods of exuberance were accommodated by the financial system, reflected by increasing leverage and asset price inflation, followed by a correction. Without any doubt, the best example in Dutch financial history is the Tulip Mania, which took place around 1635. This episode is especially known for its incredible price increases. At the peak, 14 thousand guilders were paid for a single tulip bulb – more than a workman earned in his entire life those days. Less known is that the speculative bubble was largely driven by financial innovation. In the years before the Tulip Mania, new financial markets evolved in the Netherlands, including a stock exchange and futures markets. Sophisticated trading techniques were developed, allowing short selling and the use of put and call options. Derivative contracts allowed massive trading in tulips that were not even planted yet – a genuine financial innovation at the time. Many investors did not realise that these new instruments were inflating a speculative bubble on an unprecedented scale and lost all their money when the market collapsed after two years. The Tulip Mania illustrates how imbalances can develop when previous constraints are lifted – in this case by new financial tools allowing investors to take large speculative positions. But it also illustrates the role of naive optimism and even greed. 5. Misguided incentives are often also at the root of growing imbalances, because of conflicting micro and macro perspectives. This is because at the micro level, market participants tend to take the environment in which they operate as given, for instance prices and the behaviour of other market participants. But factors that are considered exogenous at the micro level may become endogenous for the financial system as a whole. At the macro level, this easily leads to fallacies of composition. For example, for an individual investor, increasing leverage is a way to boost returns. But if everybody does this, without sufficient profitable investment opportunities, it can only be counterproductive by reducing long-term yields and raising risks. Pro-cyclicality 6. A closely related issue is the financial system’s inherent pro-cyclicality. We all know that with a favourable economic outlook and upbeat financial markets, balance sheets look strong for both financial firms and their counterparts in the real economy. In such an environment, it is understandable that banks’ lending criteria become looser and, for instance, pension contributions are reduced. As the cycle turns, lending criteria are tightened and firms will find it more difficult to finance their investments, which exacerbates economic fluctuations. 7. So, financial institutions’ pro-cyclical behaviour is to some extent inevitable. The same holds for the role of regulation, which may strengthen pro-cyclicality: regulatory rules are more likely to become binding during unfavourable times. Nonetheless, there are examples where we managed to soften this trade-off between sound risk management and procyclicality. One example is the new Capital Accord, Basle II, which requires banks to perform stress tests and demonstrate that they hold sufficient capital buffers above the regulatory minimum level when economic conditions are favourable. Another example is the Dutch Financial Assessment Framework for pension funds, implemented last year. Pension funds now have the possibility to make part of their liabilities conditional, allowing them to spread out shocks over 15 years. In addition, pension funds are required to use this long horizon when setting their premiums. This way, our defined benefit pension system has become more sustainable and at the same time less pro-cyclical. It is important that this carefully designed system will also be better acknowledged in the new IFRS accounting rules. We must avoid an overly rigid application of these rules, which should reflect the real risks and risk mitigants, and should therefore take into account the conditionality of Dutch pension contracts. Characteristics of the current crisis 8. It is too early to provide a thorough analysis of the causes and characteristics of the recent financial turbulence. Apart from the fact that markets are still fragile, it will probably take several years before we are in a position to put these developments fully into perspective. Nonetheless, even at this stage it is not hard to find similarities with earlier crisis episodes. In particular, there has been a structural change in the form of financial innovation. Deregulation and liberalisation have created scope for new financial instruments and enhanced the mobility of risks. This is most clearly illustrated by the so-called “originate-todistribute” banking model, which has emerged over the past decade. By securitising loans, retail banks can focus on their role as originators, while other institutions such as investment banks specialise in bundling these loans into structured products that are then sold to investors. The benefits are clear: specialisation along the securitisation chain creates a more efficient financial intermediation process, in which risks can be priced and transferred. 9. However, the shortcomings of the originate-to-distribute model have also become painfully clear and have everything to do with incentives. Some examples: • Obviously, a bank that sells its risks to other parties has less interest to vet the original borrower, nor to continue monitoring these risks as closely as before. • Unbalanced remuneration incentives are another source of excessive risk taking. Employees who receive massive bonuses when earnings are high but are hardly hit when losses are made, are probably less prudent than would be in the interest of their employer. This not to say that bonus systems are by definition wrong, but they should be designed in such a way that curbs exist on inappropriate behaviour. Perhaps, one way to improve this is to ensure that an employee’s time horizon is aligned with that of more general interest, for instance by making bonus payments dependent on broad performance indicators over a longer period. • Incentives are also affected by insufficient risk awareness. For complex financial instruments such as structured products, it is difficult to assess their value and underlying risks. This, and a lack of experience how these instruments are performing under stress, has complicated the determination of adequate credit ratings for structured products. In addition, rating agencies are confronted with conflicts of interest between debt issuers, who pay for the ratings, and investors who rely on them. • Wrong incentives are also due to slow implementation of new regulation which, I am afraid, is a fact of life. Already in the 1990s it had become clear that the old Basle Accord was becoming outdated and needed to be replaced with a new framework. Basle II is more risk-oriented and provides better checks and balances. It should have been implemented earlier; and, if it had, the recent developments would probably have been less turbulent. Indeed, under the old Accord, banks could circumvent regulatory requirements by transferring risks to special off-balance entities such as Structures Investment Vehicles (SIVs) and conduits. 10. Let me revisit the interaction between micro and macro perspectives, which has become increasingly relevant in today’s market-oriented financial system. Wrong incentives at the micro level have resulted in excessive risk taking, such as the supply of subprime mortgages to households that cannot afford them. At the macro level, the size and distribution of risks is blurred by complex instruments and risk transfer mechanisms. It has also become more difficult to interpret macroeconomic data on money and credit growth, which makes it more challenging to formulate a balanced monetary policy. Furthermore, with the deterioration of market sentiment and evaporation of market liquidity, risks have rebounded to individual firms in the form of funding liquidity problems. 11. So, apart from the similarities with earlier crisis episodes, what makes this crisis special? Let me stress two striking features: • First, many of the risks that crystallised in the past year were on our radar screen long before the crisis started. If you read the numerous Financial Stability Reports that were published in the past years, including our own Overview of Financial Stability, you will see several analyses about excessive risk tolerance, hazardous risk transfer mechanisms and possible shortcomings of the originate-to-distribute model. One of the key lessons is why we have not been able to translate our risk assessment into mitigating action. • Second, this crisis stands out on account of its global nature. More than in the past, the turmoil affects all advanced economies, reflecting the integration of financial systems over the past decades. Policy implications: FSF recommendations 12. This global scope underscores the importance of an international policy response. Fortunately, international cooperation between financial authorities has increased over time. Examples are standard setters such as the Basle Committee on Banking Supervision (BCBS) and the International Accounting Standards Board (IASB), and international organisations like the International Monetary Fund (IMF) and the Bank for International Settlements (BIS). All these organisations, as well as the major economies, are represented in the Financial Stability Forum (FSF) which meets biannually. When the market turbulence intensified last summer, the FSF was asked by the G7 to take the lead in organising a coordinated policy response. In my capacity as chairman of the Basle Committee, I am a member of the FSF working group that prepared a report that was published last month. 13. The FSF report includes 67 policy recommendations. It is impossible to discuss them all, but let me just mention some of the major themes: • Many recommendations are aimed at strengthening firms’ risk management. Perhaps the best contribution to this is a timely implementation of Basle II, some elements of which will be strengthened (e.g. capital treatment of structured credit and securitisation activities, risk management practices (pillar 2)). In addition, regulators should work with market participants to mitigate the risks arising from inappropriate remuneration structures. • Many recommendations are aimed at improving transparency and valuation. When publishing their upcoming mid-year reports, financial institutions should disclose their risk exposures according to a template in the FSF report. This is important to enhance consistency across firms. Other proposals aim at improving accounting standards for off-balance sheet vehicles and strengthening guidance on the valuation of financial instruments. A specific set of recommendations focus on the role and uses of credit ratings. Rating agencies should improve the quality of the rating process and avoid conflicts of interest in rating structured products. Furthermore, these ratings should be differentiated from those of regular bonds, for instance by using a different rating scale. At the same time, investors should address their over-reliance on ratings. • Several recommendations refer to the role of the official authorities. I already indicated that many of the risks that have manifested themselves were not a surprise; to some extent, we saw this crisis coming. Therefore, it is important to improve the translation of our risk assessments into action. This requires better information exchange between authorities and with the private sector. It involves improving cooperation between regulators and central banks but also cross-border (e.g. supervisory colleges). Finally, crisis management arrangements need to be strengthened. This includes central banks’ liquidity operations which must be more flexible, avoid stigma-effects and allow cooperation with other central banks (e.g. by establishing swap lines and allowing cross-border use of collateral). For most of these measures, it is not difficult to see how they influence incentives. Remuneration structures, possible conflicts of interest and stigma-problems clearly have a bearing on the behaviour of market participants. 14. The FSF recommendations have been welcomed by the international financial community. But the real challenge is to implement them in such a way that the checks and balances in the financial system are restored so it becomes less prone to instability. In other words: we must get the incentives right. The Netherlands is in a good position to implement the recommendations. Our institutional set-up is helpful: the cooperation between central bank and supervisors is already ensured because they are combined in one institution. But we must avoid complacency; the implementation of the FSF recommendations will be one of our top priorities in the next months. Furthermore, even though we are on the right track, risks from the macro-financial environment have not disappeared. Banks are going through a fundamental adjustment process, which needs time. Financial markets, like the interbank money market, do not perform as they should and the US housing market is still weak. Therefore, the economic outlook remains uncertain. Concluding remarks 15. The international response to the credit crisis, coordinated by the Financial Stability Forum, is a crucial first step towards restoring financial stability. But I am sure that, at some point, our incentives will be tested again. Therefore, we need creative minds that help us to identify new imbalances at an early stage. These are great times for financial economists. Traditional macroeconomic analysis and monetary economics have been extended by a variety of financial stability issues, with both micro and macro dimensions. I am confident that this conference will contribute to this interesting and rapidly developing field. | netherlands bank | 2,008 | 5 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, on receiving an Honorary Doctorate at Tilburg University, Tilburg, 12 June 2008. | Nout Wellink: The interaction between economic science and policy making Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, on receiving an Honorary Doctorate at Tilburg University, Tilburg, 12 June 2008. * * * I would like to congratulate CenTER with its 20th Anniversary, but also with its academic record. I consider it an outstanding achievement that you are in the top three economics faculties in Europe and number 24 in the world. I can only hope that you achieve your objective of entering the top 20 soon. As for me, I am especially grateful to receive an Honorary Doctorate from this renowned Catholic University. Being a Roman Catholic myself, I deem it appropriate to start with a confession. At the start of my professional career, I was asked to become an academic here at the Tilburg University. I hesitated for a while, but eventually I declined the job. At first, I therefore sensed a slight feeling of guilt concerning the honour that is being conferred upon me today: to receive academic recognition exactly from this university, where with a little twist of fate I could have spent my working life, contributing to scientific knowledge. But then, on further reflection, I started to like the idea. Although I did not become a full time academic, I have always kept a strong interest in scientific research. In fact I believe that throughout the years my policy work has benefited greatly from scientific input. The organisers have interpreted this fact the other way around, when they emphasize my contribution to the application of scientific insights in solving real world problems. I thank them for this. I accept my Honorary Doctorate with delight. I would like to dedicate it to the interaction between economic science and policy making. Tensions between economic science and policy? In my view, the interaction between science and policy has brought tremendous progress in both fields. We should be careful to maintain and improve this interaction when possible. Although this point may seem to be self-evident at first sight, it is questioned by some. Several observers notice an increasing gap between highly formalised theory and the practical needs of policy making. An illustration of such a perceived gap in my own field of monetary economics is given in a recent overview paper by Gregory Mankiw, who himself has been an academic as well as Chairman of the Council of Economic Advisors in Washington. On the basis of a thorough review in a highly-ranked journal, he concludes that recent developments in macro economic modelling have had “close to zero impact on practical policy making”. Another example has been given by my British colleague Mervyn King with respect to modern communication strategies. He argues that the success of such strategies in stabilising inflation expectations at a low level is not yet fully understood from a scientific perspective. His claim is, therefore, that monetary policy is ahead of economic science in that respect. Let me be clear on these points. There are indeed limits on the extent to which policy judgement can be based on science. In almost any policy decision, experience, intuition, “Fingerspitzengefühl”, or whatever name we can put to it, plays a crucial role. Perhaps the role of these elements has even increased in recent times. The outside world has become increasingly international and the economic system has become more complex. Let me give you just one example. At DNB, it is our job to assess the pass-through of the credit market crisis of the past year onto the real economy. The scientific approach would be to rely on model estimates. But unfortunately, the degree of uncertainty that always surrounds such estimates jumps to even higher levels in times of financial stress. This illustrates that our judgement cannot be based on science alone. But does this imply that there is a gap between science and policy? I do not think so. After all, our research department has responded to the gap in our knowledge by shifting its attention to economic interactions under extreme events. I would therefore rather stress a natural interaction between science and policy than the existence of a gap. Fostering the interaction between science and policy On the interaction between science and policy, a first thing to note is that macro-economic science actually emerged from the need to address practical policy issues related to the Great Depression in the 1930s. Science and policy perform complementary tasks. Without any understanding of how the real world operates, it would be rather difficult to influence it. Similarly, it seems less relevant to understand what is going on, if these insights are not used for better policies. Scientists and policy makers therefore need to make efforts to understand each other. Policy makers can learn from structuring their thinking and ensuring its consistency. Scientists can learn from incorporating the flexibility and practical relevance that is needed for solving real world problems under political constraints. I therefore do not believe in a model in which universities focus exclusively on science while policy making institutions abstain from any role in scientific research. The potential synergies between both functions are large, but it takes continuous efforts to realise those. In The Netherlands we have a strong tradition of basing policy on scientific insights, thanks to the efforts made by Tinbergen and the Netherlands Bureau for Economic Policy Analysis (CPB). As for central banks, I believe that the worldwide movement towards independence has been one of the driving factors of a greater orientation towards a scientific foundation of policies. Being free from political influence and preferences, our legitimacy partly depends on it. As such, we have found practical ways for fostering mutual understanding between science and policy. One is the direct way. Several central banks have appointed renowned academics in top positions. Ben Bernanke is at the FED, Mervyn King at the Bank of England, Athanasios Orphanides at the central bank of Cyprus and Stanley Fischer at the Bank of Israel. It is not only that policy discussions benefit from contributions of these people; they also use their networks for bringing topical policy issues into the scientific debate. Another way for bringing science and policy closer is by hiring specialists in central banks who understand the language of a specific discipline. This is what we do at DNB. We employ researchers in all fields that relate to our core tasks. For example, research in recent years has focused on Mervyn King’s point about why modern monetary policy strategies may work in stabilising inflation expectations. But it has also dealt with decision-making within committee structures, economic modelling, payment systems, behavioural finance, the efficiency of banks, financial conglomerates and so on. Researchers at DNB actually have a challenging job in bridging science and policy. They have to keep themselves up to date with scientific developments in their field; they work independently; on policy-relevant topics; and they are asked to translate their findings into practical policy advice. This last element is probably what distinguishes research at central banks from research at universities, where the incentives for specialising in a more fundamental type of research are stronger. Impact of economic science on policy I have argued that science and policy perform complementary functions, and that central banks perform a key function in fostering mutual understanding. Let me now address the impact of science on policy. I very much believe in the maxim that “most of the fundamental ideas of science are essentially simple, and may, as a rule, be expressed in a language comprehensible to everyone”. This is not something that I have made up myself, but is actually a quote by Einstein. In my own field of monetary policy the fundamental ideas of science have indeed been intuitive and simple. They have had a tremendous impact on policy. I guess that most of you are familiar with many of the key insights. On the relevance of price stability; on the costs of inflation; on the inability of monetary policy to raise the structural growth rate of the economy; on the importance of central bank independence from political influence. The point here is that these essentially simple insights were distilled from a huge and often very complicated body of research. I am thinking here about contributions in the 1960s and 1970s on the shape of the Phillips curve, research on time inconsistency that emerged from the late 1970s onwards, research on central bank independence in the 1980s and 1990s, and recent discussions on central bank accountability and communication. Perhaps current researchers can take comfort in the fact that one day the outcomes of current scientific debates may also become glaringly obvious. But in the meantime we need to struggle on before science reveals the answer to us. Conclusion Let me conclude with a forward looking perspective. It seems obvious that globalisation and financial innovations will continue, so that complexity in the economic and financial system will continue to increase. Take the financial turmoil of the past year, to which I referred already. Obviously there is a need to tailor our policies, for example financial supervision and monetary policy, to the dynamics that we have witnessed in the financial sector. But in order to do so we need a thorough understanding of what is going on. With a more complex and dynamic financial system, our demand for high quality analysis and research can only increase. At the same time, while demands are increasing, resources are under pressure. The efficiency operations of the current government that apply to the ministries and the CPB also apply to DNB. While I fully support the need for an efficient government and an efficient central bank, I also see a risk that knowledge-intensive functions could be under disproportionate pressure. A key characteristic of research is that it requires relatively long time horizons, and that its pay-off emerges in the medium rather than in the short run. As a result, it can easily be crowded out by the many policy issues that continue to require immediate attention. The challenge is to protect key research areas from such pressures, and to maintain the human capital base in our institutions. The need for research will always remain, whether policy makers immediately like the answers or not. For each question that we answer, new ones arise. I truly believe that the interaction between science and policy has brought tremendous progress in both fields. We should continue our efforts to foster mutual understanding. Let me once again show my gratitude for the honour that you have conferred upon me and thank you for your attention. | netherlands bank | 2,008 | 6 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the ING Microfinance Seminar 'A billion to gain - the next phase', Amsterdam, 16 June 2008. | Nout Wellink: The significant role of microfinance and supervisory issues Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the ING Microfinance Seminar “A billion to gain – the next phase”, Amsterdam, 16 June 2008. * * * Introduction 1. I am pleased to be joining you today and to be speaking to so many microfinance experts. Before starting I would like to commend the conference organisers for putting together such a comprehensive programme on this important topic. Microfinance is becoming ever more relevant, and there can therefore be no doubt that we need to keep it on our agendas. Today, I want to touch upon two issues. I will start with the significant and increasing role of microfinance to combat poverty in the world. This role cannot be called “micro” anymore. Then, I will discuss some supervisory issues that follow from the microfinance concept. Microfinance is booming 2. To start off with: microfinance is booming! It all started in the 1970s with the Nobel price laureate Mohamed Yunus, who was the first to experiment with the provision of very small – or micro- loans to people in Bangladesh. He then founded the famous Grameen bank. And nowadays, it cannot be denied that microfinance has successfully enabled extremely impoverished people, especially women, to engage in self-employment projects. These people were previously considered unbankable, as they typically do not meet even minimal qualifications to gain access to traditional credit, such as steady employment or a verifiable credit history. Microfinance allows them to generate income and to begin to build wealth and ultimately exit poverty. The term microfinance is generally used for the provision of financial services, in most cases micro-loans, to the poor, and many people have begun to realise its opportunities. Indeed, the concept of microfinance has been accepted as an effective means to reach out to the poor. And this conviction is not just confined to charitable institutions, but can beyond doubt be called a worldwide drive. Microfinance institutions have notably expanded their loan portfolios. Data from The Microfinance Information Exchange show that over the period 2001-2006, the number of micro credit borrowers each year increased on average by 19%. Over the same time period, the average loan portfolio grew by an annual 30%. This is huge. For comparison, in the EU-25, the average loan portfolio growth reaches a mere 6.4%. By the end of 2006, globally more than 1100 MFIs were active, comprising over 59 million borrowers. Also savings accounts surge, totalling 16 billion US dollars in 2006 and 68 million savers. 3. Meanwhile, also private organisations and investors have found their way to microfinance and microfinance institutions, and devote ample resources to them. Although exact figures are not available, it has been estimated that in 2006 worldwide $ 4 to 5 billion was invested in microfinance institutions. Especially investors with a long-term perspective, such as pension funds, consider microfinance an attractive investment. This is no wonder: usually returns are in line with market averages, while risks are relatively low. Moreover, microfinance shows a low correlation with international financial markets and hence provides diversification benefits. 4. And on top of this, as we can see here today, microfinance starts to attract increasing interest from commercial banks, including ING. One element evidencing this interest is the financial support provided by way of loans to or investments in microfinance institutions. But in my opinion, a second element is far more important: namely the sharing of expertise in banking business and the provision of assistance and training. Enhanced cooperation between existing financial institutions and microfinance institutions contributes to the development of local financial markets. For example, commercial banks may help microfinance institutions expand their portfolios with saving services, varied loan products and insurance, while microfinance institutions in turn may facilitate the development of commercial banks’ customer base. Furthermore, microfinance institutions may build upon the existing IT and risk management infrastructure of commercial banks. 5. Another reason for the remarkable growth of the microfinance sector is that new technological developments are quickly being picked up. Recently, I came across an internet organisation set up to enable private individuals to lend money to poor people in developing countries. The creditors can actually see and choose the persons to whom they lend. The money is transferred to the person via a local microfinance institution. Another innovative feature of this concept is that the loan providers receive regular updates on the borrower. This brings the benefits of microfinance really at your doorstep! And look, for instance, at the telecommunication industry. Rapid innovations have made it possible to conduct your banking operations via mobile phone. For banks, it offers the opportunity to transmit loan applications and check credit details instantly. For microfinance, this means a real breakthrough. As you know, a core problem for microfinance institutions is the geographically wide dispersion of their client base. This makes it difficult to serve clients in very remote areas and drives up expenditures. Operational costs can be as high as 15 to 20% of loans, compared to less than 5% for banks in industrialised countries. The introduction of mobile phone banking now makes it possible to reach millions of people, in a fraction of a second and without the high costs of establishing an extensive network of offices. Such cost savings are important for microfinance institutions, as they allow them to reduce interest rate margins while not impairing profitability. 6. These positive figures are truly good news. As a central banker, I care for economic growth and the reliable functioning of financial markets. And microfinance clearly contributes to these goals. For one, microfinance stimulates households to start business activities. Access to credit allows poor people to take advantage of economic opportunities, thus contributing to local economic development and job creation. Second, microfinance fills a gap in the traditional financial infrastructure, which did not provide for lending to the poor. Indeed, broad access to financial services is a key characteristic of a deep and efficient financial system. It is encouraging to see that the market is now taking over the role which was previously only performed by governments or NGOs. And third, more and more microfinance institutions have become real financial intermediaries and now also offer deposit facilities to households. As such, microfinance can help households to smoothen their consumption over time, reducing saving and borrowing constraints. Such constraints are particularly relevant for poor households because their incomes are often uncertain and they generally lack collateral. At the same time, deposits form an additional funding base for microfinance institutions and decrease their dependency on external funding. In these ways, microfinance enhances economic growth, enriches financial markets and increases welfare of individual households. Role for the prudential supervisor 7. But this is only one reason for my interest in microfinance. The other one follows from my role as prudential supervisor. This brings me to the second remark I want to make today. So far, the growth of microfinance has, by and large, occurred outside a regulatory framework. But as a depositor, you expect your bank to be safe and not to take undue risk, so that you can retrieve your money at all times. If the bank accepts too much risk, it may no longer be able to meet its obligations to depositors. Therefore, in most countries, only licensed banks are allowed to attract deposits from the public. Licensed banks are subject to prudential supervision and have to comply with an extensive and strict set of regulations. The prudential supervisor requires banks, for example, to have in place an effective risk management system to screen, price and manage risks. For microfinance institutions, the protection of depositors is especially important. If a microfinance institution runs into trouble and cannot repay its depositors, this will affect a very large group of people who do not have the buffers to cushion such a loss. The effects of such a failure on individual borrowers´ and their families´ lives can be disastrous. 8. The need for depositor protection is underlined by the finding that the quality of the micro credit portfolio may deteriorate very rapidly. If some debtors are unable to repay their loans, this may induce other debtors to default on their loans as well. This perverse incentive may be especially strong in the case of credit provided to a group of persons. Furthermore, micro credit risks are usually more correlated than those of a traditional bank, since the loan portfolio generally consists of a relatively homogenous group of people who depend on the regional economy. Also, as costs are generally higher microfinance institutions may have smaller financial buffers. At the same time, in many cases it will be difficult for the microfinance institution to raise additional capital on short notice. For deposit-taking microfinance institutions, prudential supervision is hence of high relevance. 9. Though most agree that prudential supervision of microfinance institutions is needed, it is not yet clear what this supervision actually should comprise. Compliance with prudential rules can be costly to supervised entities and may be especially burdensome for microfinance institutions. Under circumstances, supervision may even stifle such a valuable and booming sector as microfinance. In devising a supervisory framework for microfinance activities, we therefore have to take the unique characteristics of microfinance into account. Most conspicuous of these characteristics is perhaps the lack of physical collateral. Other characteristics specific to microfinance institutions that need to be taken into account are a quick turnover rate, high operational costs and a different lending process. Also know-yourcustomer requirements are burdensome, as many poor people do not have a passport or other proof of identity. 10. We also need to be mindful of the large differences between microfinance activities and microfinance institutions from one country to another. For instance in Brazil, a popular form of microfinance is the use of correspondent banking, or in other terms “branchless banking”. Due to the sheer size of this country, commercial banks are only located in the main cities and did not or could not offer financial services to people in distinct villages until 1999. With the lifting of several regulations in that year, commercial banks were allowed to set up relationships with non-financial and non-bank firms to provide a wider range of services. Many banks contracted local chains, for instance grocery stores, pharmacies, etc., which were allowed to handle simple banking operations on behalf of the financial institution. However, the financial institution itself is the ultimate provider of financial services and remains responsible in the end. In India, in the 1999s, microfinance evolved quite successfully through so-called Self Help Groups. In these groups, 10 to 20 persons pool savings, collectively obtain loans and lend to each other. And in Bolivia, the most successful microfinance institution was incorporated as a commercial bank in 1992. 11. But despite these differences, microfinance supervision should not and cannot be a complete divergent regime. A different supervisory framework for microfinance activities carries the risk of unbalancing the international level playing field. Moreover, many banking standards already offer flexibility to allow for the level of complexity and size of institutions, the level of risks or the existence of international activities. And all the same, supervision of microfinance institutions need not be harmful per se. Adequate supervision may also enhance the perceived legitimacy of microfinance institutions and improve their operational management, due to for instance the higher standards for reporting and financial control. This may broaden their access to funding, allowing them to expand their financial activities and serving more clients. Furthermore, there may exist a positive relationship between the development of supervisory guidance for microfinance activities and for supervision in general. So taking all this together, we should search for a tailor-made solution within the scope of existing regulation. 12. One such solution can be found in the Basel Core Principles. To support supervisors worldwide in building and improving a set of prudential regulations, the Basel Committee for Banking Supervision has developed this set of minimum standards for sound supervision. The Core Principles provide a benchmark for a wide range of supervisory aspects, in areas such as licensing, capital adequacy, risk management, and more. In total there are 25 Principles. But, I stress, these are principles, not rules, and require further specification. The Basel Committee considers that many of these Principles would also be appropriate for nonbank financial institutions that offer deposit and lending services similar to those provided by banks. But the Committee also recognizes that some of these categories of institutions may be regulated differently from banks as long as they do not hold, collectively, a significant proportion of deposits in a financial system. However, they need some form of regulation commensurate to the type and size of their transactions. How should we tailor regulation to the unique characteristics of microfinance activities? The Basel Committee is currently working on illustrating what forms regulation can take, keeping in mind the diversity of the sector. That is why this effort is a collective one, and why the Committee works together with supervisors from all over the world in the Committee’s International Liaison Group, as well as the IMF, the World Bank, CGAP and regional groups of banking supervisors. Concluding remarks 13. Ladies and gentlemen, I will conclude. Microfinance is booming. It is now widely acknowledged as an effective way to reach out to the poor. And, as I said in the beginning, this belief is not just confined to charitable institutions, but felt the world over. Still, the current market size forms only a small part of the estimated global demand for microfinance services. As such, the broadening of financial services offered by microfinance institutions, specifically the deposit-taking facilities offered by many microfinance institutions, is a welcome development. In parallel with this, the role of the prudential supervisor will become ever more relevant. Prudential supervision can contribute to inclusive financial systems by taking account of the specific characteristics of microfinance while not disturbing the international level playing field. The efforts of the Basel International Liaison Group will be an important step forward in this regard. Furthermore, adequate supervision may enhance the perceived legitimacy of microfinance institutions, improve their operational management and extend their access to funding. In this way, microfinance not only contributes to the economic development of a country, but also enriches the financial system and financial supervision. So maybe, rather than “A billion to gain”, it’s a question of “Billions to gain”! Thank you. | netherlands bank | 2,008 | 6 |
Introductory speech by Dr Nout Wellink, President of the Netherlands Bank & Chairman of the BCBS, at the workshop on The role of financial imbalances in the setting of monetary policy. Lessons from the current crisis, Amsterdam, 23 June 2008. | Nout Wellink: The role of financial imbalances in the setting of monetary policy – lessons from the current crisis Introductory speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the workshop on “The role of financial imbalances in the setting of monetary policy. Lessons from the current crisis”, Amsterdam, 23 June 2008. * * * The recent financial turmoil has highlighted once again that the role of financial imbalances is a major challenge for central banks focusing on price stability. Most of the analyses of the causes of the financial turbulence that I have read stress the role of new financial developments, which make this event special. But the recent crisis is just one of a series of episodes over the past 30 years when the paths of asset prices – most notably equities and housing – were a highly distorting factor that ex post turned out to have disruptive macroeconomic effects. The aim of this workshop is to further our understanding of the role of monetary policy in addressing financial imbalances. The speakers in the panel that will follow my remarks will discuss whether monetary policy should be actively used to prevent the build up of financial imbalances, and what the optimal monetary policy response should be when financial imbalances do occur. This debate hinges on the question of whether we can ex ante identify imbalances that are building up. In my remarks, I will address this issue based on my experience as policy maker. In my view, there are several, interrelated ingredients of an accumulating imbalance: The first is low real long-term interest rates relative to a natural rate of interest, particularly in a context of a robust economy characterised by high productivity growth, strong economic growth and low inflation. It is well known that the natural rate of interest is difficult to estimate – just think about the challenge of assessing changes in productivity growth. But I think that a comparison with a historical average of past actual rates can give an idea of whether interest rates are out of line. Low interest rates underpin the second ingredient, which the recent financial turmoil has brought to everyone’s attention – strong credit growth. The current intellectual debate highlights how standard macroeconomic theories in the Lucasian tradition – based on optimizing agents with rational expectations, complete markets and fully flexible prices – have a hard time assigning credit a relevant role. Economists are therefore increasingly turning for insights to the theories of Minsky or Kindleberger, which were published in the 1970s, or, even further back, to the business cycle theories dominant in England in the 1920s, and Hayek’s work from the 1930s. The third element relates to the high levels of debt that can result from a prolonged period of strong credit growth, and which make the economy vulnerable to negative shocks. In my view, the importance of the stock of debt is a manifestation of a more general phenomenon, whereby in a context of disequilibrium – such as the accumulation of financial imbalances – stocks dominate flows as determinants of macroeconomic dynamics. When critical stock-flow ratios become very large, financial market players may at first become suspicious and then very rapidly flee into holdings of liquid assets, thus triggering a financial turbulence. The fourth ingredient is sharply rising asset prices – typically in equity or real estate markets. While an asset price bubble is notoriously difficult to identify, here again deviations from some form of historical trend can give some guidance. In an international dimension, sizeable current account deficits and high levels of international debt can point to imbalances that can have disruptive effects. While we all know how this can play out in emerging market economies, such episodes also occurred in industrial economies – just think for example about the Nordic banking crises in the late 1980s–early 1990s. In the current context of global imbalances, it has been argued that the large current account deficit and rising international debt in the United States reflects the large decline in savings by US households during the housing credit bubble. But how can we quantitatively verify the existence and magnitude of financial imbalances along these five dimensions? This is a challenge for policy makers, academics and market participants alike. There is an empirical literature that suggests that financial imbalances might be detected but its findings are far from undisputed. In my view, there is definitely a need for more in-depth research that helps us understand the dynamics of the accumulation of imbalances, even if this research comes up with interval estimates rather than point estimates. These margins (or bands) might be large but exceeding them would definitely be a sign that something is going wrong. But even if imbalances might not be accurately assessed by empirical research, based on my personal experience as a policy maker there is clearly a sense in which they can be detected. “If it looks like a duck and quacks like a duck, chances are it is a duck”. To illustrate this, let me go through a list of episodes that highlight how a “duck” can be recognized by low interest rates, strong credit growth, high debt levels and sharply rising asset prices. Having to be selective, I will pick out four historical episodes, before turning to the financial turmoil that started in August last year: The housing bubble in the Netherlands in the 1970s the Japanese asset bubble in the 1980s the dot.com bubble in the United States in the 1990s the boom in the Dutch housing market in the 1990s. The housing bubble in the Netherlands in the 1970s Banks and households in the Netherlands tend to forget that in the 1970s we had a real estate bubble that burst violently. In 1975-76, the Dutch mortgage and housing markets went through a period of abnormal growth. Low – at some point even negative – real interest rates in a context of high inflation supported a sharp rise in demand for housing, while banks and insurance companies pushed households to take out as high as possible loans. 1 Financial innovation, which created new forms of mortgages, also spurred credit growth, as did the extension of governmental guarantees from mortgages for new houses to all types of house purchases. Household debt and house prices rose sharply. DNB was clearly worried about these developments. The explosive mortgage growth, which peaked at an annual rate of 29% in 1976, and the support it had received from governmental policies, were highlighted in 1976 in our Annual Report. 2 An attempt to introduce credit restrictions was initially thwarted by the government. When they were finally imposed in 1977, they contributed to slowing mortgage lending, but it was too late to prevent a collapse of the Dutch housing market. In 1976, house prices started to tumble, as interest rates rose Groeneveld (1997). See De Haas et al (2000). and the economy went into a recession. By 1983, house prices had fallen by around 25% and mortgage lending stopped growing. The Japanese asset bubble in the 1980s The Japanese asset bubble of the 1980s is a trauma that has had an important influence on policy makers around the globe. In the second half of the 1980s, asset prices – most notably equity and housing prices – rose sharply and bank lending grew at a fast pace. These trends occurred against the background of an overheating economy, while inflation remained subdued, mainly because of the rapid appreciation of the yen. 3 The aggressive lending behaviour of over-optimistic banks in many ways resembled that of Dutch banks in the mid1970s. Interest rates remained relatively low until the Bank of Japan tightened monetary policy in 1987 and more substantially in 1989. Equity and housing prices collapsed in 1989, dragging balance sheets of banks, firms and households into a prolonged crisis, and eventually leading to a credit crunch. The dot.com bubble in the United States in the 1990s US stock prices, an in particular those of the IT sector, rallied in the late 1990s in a context of strong productivity growth, low and stable inflation, and low interest rates. At the time, many observers saw this as a manifestation of a so-called “new economy”. But others pointed to low or even negative savings rates coupled with a growing current account deficit as unsustainable imbalances. In the introduction to our Annual Report in 1998, we wrote that it was clear that at some point a correction had to happen but that it was hard to predict its trigger and its timing. 4 In the event, the boom ended in coincidence with a tightening of monetary policy and was followed by a recession, with price changes in the United States approaching deflation in the early 2000s. The boom in the Dutch housing market in the 1990s. In some respects, the housing market boom of the 1990s resembled the bubble of the mid1970s. Between 1994 and 2000, mortgage lending grew very rapidly in a context of rapid economic growth, reaching annual rates of 15%. As a result, mortgage debt as a percentage of GNP became one the highest in Europe. As house prices boomed, home equity withdrawals – used for home improvements but also to finance consumption or investment on the stock market – grew rapidly. 5 Similarly to the boom of the 1970s, credit growth was supported by low and falling interest rates, banks’ efforts to encourage mortgage borrowing – by relaxing their acceptance criteria in an effort to increase their market share – and financial innovation, in the form of new types of mortgages. Demographic factors or fiscal legislation also played a role. This said, a main difference between the 1990s housing boom and the bubble in the mid1970s is that supply side developments, and in particular the unusually rigid supply of new houses, played a much more prominent role in the 1990s (DNB, 2008a). See Ito and Mishkin (2004). The influence of the appreciation of the yen on the Bank of Japan’s accommodative monetary policy in the second half of the 1990s is discussed in Ito (1992). See DNB (1998). See DNB (1999, 2002). Data for 2003, when the growth of house prices and home equity withdrawals had moderated, indicated that 70% of home equity withdrawal where used for home improvement (DNB, 2003). At DNB we monitored these developments very closely and discussed whether the strong growth in mortgage lending could be followed by a sudden collapse in the housing market. 6 A study was commissioned by DNB to carefully examine bank credit in the Netherlands. 7 In the foreword, I stressed how previous experiences in the United Kingdom and Scandinavian countries led to a decoupling from fundamentals and to serious consequences once credit growth collapsed. I concluded that, “an excessive credit growth can hold risks for both macro and financial stability.” In contrast to the 1970s housing bubble, the boom in the 1990s did not lead to a financial crisis. In the early 2000s, the growth of house prices and credit dampened against the background of falling disposable income and rising unemployment, as a result of slowing global growth and rising interest rates. The current turmoil Let me turn to the recent financial crisis and pose the question of whether there was evidence of excesses in financial markets in the years before the crisis erupted in August 2007. In the years before the crisis, low and stable consumer price inflation was accompanied by asset price inflation that reflected underlying imbalances. In particular, market participants’ overly optimistic risk assessments contributed to keeping long-term interest rates at low levels which – we know now – were unwarranted. The environment of low (real, long-term) interest rates and high credit growth in 2003-04 appears ex post to have been conducive to the problems that emerged last year. As I recently stated elsewhere, “many of the risks that crystallised in the past year were on our radar screen long before the crisis started.” 8 Over the past years, excessive risk tolerance, hazardous risk transfer mechanisms and possible shortcomings of the originateto-distribute model were time and again analysed in Financial Stability Reports – including our own Overview of Financial Stability. 9 Why we have not been fully able to translate these risk assessments into an efficacious preventive action is something that we need to reflect on very carefully. Can monetary policy lean against the wind and be used as an instrument to prevent the accumulation of imbalances? And how should it react to the problems brought about by a sudden unwinding of imbalances? I hope that the market participants, scholars and policymakers that are joining us today for this workshop, will help us gain insights into these important issues. References Capel and Houben (1998) “Asset inflation in the Netherlands: assessment, economic risks and monetary policy implications”. In The role of asset prices in the formulation of monetary policy, BIS Papers 5, March, pp 264-279. Reprinted in DNB Reprint series 588. De Haas, Houben, Kakes and Korthorst (2000): “De kredietverlening door Nederlandse banken onder de loep”, DNB Monetaire Monografien DNB (1976) Annual Report, Algemeen overzicht. See e.g. Groeneveld (1997) and Capel and Houben (1998). De Haas et al, 2000. Wellink (2008). The Overview of Financial Stability published in June 2005, for example, highlighted the underestimation of credit risks, and discussed reasons and consequences of this phenomenon (DNB, 2005). See also DNB (2006, 2007a, 2007b). DNB (1998) Annual Report, Algemeen overzicht. DNB (1999) Annual Report, Algemeen overzicht. DNB (2002) Quarterly Bulletin, June. DNB (2003) Quarterly Bulletin, September. DNB (2005) Financial Stability Overview, no.2, June. DNB (2006) Annual Report, chapter on financial stability. DNB (2007a) Financial Stability Overview, no.5, March. DNB (2007b) “Will the mortgage crisis in the US affect financial stability?”, Quarterly Bulletin, June. DNB (2008) “The lagging housing market in the Netherlands”, Quarterly Bulletin, March. Groeneveld (1997) “Een hypotheek op de toekomst”, ESB, vol.82, nr.4121, 24 september. Ito (1992): “Losing face”. The International Economy, May/June, pp.46-49. Ito and Mishkin (2004): “Two decades of Japanese monetary policy and the deflation problem”. NBER Working Paper 10878, October. Wellink (2008) “It’s the incentive, stupid!” Speech at the conference on “Integrating micro and macroeconomic perspectives on financial stability”, University of Groningen, 26 May 2008. | netherlands bank | 2,008 | 7 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Opening of Duisenberg School of Finance, Amsterdam, 15 September 2008. | Nout Wellink: Wim Duisenberg, financial turmoil, fit and proper, need for financial education Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Opening of Duisenberg School of Finance, Amsterdam, 15 September 2008. * * * Introduction Allow me to start with a short anecdote regarding Wim Duisenberg. As you know, Wim was professor in macro-economics at the University of Amsterdam. He obtained his PhD in 1965 on “The economic consequences of disarmament”. The evening before the promotion ceremony his friend Jan Pen called him. After having a general discussion on the topic, he pointed out that Wim had made a rather severe mistake on page so and so. As Pen had spotted the mistake, he informed Wim that he would question him during the day to come. Pen persisted and indeed, the next day, during the ceremony he pointed out the mistake to Wim and asked him what he was going to do about it. Wim was summoned to answer to this accusation – and calmly replied: “Thank you, we will take this into account in the next print”. Wim Duisenberg Wim was, as this story points out, a man of science AND of practicality. He cherished the high arts of financial theory as an IMF advisor, but simultaneously relished the speed and actions that the financial system demanded, as Minister of Finance and as Central Bank President. It was in his position as President of De Nederlandsche Bank that Wim made clear statements on his ambition to combine theoretical knowledge with practical expertise. He adamantly supported the transfer of the Bank’s research department out of the dark and dusky vaults, shaping it into a more vibrant and policy oriented department. Wim wanted to have the best minds within the Bank at the disposition of those that had to take stands on practical policy decisions. The forged alliance could tackle any issue at hand. This was few decades ago, but Wim was ahead of his time and quickly came to realize that having the best minds does not offer a singe packet solution to financial institutions, including to De Nederlandsche Bank itself. Keeping your best people rooted in financial practice and education – one not without the other – was his core policy. Current events & black swans Wim was not on his own in wanting to have the best minds for his organisation. Nowadays, many companies keep stressing that they themselves have the “best and brightest”, taken from high class universities all over the world. Yet, the turmoil in financial markets spurs me to occasionally ask a board member of any of these institutions if they do not feel too big to be managed. The general reply is that simply because the “best and brightest” are part of the company, there is no further need to enhance the management structure, or even look into additional safeguards. It is these companies that tend to ignore that knowledge needs to be applied sensibly. If anything, it is exactly the current turmoil which stresses not to single-handedly focus on those among us that excel in their financial, theoretical skills, if this implies that we fail to open our eyes to external developments. Developments such as risk management, corporate governance and social responsibility, all of which shape the way the financial system works on a day to day basis. “Our blindness with respect to randomness”, as skilfully narrated by Taleb in his Black Swan, clearly underlines this point. As all of us tend to have limited to no knowledge at all of unexpected events, the proposition “we know” is an illusion. Science of risk management, for instance, adds knowledge, but does not uncover the full veil of the world and its events, which leaves us with Knightian uncertainty. As such, the value of experts can also be questioned, if this implies that experts do not take empirical evidence into account, but base themselves merely on their own, by nature limited, expertise. What a globalized world requires is continuous education, discussion and peer to peer stimulation to keep up with the pace of exactly these unexpected events. Fit and proper This emphasis on up-to-date financial knowledge is also reflected in our own focus on fit and proper requirements of financial institutions in the Netherlands. Starting at the top, knowledge and expertise at a board level is a prerequisite. The Bank as supervisor has the task to monitor and uphold these. To ensure the proper discharge of their responsibilities, it is important that board members have the skills to run the company. They should have personal qualities such as honesty, diligence, independent-mindedness and fairness, in order to ensure that the company is run ethically, in compliance with relevant legislation and in a manner that treats its customers fairly. “Propriety” requires that they are of good repute and integrity. “Fitness” requires that a person appointed as a director or manager has the necessary professional qualifications, knowledge and experience to enable sound and prudent management. In Dutch law regarding pension funds – Pension Fund Governance – further elaboration has led to extensive overviews from within the pension sector on specific fitness issues. The ability to manage an organisation is an obvious one, as is having knowledge of applicable laws and regulations. Financial education Having said that, even if at the board level these issues are tackled properly, this is not sufficient enough. It is throughout the organisation that adequate knowledge and expertise has to be available; the capacities of a board member on its own cannot be used to sign off for an organisation as a whole. Financial education provides the means to realize fitness and propriety on every essential level in financial organisations and having a clear understanding of risks involved, of the need of integrity, structure and governance. Conclusion Concluding, this brings me back to Wim Duisenberg. Wim was, as I mentioned, ahead of his time. His wish to combine financial theory and practice is reflected even more than ever in the current times, where uncertain events of differing magnitude force us to reconsider our own validation methods. The Duisenberg school of finance bares witness to that. Our partners, as we have seen and heard today, have given the clear commitment to invest in financial education, in future students and in a manner of education and research that outstretches the current limitations on financial knowledge. I cannot imagine anyone more suited than Wim to lend his name to the institution that is officially opened here today. | netherlands bank | 2,008 | 9 |
Remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the International Conference of Banking Supervisors 2008, Brussels, 24 September 2008. | Nout Wellink: Responding to uncertainty Remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the International Conference of Banking Supervisors 2008, Brussels, 24 September 2008. * * * Introduction Good morning and welcome to Brussels for this fifteenth International Conference of Banking Supervisors. I would like to begin by thanking Governor Guy Quaden of the National Bank of Belgian and Chairman Jean-Paul Servais of Belgium’s Banking, Finance and Insurance Commission for graciously hosting this conference. The organisation of this conference began shortly after the ICBS in Mexico ended. Despite the extensive preparation of our Belgian hosts, I do not think any kind of planning could have prepared us for what we are now experiencing in the financial markets. The events we have witnessed in the past two weeks are nothing short of extraordinary. Some of the world’s largest financial institutions have declared bankruptcy, have been purchased or have been thrown a government lifeline. Considerable uncertainty and market volatility persist and will likely continue for some time to come. The official sector, including the supervisory community, are working to promote a deleveraging process that limits as much as possible the spillover from the financial to the real economy. As supervisors, central bankers and policy makers – what are we to make of all of this? Just as we caution bankers during the good times to prepare for the rough times that inevitably lie ahead, we too must use this opportunity to assess the lessons learned to better prepare for the future. This morning I would like to share with you some of my views on the lessons the crisis has taught us and, more importantly, how we can use this experience to better prepare for the future. Clearly, we are still in the midst of this process and more lessons are likely to arise. As you know, both Belgium and my home country, the Netherlands, are on the shore of the North Sea, which can be extremely stormy at times. In the past, people were at the mercy of these storms. For instance, in 1570 more then 20,000 people died during one of the worst storms in history. So how did people react? They built dikes to protect against the floodwaters. Despite these buffers, a bit more than 50 years ago, the Netherlands as well as Belgium, the UK and Germany were caught again by an enormous flood, which flowed over the dikes – the buffers – that had been built up during the good years. I believe this story is a good metaphor for what has recently happened to the global financial system. From time to time we witness financial storms. As supervisors we learn from these experiences and build dikes, or buffers, to protect against future floods. Nevertheless, the land beneath the dikes – our financial system and economies – can erode due to the passing of time or the battering from a tremendous storm. As the builders of the dikes, it is our role to continually monitor the strength and condition of the dikes; to assess the damage caused by each storm and try to anticipate the next storm. Bankers too have an important role in preserving the soundness of the dike – supervisors by themselves can not have sole responsibility. Origins of the storm As with almost any financial crisis, leverage and risk concentrations have played a central role in the current situation. I will be quick to add, however, that leverage in and of itself was not the problem. Indeed, risk taking and leverage are essential elements in banking. Instead, what I will focus on is the manner in which these elements are managed and controlled. As in other financial storms, it is poor execution of the basics that are at the root of today’s problems. Complacency – on the part of bankers and supervisors – certainly played a role. The banking industry is exceedingly optimistic during times of benign economic conditions – when the seas are calm. It is difficult to keep a proper perspective and to exercise prudent judgment when all of your competitors are generating huge volumes of business. As one banker famously said last year “As long as the music is playing, you’ve got to get up and dance”. Well, if it is the role of the central banker to take away the punch bowl just as the party gets going, perhaps the role of the supervisor is to silence the band so the bankers stop dancing. Supervisors – for our part – tend to focus on bank-specific issues. But, as we have learned, we must also pay attention to the broader aspects of financial stability. For example, excessive leverage, risk concentrations and maturity mismatches – whether on- or offbalance sheet – are examples of destructive forces that, especially in combination, can have severe consequences for entire sectors and economies. One of the main lessons from this turmoil is clear: bankers and supervisors need to remain focused on the big picture and the longer term horizon. Risk management and oversight Let me give you a few examples of some fundamental aspects of risk management and oversight that were violated by many. As supervisors, we have seen time and time again that financial crises are characterised by the failure to adhere to basic risk management principles, especially during times of financial innovation. This crisis is no different. Weakness in fundamental underwriting principles, among other factors, was a key contributor to asset quality problems. So was poor risk management, which at some firms allowed the build-up of massive risk concentrations across the firm that further compounded already shaky asset quality. Some banks were caught completely unaware by concentrations to subprime loans that they had in their loan portfolios. Others did not fully understand their full exposure to subprime mortgages, particularly when they purchased an exposure that contained dozens of other exposures – I am of course referring here to CDOs of ABS. Poor asset quality and risk concentrations are at the heart of the turmoil involving subprime mortgages which has led to the exceptional uncertainty and volatility that we see today. These problems have been further compounded by uncertainties relating to valuation practices. What should we take away from this? That banks – and supervisors – must redouble their efforts to ensure that sound underwriting standards are in place and that there are adequate, systematic procedures for identifying firm-wide risk concentrations. Originate-to-distribute business model What other factors – aside from complacency – have hindered adoption of such basic principles? Perhaps one of the stumbling blocks has been the expanded use of the originate-to-distribute model. Managing this model’s associated risks poses significant challenges and, in some cases, has led to large risk exposures and concentrations that firms’ senior management failed to detect. The recent problem with the originate-to-distribute model has been one of incentives. Instead of the traditional focus on a borrower’s ability to repay a loan, many banks focused instead on generating a high volume of loans, and booking as income the fees received to originate the mortgages. Many firms chose not to invest the necessary time and resources in thorough credit analysis and underwriting since someone else would be purchasing the mortgage. Investors did not perform their own due diligence. Instead, they relied on the due diligence of originators and packagers, who lacked interest in exercising this due diligence. They also placed undue reliance on the judgments of the credit rating agencies, and the capacity of modern technology and diversification to manage financial risks. What can we draw from this? The combination of excess lending with an obvious failure to adhere to fundamental and sound risk management standards not only produced significant losses in mortgage portfolios; it also tainted an asset type that was key in the broader securitisation and credit distribution process. The reckless use of the originate-to-distribute model increased uncertainty regarding credit quality, where risk resides and the impact of deterioration. This heightened uncertainty suggests that in maintaining their capital buffers – the dikes – banks need to do a better job capturing the risks related to this business model. We have to build higher dikes but must not forget the importance of building on a sound foundation, which is high quality capital. Basel II provides the necessary framework within which to achieve these enhancements. I will return to the capital issue in a moment. Liquidity Liquidity was another victim of the current storm and its demise holds valuable lessons for supervisors. Increasing banks' liquidity cushions and improving liquidity risk management and supervision has been an area of sharp focus for the Committee. We have seen massive illiquidity in certain market segments (especially complex structured products) for a much longer period than any market participant would have predicted. Complex and illiquid investor-specific instruments, such as resecuritisations, have experienced significant marketvalue losses, which has led to the loss of confidence in their financial worthiness and the drying up of liquidity in the short-term interbank market. The recent turmoil has shown that banks must strengthen their liquidity buffers. One way to do this is to increase their holdings of high quality liquid securities – in particular, liquid central government securities. The Committee’s guidance on sound liquidity risk management and supervision and vigorous supervisory follow-up will help raise the bar in this area. We will continue to examine the topic of liquidity with a focus on cross-border aspects of liquidity supervision. While liquidity risk cannot be mitigated with capital, capital is itself a form of liquidity since, unlike other liabilities, it does not have to be repaid. Furthermore, a strong capital buffer enhances a bank’s creditworthiness and, from the market’s perspective, reduces its counterparty risk. This helps to ensure continued access to funding. Capital adequacy And this brings me to the issue of capital adequacy. After several years of high profits, often record profits, we know that the level of risk was grossly underestimated by many financial institutions. This latest storm has therefore revealed cracks in the dikes and the supervisory community is in the process of patching up those cracks. High losses have put pressure on capital cushions and many banks have been forced to go to the market to replenish their capital base. This is critical if a contraction in lending and credit are to be avoided. Of greater importance, though, are the cracks in the dike that are not yet evident. While we do not know the nature and strength of the next storm, we can take measures today to strengthen the dike so it could withstand the battering. One of those measures is to significantly strengthen banks’ capital buffers. In addition to moving ahead aggressively with Basel II, the Committee has issued a proposal to strengthen the capital treatment for risks not captured under Basel II’s existing trading book regime. In this context, the Committee is also carefully considering the topic of procyclicality, especially as it is influenced by bank capital issues. There are many dimensions here, such as the level and quality of capital; provisioning, capital buffers and the ability of banks to dip into those buffers. We will continue to review these and other issues related to procyclicality and are in the process of developing a work programme to address both near term and longer-term issues. The Committee is also developing enhanced guidance under Pillar 2, the supervisory review process. Here, our focus is on improving risk management practices, such as stress testing and the management of risks arising from complex instruments, among other things. We are also developing proposals to strengthen Pillar 3 disclosures, especially for securitisation activities. Conclusion We have learned much from the severe storm that is currently raging. I have outlined some of the measures that banks and supervisors must take to better prepare for the next storm. But what is becoming increasingly clear is that, over time, the banking system needs to strengthen capital and liquidity buffers to withstand prolonged periods of stress in the financial system and the broader economy. This will be done in a manner that does not aggravate the current stress in the system. Enhancements to risk management and market transparency will help, but we must enhance banks’ buffers to reflect the increased degree of uncertainty in the system. The need for increased margins to protect against uncertainty will also become apparent as rapid financial innovation continues and uncertainty increases about how new products, valuations, markets and the real economy will interact in times of stress. This will better reflect the risks that already are inherent – but perhaps not easily recognised – in banks' portfolios, either in regulatory or internal metrics. Finally, enforcement by banks and supervisors of the basics of sound risk management and underwriting practices are key to promoting a return to financial stability. | netherlands bank | 2,008 | 9 |
Remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Symposium about Integrity, Amsterdam, 30 October 2008. | Nout Wellink: Financial sector integrity Remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Symposium about Integrity, Amsterdam, 30 October 2008. * * * Back in around 1630, average annual income in the Low Countries was 150 guilders, a barrel of butter cost about 100 guilders and eight fat pigs were worth close on 250 guilders. But a red and white flamed tulip, the Semper Augustus, cost 6000 guilders, almost as much as a house on a canal. That was at the peak of the tulip mania: the frenetic trade in tulips that quickly became speculation, an economic bubble. Three years after that climax, the mania and the trade came slowly but surely to a halt. The prices began to fall sharply, and many traders went bankrupt, at that time a criminal offence that could carry a long prison sentence. Fortunes dissolved into thin air and many of those involved lost their jobs. In April 1637, the government intervened by invalidating all speculative agreements and capping the price of tulip bulbs at 50 guilders. But what really triggered the beginning of the end? A simple lack of confidence. In fact, all markets are built on confidence. From the Albert Cuyp street market to the stock exchange on Beursplein 5, from Amsterdam to Tokyo. Confidence in the quality of the products, in the reputation of the seller, in the timeliness of delivery. The financial market is especially dependent on confidence. Confidence in every layer and link in the system. Confidence in reliable figures and sound people and in well-enforced laws against fraud and corruption. Integrity and confidence are not synonymous, but they are interdependent. Confidence is obviously closely related, and interlinked, to integrity: confidence is essential for economic transactions and that confidence is based on the integrity of market players. So it goes without saying that integrity is not just a matter for sociologists, but for economists too. And it’s also self-evident that integrity is a topical subject, which plays an important role in the causes of, and the solutions for, the current credit crisis. That in turn is why I find it so important to exchange views with you on integrity here today. It is imperative that the sector, that you, show that you embrace integrity as your cornerstone. And that you realise that sound conduct goes beyond strict compliance with the letter of the law. Laws and regulations reflect the prevailing social norms and values. Since regulations codify norms and values, it is vital that the financial sector keeps in touch with the current and changing views in society on what integrity involves and what type of conduct is worthy of confidence. As Ien Dales said back in 1992: “It’s no good being just a little honest”. Confidence is not just about integrity. The solvency and stability of the financial system are also crucial for confidence in the sector. But the sector still needs to observe business integrity, in a way that we as a society find admissible and acceptable. Monitoring and safeguarding business integrity is a job for the supervisors. In the Netherlands we apply the Twin Peaks model, for which the US Minister of Finance Paulson recently expressed a preference. In this model, we separate market conduct supervision and prudential supervision. The Authority for the Financial Markets (AFM) exercises supervision on the conduct of financial institutions in the market and towards their customers, and DNB targets the solidity of financial enterprises. An important component in the supervision by DNB and AFM is the supervision of financial sector integrity. How does DNB go about it? By exercising supervision on the various levels of integrity: supervision of personal integrity, relationship integrity, organisational integrity and market integrity. We target the main risks: money laundering, terrorist financing, fraud, harm to third parties and insider trading. These risks could affect the activities of financial institutions and harm their reputation. DNB expects that institutions will act responsibly in identifying and managing such risks. For most enterprises, and particularly financial institutions, the tone at the top is more significant for business integrity than the conduct of individual employees. The integrity of directors and those who determine or co-determine policy at financial institutions has traditionally been verified by the integrity test. The trustworthiness of an enterprise’s top management should be beyond doubt. In 2007, DNB conducted integrity tests on 1578 persons responsible for determining policy. Not one of them failed the test, although 58 candidates withdrew their application. These tests sometimes hinge on delicate considerations. Is, say, Mr X, who threatened a traffic warden after receiving a traffic fine, still a fit and proper director? And how do you deal with the director who, whether or not intentionally, fails to report previous offences on his integrity form. Openness plays an important role in such decisions. For DNB, failure to mention a mistake is sometimes worse than the mistake itself. I assure you that DNB treats such questions with the greatest possible care. And of course we require the highest standards of integrity from our own employees and organisation. For DNB too, a sharp awareness of integrity at all layers of the organisation is crucial. We work hard on that. Not only through rules and regulations but also through training sessions on integrity in the workplace. Such sessions lend DNB employees greater insight into the integrity dilemmas that may arise in their work. But more importantly, DNB employees discuss integrity and what it means for us. In addition, our central compliance department continuously analyses the integrity risks that we run as a central bank and supervisor, especially in view of our public role. Unsound conduct by DNB or its employees could have an immediate impact on public confidence in our organisation. The Prevention of Money Laundering and Terrorist Financing Act, which recently came into effect, gives substance to customer due diligence. Financial institutions must at all times apply the basic criteria: know your customer and know your business. In other words: even if an institution’s employees are sound, they may unwittingly do business with dishonest customers. Banks could be drawn into money laundering constructions engineered by criminal organisations that use complex methods to finance real estate with criminal gains. Besides “know your customer”, there are specific sanctions regulations aimed in part at preventing terrorist financing. Institutions must also take measures to prevent their misuse for financing weapons of mass destruction in countries such as Iran. DNB is obviously not the only supervisor of these practices. Under UN resolutions and EU legislation, institutions are obliged to have a clear view of their trade financing activities. We must always stay alert for new developments. In 2006, for example, an estimated USD 1 billion was spent on goods and services in digital virtual communities. The combination of anonymity and the possibility of channelling profits to the real economy make such websites a potential source of terrorist financing. In tracking down risks, we sometimes look right through sectors to examine a specific issue. The real estate sector is a good example. The real estate market is often closed and intransparent, with a select group of players who can act in various capacities. That makes the sector vulnerable and exposed to dubious practices. Seeing this as a serious concern, DNB has asked the sector to establish a robust framework of control measures. Besides monitoring the development of risk, DNB also seeks methods to make integrity supervision more efficient. This is aptly illustrated by the so-termed self-assessments, whereby institutions assess their business integrity with the help of questionnaires. DNB subsequently examines these self-assessments. This is an efficient way to chart the risks within a sector without having to visit each institution individually. Self-assessments were introduced at small and medium-sized insurers this autumn; they were developed in consultation with the sector in order to accommodate insurer-specific features. We also learnt greatly from the AFM’s experiences with its contribution model. DNB’s operational supervision is obviously closely connected to the integrity issues of concern to the intelligence and security service, the AFM, tax authorities, fiscal and economic intelligence service and the police. DNB neither prepares nor continues the work of the investigative and prosecution authorities, but we cooperate well with them and share information with other supervisors and investigative and prosecution agencies, naturally keeping within the statutory bounds of confidentiality. As the chair of the Financial Expertise Centrum, the FEC, DNB is committed to further intensifying cooperation between the services. Besides the integrity supervision of persons, business relations and organisations, DNB also concerns itself with the integrity of the entire financial sector. Here too, integrity goes beyond compliance with statutory rules and provisions. Unsound conduct can damage the sector as a whole, even if, strictly speaking, no violations occur. The wrong sort of incentives could induce sound people, working in sound companies, to exhibit behaviour that impacts negatively on market integrity in general. Notably in this area, it is up to the sector to act responsibility. You are responsible for making the right choices. Where those choices are difficult, DNB would be glad to discuss them with you. But if you don’t make any choices at all, you will find that DNB takes its role as supervisor very seriously when it comes to integrity. In my view, this sector is itself responsible for all aspects and manifestations of sound conduct. Confidence must be earned! And what the sector, or certain players in the sector, do or do not earn, is now a target of much agitation and dissatisfaction and a subject of debate that focuses particularly on transaction-related bonuses. Without going so far as to say that the credit crisis is a direct result of such bonuses, we can say that the incentives attached to such bonuses could generate irresponsible and socially undesirable behaviour. Behaviour that in any case lowers confidence in the reliability of the financial sector. Let me assure you that DNB will keep a strict watch on bonus structures at financial institutions that induce directors to take irresponsible risks. We do not need to completely prohibit bonuses, but it is essential to align the size and the time frame of bonuses more closely to the longer-term goals of the enterprise itself. As far as I am concerned, bonuses could be scrapped altogether. I would prefer to see executives drawing good, competitive salaries. That salary should be enough incentive for a good and sound performance that actually contributes to financial institutions’ long-term objectives. I am convinced that the financial sector itself would benefit most from stable pay structures. Of course this issue must be tackled internationally. Globalisation has removed the borders in the financial sector. Since financial risks have become marketable, and borders between countries have blurred, losses are spread more widely. We not only reap the rewards of globalisation, but the bitter fruits too, because everybody is affected when things go badly wrong. That’s why we need international discussion and action on bonus structures, integrity and other such matters. The Financial Stability Forum, in which I sit as the chairman of the Basel Committee, published a code of conduct for pay structures in July. It centres on the recommendation that pay incentives should be based on actual performance and should be in line with the longterm interests of shareholders and the profitability of the enterprise as a whole. In addition, DNB is supported at national level by the AFM’s serious approach to its integrity task. AFM supervises the sound conduct of the sector towards its customers, the consumers. And only when the sector deals soundly with consumer interests, will consumers regain confidence in the financial sector. The first steps have been taken: nationally and internationally, financial sector integrity is on the agenda. In the coming period we will join in European and global discussions on sound, confidence-inspiring international supervision. Supervisors, governments and enterprises together. Because if there’s one thing we’ve learnt from the credit crisis, from the loss of confidence in the financial sector, it is – in my opinion – that we can only regain that confidence through national and international cooperation! | netherlands bank | 2,008 | 11 |
Keynote address by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the High Level Meeting "The Role of Banking and Banking Supervision in Financial Stability", Beijing, 17 November 2008. | Nout Wellink: The importance of banking supervision in financial stability Keynote address by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the High Level Meeting “The Role of Banking and Banking Supervision in Financial Stability”, Beijing, 17 November 2008. * * * Introduction I would like to begin by thanking the FSI and EMEAP for organising this very timely event as well as the People’s Bank of China for their warm hospitality. I am grateful for the opportunity to discuss the Basel Committee’s response to the financial market crisis. This morning I would like to present our strategy for addressing the fundamental weaknesses with respect to the regulation, supervision and risk management of internationally-active banks that have been revealed by the rapidly evolving crisis. Our work programme is well advanced and provides practical responses to the financial stability concerns raised by policy makers related to the banking sector, which is at the core of the global credit intermediation process. Successful implementation of this strategy requires a global effort and the Committee will reach out to countries that are critical to this process. Background on crisis and emerging lessons Before I talk about the Committee’s response, I think it is important to provide some context as to how we have arrived at where we are today. From a supervisory perspective, the main contributing factors that came together to form a perfect storm include: • a large amount of pre-crisis, system-wide liquidity, which led to excessive risk taking; • inadequate measures to contain leverage, maturity mismatches, risk concentrations and the erosion of liquidity buffers over the credit cycle; • regulatory gaps, which left important segments of the financial system under regulated; • poor incentives in regulatory frameworks; • poor underwriting standards; • outsourcing of the due diligence process to the rating agencies; and • fundamental shortcomings in financial institution’s governance, of which the current risk management shortcomings are just a symptom. The crisis, which has re-concentrated risk in the banking sector, has resulted in financial market stress and massive deleveraging of historic proportions, with increasing spillover to the real economy. The speed and scale of these developments have been nothing short of astonishing. The response by the official sector also has been unprecedented, covering a wide range of measures. These are now helping to stabilise the banking sector and financial markets. But it is clear that we continue to face significant challenges as real economic activity slows. The official sector, including supervisory authorities, continues to work nationally and collectively to promote an orderly deleveraging process. We also need to develop a coordinated strategy to put the banking system on a sound footing over the longer term. Such efforts will further reinforce near term confidence-building measures and provide a long term target around which national and global policy making efforts can converge. They also will provide the basis for an exit strategy from the increased official sector engagement in the banking sector. I would like to focus the remainder of my remarks on how we can go about achieving this longer term strategy. The Basel Committee’s response The primary objective of the Committee’s strategy is to strengthen capital and liquidity buffers and help contain leverage in the system arising from both on- and off-balance sheet activities. It also will promote stronger risk management and governance practices and limit risk concentrations within and across banking institutions, and strengthen market transparency. Ultimately, our goal is to help ensure that the banking sector serves its traditional role as a shock absorber to the financial system, rather than an amplifier of risk between the financial sector and the real economy. The Committee will promote multiple and reinforcing lines of defence in supervisory and risk management frameworks to enhance bank resilience. Let me discuss in more depth the key building blocks of our strategy. Strengthening capital buffers I will start with the Committee’s initiatives to strengthen the regulatory capital framework. I would note up front that regulators need to be extremely cautious about adding to the already severe procyclical behaviour in the market place. As such, we do not propose to raise global minimum capital ratios during a crisis. However, banks need to ensure they have adequate buffers above the current regulatory minimum that reflect the nature of their portfolios and their exposure to a plausibly severe economic downturn scenario. With that background, I will now provide you with more clarity about the Committee’s approach to strengthen the capital regime, building on the three pillars of the Basel II framework. Any enhancements will be introduced in a manner that promotes the near term resilience of the banking sector and its ability to provide credit to the economy. Moreover, we cannot set long term capital requirements on the basis of market reactions in the midst of the most severe deleveraging process we have seen in our lifetime. This effort needs to be carried out as part of a considered process that balances the objective of maintaining a vibrant, competitive banking sector in good times against the need to enhance the sector’s resilience in future periods of financial and economic stress. Risk capture Let me begin with the issue of the risk capture of the Basel II framework. The move to Basel II addresses many of the risks that were not captured under the Basel I framework and helps reduce a number of the perverse incentives that contributed to the crisis. The three pillars of Basel II will help ensure that capital regulation is better positioned to handle periods of rapid innovation and the new products that such periods produce. Moreover, Basel II will ensure that all contractual exposures to off-balance-sheet vehicles are subject to regulatory capital requirements. Non-contractual exposures and implicit support will be addressed through enhancements to the Pillar 2 framework. Last April, the Committee announced a number of steps to enhance the risk capture of the Basel II capital framework. These measures are an important part of the Financial Stability Forum’s response to the crisis that was set out in its April 2008 Report on Enhancing Market and Institutional Resilience. For example, the Basel Committee’s efforts strengthen the capital treatment for off-balance sheet exposures and securitisations. The Committee expects to issue proposals for the capital treatment of these exposures in early 2009. The proposals are subject to public consultation and we will carefully consider all comments received. We also have issued a proposal to strengthen the capital framework for the trading book. In particular, we will address the risks of less liquid credit products, which have produced the majority of losses in the banking sector to date. While the proposals reflect the inherent risks already embedded in banks’ trading books, they will be phased in over an appropriate period to give the banking sector time to adjust to the new requirements. We are strengthening the disclosure requirements for banks’ risk exposures and the adequacy of capital to support these exposures. We are focusing in particular on trading, securitisation and off-balance sheet activities. Finally, we will review the role of external ratings in the Basel II framework. I should point out that the use of external ratings is limited to the simple Standardised Approach for credit risk and the Securitisation Framework. Our review will include how any unintended consequences could be mitigated. Quality of capital Let me now turn to the issue of the quality of capital. The Committee has been reviewing the key elements of Tier 1 capital and the importance of ensuring strong core capital. A strong, high quality capital base is critical for banks to be able to absorb losses and maintain lending during periods of severe economic and financial stress. The Committee will continue to provide global leadership on what the key elements of a strong capital base should be, reflecting the lessons of recent developments. Such an effort will ensure that both prudential and competitive equity objectives are maintained in the future. Procyclicality The crisis shows that banks need to build strong capital buffers and provisions in good times so that they can be drawn upon in periods of stress. This in turn dampens the risk of spillover from the financial sector to the real economy. Reflecting the lessons of the crisis, there are a number of steps the Committee is considering to dampen the potential procyclicality of the Basel II framework. It is important to note that the crisis built up under the Basel I regime, while Basel II only became effective in most countries at the beginning of this year. We will explore promoting strong capital buffers above the minimum levels and how those can be used during a downturn to dampen shocks and encourage continued lending. The Committee also is assessing ways to strengthen prudential filters, promote through-the-cycle provisioning, and contribute to efforts to strengthen accounting standards for financial instruments. Finally, the introduction of the incremental risk charge in the trading book should help dampen the cyclicality of trading book capital. Supplemental measures Supervisors are reviewing the need to supplement risk-based prudential and risk management approaches with simple, transparent gross measures of risk. In combination, such risk-based and gross measures may provide a further check on the build-up of leverage at financial institutions and the underestimation of risk during rapid periods of credit growth or in new business lines that have not experienced a downturn. Moreover, in periods of stress a large gap may open between what the risk-based metric requires, and what the market expects through simpler metrics. I hasten to add that simple metrics alone can and will be gamed, as the recent experience under Basel I has shown, particularly related to the growth of exposures to off-balance sheet vehicles. Both risk-based and simple measures therefore may be needed going forward. Strengthen liquidity risk management and buffers A second key building block of our strategy is raising the bar on liquidity risk management and supervision. The Committee recently issued Principles for Sound Liquidity Risk Management and Supervision. This guidance sets a higher soundness standard for banks and supervisors to meet. We will put in place a process to ensure that the principles set out in the paper are implemented in practice. However, we also need to redouble our efforts to develop more consistent benchmarks for sound liquidity at global banks. This includes benchmarks for liquidity cushions, maturity mismatch, funding liquidity diversification, and resilience to stress. The mandate of the Committee’s Working Group on Liquidity has been expanded to deal with this next set of issues. Strengthening risk management practices A third area of high priority focus is on strengthening governance and risk management practices. Most of the risk management shortcomings revealed by the crisis related to the failure to implement the basics of firm-wide risk management. This points to weaknesses in governance at the top of the firm. What can we do differently in the future? First and foremost, it remains the responsibility of the private sector to take the lead in strengthening firm-wide governance and risk management frameworks. As far as supervisors are concerned, we are enhancing our supervisory tools and standards to reflect recent lessons, especially in areas like securitisations; management of contractual and noncontractual exposures to off balance sheet vehicles; stress testing and the management of firm-wide concentration; and sound valuations. We will be issuing additional guidance on these topics around the new year. We also need to do a much better job following up on our guidance in a coordinated global manner. Finally, we can use the leverage of Pillar 2 – the supervisory review process – to promote improvements in firm-wide governance, risk management, and controls, and to establish clear links to the assessment of capital adequacy. Pillar 2 also can be used to promote better alignment between long term risk management and control objectives and the incentives created by compensation schemes. Such coordinated supervisory follow up efforts will be critical to ensure that industry and supervisory sound principles are sustained when competitive pressures reassert themselves. Strengthening counterparty credit risk Another building block of the Committee’s strategy is strengthening counterparty credit risk practices. The Committee will review the treatment of this risk under the three pillars of Basel II to strengthen minimum capital, risk management, and transparency inside and outside banks. This effort can help individual banks and the system better withstand the failure of one or more major counterparties. It also can help contain leverage outside the banking sector, and it can reinforce efforts to strengthen the infrastructure for OTC derivatives, possibly using Pillars 1 and 2 as inducements. This forms part of a broader effort to assess the scope of regulation and oversight beyond the core banking sector. Strengthening bank resolution and the supervision of cross-border banks Let me also say a few words on our work to strengthen bank resolution practices and the supervision of cross border banks. The Committee’s Cross-border Bank Resolution Group is assessing key issues and global incompatibilities in the resolutions of global banking groups. This effort should strengthen supervisory understanding of the challenges that can arise when resolving a global banking institution and possible ways to manage through them more effectively. We also need to deepen the work of the Committee to promote effective supervisory colleges at cross-border banks, building on the extensive work of the Accord Implementation Group in this area. In practice, this means dealing with concrete issues like capital, liquidity and the division of responsibilities between home and host supervisors in good times and in stress. Strengthening the system-wide approach to supervision Finally, we need to strengthen the system-wide approach to supervision, another building block for our strategy. It is important that we move to embed institutional level supervision into a broader context that seeks to make the overall financial system more resilient to stress. The Committee, through its central bank and supervisory membership and outreach efforts, is in a unique position to translate broader concerns of central banks, supervisors, and others into concrete, coordinated bank supervisory and regulatory responses at both the national and global level. Focusing resources in this way can help make the regulatory, supervisory and risk management infrastructure more resilient to emerging pockets of stress in an environment of rapid innovation and change. There are a number of practical ways we can make this link. • One approach – that I talked about earlier – is the establishment of a capital framework that promotes strong buffers in good times and ways to dip into them in bad times. • Another is through coordinated global reviews to contain deterioration in global underwriting standards and to address imbalances in risk controls and business growth in competitive environments. • An assessment of gaps in global regulations and ways to correct them is a third way to strengthen a system-wide approach to supervision. • Assessing different ways to promote better risk management of participants in major payment systems, derivative markets, and clearing houses is another. • And finally, establishing stronger links between the objectives of central bank liquidity operations and liquidity regulation and supervision is another way to strengthen system-wide supervision. Conclusion Financial markets, individual firms and supervisors have all been severely tested by this financial crisis. We have put in place a comprehensive strategy to address the lessons as they relate to the banking sector, and we are well along in executing on it. Our efforts will strengthen capital and liquidity buffers; improve risk management practices; enhance transparency; and strengthen the supervision of banks and the system-wide approach to supervision. It is important to note that this is a longer term strategy. Some elements need to be tackled now while others will take more time. The Committee is mindful of the need to introduce these enhancements in a manner that promotes both near term confidence and longer term financial stability. | netherlands bank | 2,008 | 11 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the BCBS, at the 44th SEACEN Governors' Conference 2008 Preserving monetary and financial stability in the new global environment, Kuala Lumpur, 6 February 2009. | Nout Wellink: Supervisory arrangements – lessons from the crisis Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the 44th SEACEN Governors’ Conference 2008 “Preserving monetary and financial stability in the new global environment”, Kuala Lumpur, 6 February 2009. * * * When former US President Bush welcomed G20 world leaders in Washington last November to discuss the financial crisis, neither French President Sarkozy nor German chancellor Merkel had the honour of sitting next to him at the formal dinner. In fact, none of the Western leaders had. As a clear display of the shifting balance of economic power, President Hu Jintao of China and President Lula da Silva of Brazil sat either side of Bush. Evidently the world economic order is changing. Emerging economies are catching up with the developed world at great speed. As a result, preserving monetary and financial stability – the theme of this conference – is an ever more global challenge that requires global cooperation. The financial turmoil has underlined the importance of better coordination among public authorities at the international level. From the start of the crisis in August 2007, central banks across the world have engaged in large-scale coordinated actions to support liquidity conditions in the global money markets. More recently, national governments have acted to shore up the capital base of individual financial institutions. Regrettably, but understandably, they did so in a largely uncoordinated way. Given the many cross-border externalities that are involved, increased coordination of national measures is clearly desirable, be they capital injections or state guarantees. In spite of authorities’ efforts, uncertainty in the financial markets remains unusually high, and stabilizing financial systems is still our top priority. Nonetheless, it is not too soon to think about how we can prevent and mitigate future financial crises. Indeed, in light of weaknesses revealed by the financial crisis, the Basel Committee has developed a series of proposed enhancements to strengthen the Basel II framework. These enhancements will help ensure that banks’ risks, whether on- or off-balance sheet, are better reflected in minimum capital requirements, risk management practices and disclosures to the public. Another issue the Committee is currently addressing is procyclicality, or the possibility that regulatory requirements amplify an economic cycle. This is a difficult issue as there are a variety of factors at play – such as loan loss provisioning – that influence procyclicality. And, we should not forget that banking tends to be a cyclical business irrespective of regulatory requirements. Nonetheless, the Basel Committee has begun a comprehensive review of the potential procyclicality of the Basel II framework. The objective is to promote adequate capital buffers over the credit cycle and to mitigate the risk that the minimum capital requirement magnifies the procyclicality of the financial system. Under discussion are ways to promote a high quality Tier 1 capital buffer that banks would increase in good times and be allowed to use in difficult times. Supervisors are also reviewing the need to supplement the current risk-based approaches with simple, transparent gross measures of risk. This would constrain the amount of leverage banks could have in good times and therefore also contain the degree of deleveraging in bad times. Let me now turn to lessons that can be drawn from the financial crisis with regards to supervisory arrangements. Over the past one and a half years supervisory arrangements around the world have been put to the test. These real stress tests have provided us with important insights into the pros and cons of different supervisory arrangements. And, though there is no single optimal supervisory arrangement, three lessons can be drawn. First, as macroprudential supervision and microprudential supervision strongly overlap, central bankers and prudential supervisors should cooperate closely and continuously. Second, financial supervisors need to step up international cooperation, simply because the financial industry is particularly internationalized. Third, while prudential and conduct of business supervision are distinctly different, they are complementary and should both receive due attention. Separating prudential and conduct of business supervision institutionally helps to keep both supervisory goals in clear sight. As financial sectors today are more concentrated, more integrated and more exposed to the financial markets than ever before, problems at individual institutions are increasingly likely to have systemic consequences. Indeed, during the financial crisis we saw several examples, most notably the collapse of Lehman Brothers in September 2008 which had a truly systemic impact. These events have demonstrated that the distinction between macro- and microprudential stability is hypothetical in practice. Therefore, there is an urgent need for close and continuous cooperation between macro- and microprudential supervisors, of course with due observance of the relevant legal provisions. Such cooperation can be achieved in different institutional settings. Also when the central bank plays no role in microprudential supervision, extensive micro-macro cooperation can be and in fact should be organized. The need for effective interplay between central banks and supervisors is particularly pressing in times of crisis. In the Netherlands, increasing cooperation was relatively straightforward, because DNB has both central banking and supervisory functions under one roof. To the best of my knowledge, the same holds for most SEACEN central banks. In response to the crisis, several working groups have been established within DNB, bringing together supervisory and central banking expertise to work on multifaceted problems. One particular multidisciplinary challenge concerned the recent capital injections by the Dutch State. To determine the amount of capital that needed to be injected in well-known financial institutions like Aegon and ING, we were able to draw on the extensive expertise available in our organization. Another example of information-related synergies concerns liquidity. During the crisis, supervisory information on the liquidity arrangements, sources of funding and financial position of Dutch banks proved essential in obtaining a clear picture of their liquidity pressures. Note that the information synergies have also worked the other way round. Insight into financial market developments and information from payment systems and monetary policy operations have been extremely valuable for the performance of supervisory tasks. Contacts with major, market-leading intermediaries have also been useful for producing timely and meaningful information on major trends and sentiments in the financial system. While cooperation between central bankers and prudential supervisors naturally intensifies in periods of financial stress, more cooperation is also desirable in boom times, when the seeds for later bursts are sown. When confidence levels are high and perceived risk levels are low, authorities should act to mitigate the build-up of systemic financial vulnerabilities. In the past we have been pretty good in analysing risks to financial stability. We have failed however in effectively translating our analyses into concrete risk-mitigating actions. Indeed, we have been aware of large global imbalances for some time. But little was done about it. While global macroeconomic conditions are not at the origin of the crisis, they have contributed to it. Related to this, I believe that the macroprudential orientation of regulatory regimes, notably that of the Basel II framework, needs to be enhanced. Tight supervision of individual financial institutions will certainly remain crucial, but supervisors will also need to devote resources to understanding interactions among financial institutions and linkages within the financial system at large. This includes understanding how banks’ major business lines are linked into the broader credit intermediation process and where pockets of risk concentrations may be emerging in the financial system. A more comprehensive approach to supervision and regulation will enable supervisors to focus their limited resources on those activities that contribute most towards counteracting the build up of risk in the banking system. In setting our goals however, we must be realistic. It is not realistic to believe that we can prevent financial crises completely, as crises are a fact of life. What we can do is create a more resilient financial system, thereby decreasing the frequency and severity of financial crises. Since financial institutions and systems are part of an integrated global financial system, we need to go beyond more micro-macro cooperation at the national level. In this respect, it is encouraging that the FSF and IMF will intensify their cooperation at the global level, each complementing the other’s role. The IMF will report on its monitoring of financial stability risks to FSF meetings, and in turn will seek to incorporate relevant FSF conclusions into its own bilateral and multilateral surveillance work. A similar initiative is envisaged at the European level, where the European System of Central Banks Banking Supervision Committee and the Committee of European Banking Supervisors (CEBS) will intensify cooperation. Supervisors will also need to step up their cooperation. In line with the recommendations by the Financial Stability Forum, so-called colleges of supervisors have been established for several major cross-border financial groups. These colleges include all relevant supervisors and promote cooperation on ongoing supervisory issues. DNB is currently chairing global supervisory colleges for Aegon and ING. In fact, only two weeks ago, we hosted the ING college in Amsterdam. Colleges of supervisors are also promoted on the European level. In response to the growing integration of Europe’s banking industry and to the specific nature of trans-national banking groups, ECOFIN Finance Ministers have called for the set-up of colleges of supervisors. Furthermore, the European Commission has set up a “high level” group headed by former Bank of France Governor Jacques de Larosière, to bring forward ideas on strengthening EU financial supervision. There are two possible outcomes. Either cooperation will intensify gradually – building forth on existing institutions such as CEBS –, or cooperation will intensify abruptly – creating a European Financial Supervisory Authority. More will be known shortly, as the De Larosière group is set to give its first advice next March. Let me now turn to a third lesson from the crisis, which is related to the difference between prudential and conduct of business supervision. While prudential supervisors’ main concern is the safety and soundness of financial institutions, conduct of business supervisors first and foremost strive for a fair and transparent market. Undeniably both types of supervision are important and in fact they are generally reinforcing. Let me give an example to illustrate this. In the United States, home loans were extended to very risky borrowers, with little or no income and few, if any, assets. From a conduct of business perspective, these US consumers were not treated fairly. Had this practice been stopped in time by the relevant conduct of business supervisor, we would have fewer problems now. Unfortunately practice did not stop, but rather worsened. And now these US mortgages are awfully problematic from a prudential point of view. That being said, prudential and conduct of business supervision can also be conflicting. Prudential supervisors work most effectively behind the scenes. This contrasts with conduct of business supervision, which benefits from being in the public eye. Publicity helps to warn off consumers, investors and the industry from misconduct and wrongful practices. If both types of financial supervision are exercised by the same organization, there is the risk that an inappropriate balance is struck. Therefore, in integrated supervisory authorities, arrangements can and should be made to ensure the necessary amount of resources is allocated to both types of supervision. Establishing such arrangements, however, can be rather challenging in practice. Indeed, a key finding of the UK FSA’s internal audit review in light of Northern Rock was that too many resources had been allocated to conduct of business supervision, and too few to prudential risks. In the Netherlands, and also in Australia, the danger that either prudential or conduct of business supervision will be overlooked has been addressed institutionally. In our objectivebased supervisory arrangement, prudential and conduct of business supervision are performed by two separate institutions. The former type of supervision is the responsibility of DNB; the latter is the remit of the Dutch conduct of business supervisor, the Authority for the Financial Markets. Consequently, our institutional set-up leads to a transparent consideration of prudential interests on the one hand and conduct of business interests on the other. Let me give a clear example to illustrate this point. Some years ago a Dutch subsidiary of a foreign bank had neglected its duty of care. From a conduct of business perspective, the bank had to be penalized for this. It was clear, however, that this would entail the end of the bank. Therefore, DNB had extensive talks with the Authority for the Financial Markets on this issue, as interests clearly conflicted. These talks ultimately led to the consideration that the bank had to be penalized for not being compliant with conduct of business regulations, as long as this would not endanger the stability of the financial system. An objective-based setup thus promotes a transparent consideration of interests. In addition, linking the regulatory objectives to the supervisory structure also improves supervisory efficiency. In particular, a major advantage of objectives-based supervision is that responsibilities are consolidated in areas where natural synergies take place. While prudential supervisors focus on risks and the management of risks, conduct of business supervisors concentrate their efforts on disclosure issues and sales and marketing practices. Confidence in objective-based supervision has been supported by the US Treasury Blueprint for a modernized financial regulatory structure, which states “an objective-based regulatory approach would represent the optimal regulatory structure for the future”. Let me conclude. I began my speech with the changing world economic order. Indeed, the balance of power is shifting. Emerging economies will produce and consume an increasing share of world economic output. With more economic and political power comes more responsibility. In this respect, the increasingly active role of emerging countries in addressing global problems is encouraging. One important challenge we all face now concerns global financial stability. To promote financial stability now and in the future, cooperation between macroprudential supervisors and microprudential supervisors should be strengthened. Especially when the good times return – and they will – this will prove challenging. The international cooperation between financial supervisors should also intensify, as the current financial crisis has clearly shown. Regarding the different objectives of financial supervision, recent experiences have reinforced the arguments in favour of objective-based supervision. | netherlands bank | 2,009 | 2 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the FSI High Level Seminar, Cape Town, 29 January 2009. | Nout Wellink: The future of supervision Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the FSI High Level Seminar, Cape Town, 29 January 2009. * * * I would like to share with you my views on the future of supervision. Even though we are still in the midst of a financial crisis and the situation continues to evolve, it is not too early to assess some of the lessons for supervisors learned from the crisis so far. I have a sense that the broad direction of supervision in the future will be “back to basics”. In light of the lessons learned over the past two years, setting a strong foundation for supervision is becoming more important than ever. I would like to discuss the initiatives taken by the Basel Committee to help establish this sound basis for supervision, risk management and capital adequacy, as well as implementation of sound standards over the long run. I would like to start, however, with the basics, and for the supervisory community this means the Core Principles for Effective Bank Supervision. Core Principles for Effective Bank Supervision The Core Principles represent the basic philosophy of banking supervision, the foundation on which any strong supervisory function is built. In 2006 the Committee updated the Core Principles and their assessment Methodology to make sure that they reflected the changes in the global banking environment. A number of glaring risk management deficiencies during this crisis were lapses in some of the fundamental principles of governance and risk management. The Committee certainly cannot claim to be prophetic in stressing these fundamentals – failure to adhere to the basics is often at the core of banking problems in most crises. Let me give you a few examples of the Core Principles’ relevance in light of lessons learned from the crisis. One of the revised Core Principles stresses the importance of sound corporate governance and the essential need for strong risk management processes. The guidance states that a bank’s board must have, collectively, a sound knowledge of the activities undertaken by the firm. This collective familiarity among the boards of some of the largest banks was strikingly absent. Another revised core principle discusses the importance of high quality risk management information that should be reviewed regularly by the board and senior management. This includes the ability to understand the implications and limitations of such information. Yet another example: proper risk identification and evaluation, that is, the ability to know what your firm-wide exposures are in the first place so that they could be managed and controlled effectively. In this regard, the assessment criteria concerning credit risks were revised to make clear that they include counterparty risks associated with various financial instruments. Before we look to see what the future holds for risk management or supervision, it is essential that bankers and supervisors first make sure that a sound foundation is firmly in place. For supervisors, this foundation is the core principles. Current areas of supervisory focus Let me now say a few words about weaknesses that came to light during the crisis and which are likely to influence bank supervision in the future. The first of these relates to the need for supervisors to take a broader system-wide approach to regulation and supervision. While strong supervision of individual banking institutions remains essential, supervisors need to devote more resources to understanding interactions among banks as well as between the banking sector and other financial sectors. The Basel Committee will be exploring the practical ways to implement such a “macroprudential approach”. This more comprehensive approach to supervision and regulation will help reduce systemic risk more broadly. It will also enable supervisors to focus their limited resources on those supervisory and regulatory activities that contribute most towards making the domestic banking and regional financial system more resilient to stress. Another topic of high interest relates to “regulatory gaps”. The crisis has revealed that nondeposit taking institutions could be a major source of systemic risks. The first step for financial sector supervisors is to identify any regulatory gaps in their financial systems. The next is to employ the suitable supervisory response, which may range from traditional prudential tools, such as capital requirements, to enhanced disclosure and transparency. We need to take a fresh look at these issues so that the activity of the unregulated or underregulated players – such as mortgage brokers, mortgage companies, hedge funds or others – are subject to adequate oversight commensurate with their potential to pose systemic risk. This in turn will reduce pressure on the core banking sector and help prevent a lowering of bank standards or practices in good times. The question of whether or to what extent supervision is necessary is a difficult one. To give one example relative to this region, the Basel Committee has already started to reflect on the supervision of deposit-taking, microfinance institutions. We recognise that some of these institutions may be regulated differently from banks as long as they do not hold, in the aggregate, a significant proportion of deposits in a financial system. But at the same time, these organisations need some form of regulation commensurate to the type and size of their transactions. Through the Committee’s International Liaison Group, we are working on illustrating what forms regulation can take, keeping in mind the diversity of the sector. A third area of supervisory focus relates to cross-border cooperation. This is not a new area – the Committee was founded to promote cross-border coordination and cooperation. We recently completed a preliminary review of issues associated with the resolution of complex global banking organisations. This showed that existing national crisis management and resolution arrangements are not designed to deal specifically with cross-border banking crises. The Committee will deepen its analysis of the current crisis and the implications for resolving individual and groups of banks having cross-border operations. We will continue to promote pragmatic information sharing and the use of supervisory colleges to ensure that there are no gaps in the supervisory framework of banks during both normal times and periods of stress. Capital adequacy The crisis has shown that a strong capital base is critical to bank resilience and broader financial stability. The Basel II capital framework remains a top priority for the Committee as it provides incentives for banks to improve their firm-wide governance and risk management. Basel II should also help improve the quality of supervision and enhance market discipline. As you may know, the Committee recently issued a package of consultative documents to strengthen the three pillars of the Basel II capital framework. The enhancements we have proposed for the Pillar 2 supervisory review process should help strengthen the basics of risk management and supervision. Among other things, the supplemental guidance covers some basic governance issues that were found lacking during the crisis. The need for firm-wide governance and risk management is one example. There have been some very helpful initiatives from the private sector, such as from the IIF and the CRMPG, that aim to strengthen risk management. Pillar 2 plays a critical role in helping supervisors ensure that these efforts are in fact implemented over the long term. Another issue the Committee is currently addressing is procyclicality, or the possibility that regulatory requirements amplify an economic cycle. Procyclicality is a difficult issue as there are other factors at play – such as valuation practices, loan loss provisioning or margining practices – and banking tends to be a cyclical business irrespective of regulatory requirements. More generally, human behaviour is inherently procyclical. Failure to adequately capture risk and other unexpected developments – risk concentrations is one example – can contribute to procyclicality. This is why the move to Basel II is so important. Improving the coverage of exposures, like liquidity lines to off-balance sheet conduits, will reduce the risk that surprises in risk management and capital adequacy cause a retrenchment at the worst possible time in the cycle. With these difficult issues in mind, the Basel Committee has begun a comprehensive topdown review of the potential procyclicality of the Basel II framework. We need to retain the benefits of risk-sensitivity and differentiation across institutions. But we also need to mitigate the risk that excessive cyclicality of the minimum capital requirement magnifies the procyclicality of the financial system. The Committee is evaluating a range of measures that would help address procyclicality but could also have a countercyclical influence. For example, we are looking at ways to promote a high quality capital buffer that a bank would increase in good times and be allowed to dip into in difficult times. Also under discussion is the use of a simple, supplemental measure to reinforce the risk-based ratio. This could constrain the amount of leverage banks could have in good times and therefore also contain the degree of deleveraging in bad times. Sound standards and effective implementation Now let me say a few words about the importance of sound standards and, in particular, their implementation. Developing sound global standards in a thoughtful, inclusive manner is just the first step in the process toward the ultimate goal of better risk management and more effective supervision. The involvement of the wider supervisory community in developing sound global standards is a collective enterprise not limited to the 13 countries represented on the Committee: there are representatives from more than 20 other countries that participate directly in a variety of Basel Committee subgroups. The number of jurisdictions involved in the Committee’s work is even higher when taking into account those participating in their capacity of representatives of a larger group. A few examples I can point to include the Banking Commission of the West African Monetary Union, EMEAP in Asia, and the Association of Supervisors of Banks of the Americas – ASBA. The International Liaison Group – the ILG – serves as the Committee’s main channel to liaise regularly with senior non-member supervisors, the IMF and the World Bank. The West African Monetary Union and the South African Reserve Bank are members of the ILG. This approach is meant to be a two-way street: it is an efficient way for the Committee to get input from these regions as well as to disseminate information to the members. Even if all supervisors cannot participate directly in the work of the Committee, all are given the opportunity to comment before our products are final. The issues the ILG is currently working on were suggested by the non-Basel Committee members. These issues include risk-based supervision, provisioning and microfinance, which I touched on earlier. This helps the entire supervisory community to have a common understanding of the issues. The development of sound standards is only the first step and the critical next step is implementation. Supervisors must diligently implement the standards and consistently ensure that banks are adhering to and practicing the standards. This is another of the lessons learned during the crisis. Sound fundamental principles of credit and liquidity risk were not practiced. To help improve implementation of our sound guidance and standards, the Committee has broadened the mandate of the Accord Implementation Group. The new Standards Implementation Group (SIG) will continue to concentrate on issues relating to Basel II implementation but will also focus on all risk management guidance and standards. Conclusion I hope my remarks this morning have given you a sense of the direction in which supervision is moving. The stress witnessed over the past two years revealed major weaknesses in risk management or supervision that were not previously identified. There have certainly been a number of lessons that can already be drawn from this crisis. For supervisors, this includes greater focus on taking a system-wide approach to supervision and identifying potential regulatory gaps. It has also reinforced the Committee’s longstanding commitment to crossborder cooperation. The crisis has focused the spotlight on capital adequacy and strong liquidity and has spurred extensive consideration of ways to mitigate procyclicality. The financial crisis has also exposed many egregious examples where bankers have strayed from the basic principles of risk management and supervisors did not sufficiently follow-up to ensure implementation. Getting “back to basics” means banks and supervisors need to ensure risk governance and supervisory frameworks are underpinned by a strong foundation. In the case of supervisors, these are the Basel Core Principles. The crisis has reminded us of the importance of sound standards and has underscored that this must be accompanied by implementation and rigorous supervisory follow-up. | netherlands bank | 2,009 | 2 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the ELEC (European League for Economic Cooperation) event, Amsterdam, 6 March 2009. | Nout Wellink: Crisis intervention and policies – effectiveness and the need for coordinated action Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the ELEC (European League for Economic Cooperation) event, Amsterdam, 6 March 2009. * * * I am not telling you anything new if I say that the global financial system is ill, severely ill. Being ill is a concern, but in itself no cause for alarm. This time, however, there is something special about the state of the global financial community. Bank by bank, sector by sector, and country by country have been infected. The current financial crisis is much like a flu epidemic. A flu epidemic is by definition drastic and difficult to fight. Sometimes, the only option is to let the epidemic rage and focus on damage control, through intense coordination between the different emergency services. Damage control and the need for joint action also apply to this financial crisis. Despite extraordinary measures taken by authorities, the engine of the global financial system is not working properly. Market conditions are still fragile and banks’ access to key markets remains problematic. Banks face ongoing pressure to deleverage by shrinking their balance sheet and reducing credit supply. The financial system has great difficulties in fulfilling its role as intermediator. Banks’ own crisis management focuses on reducing exposure to risky assets, securing more stable funding and increasing capital. That is important, but insufficient to tackle the crisis. In the meantime, more and more economies are in recession. So the challenge to recover from the most serious financial crisis since the 1930s is immense. In this setting, I will discuss the recent interventions and their effectiveness, and the shortcomings in cross-border coordination. Most authorities have taken a host of measures to prevent the financial system from breaking down. We can distinguish four categories of support measures: 1) expansion of retail deposit insurance, 2) guarantees for bank liabilities other than deposits, 3) capital injections, and 4) purchases or guarantees of assets held by banks. These measures have been complemented by generous central bank liquidity provisions and policy rate cuts. To date, Australia, Germany, Spain, the United Kingdom and the United States and also the Netherlands have carried out all four measures. More than a dozen countries have adopted at least three of these measures. It is striking that most authorities prefer the same measure. In the Western world, three quarters of the countries have expanded their deposit insurance scheme and introduced guarantees for bank liabilities and capital injection programmes. Asset purchases were not very popular until recently, but have now been arranged by a number of countries. More recently, many countries have concluded that bank rescue measures alone will not be sufficient to address the financial crisis and hence should be complemented by fiscal stimulus packages. So far, fifteen countries have announced such packages in the order of 1-5% of GDP and China even announced a package of more than 10% of GDP. Despite the strong interventions, recovery of the banking system seems a long way off. So how effective are the interventions? Rather than risking a judgement while the crisis is still unfolding, I would like to stress that the resolution of the crisis is being complicated by its unique, international and complex nature. The crisis is unique in that it has presented new challenges to policymakers, such as the drying-up of securitisation markets, the simultaneous deterioration in banks’ ability to sell or fund assets, and the wave of involuntary re-intermediation of credits on banks balance sheets. The key challenge is that the unknown is by definition difficult to address and resolve. The crisis is international as it has a cross-border impact and affects all aspects of both the financial and the real economy. The right answer to this crisis is necessarily a global solution. But recent experiences have shown that the coordination of national responses to crossborder crises is problematic for at least three reasons. Burden sharing is politically extremely difficult. The mandates and objectives of authorities are still mainly organized along national lines and may conflict. And thirdly, there are potential conflicts between national resolution regimes. Complexity and interdependencies within cross-border groups aggravate this. The crisis is complex because it was triggered by innovative and intransparent products and markets. The lack of adequate information has raised uncertainty and complicated crisis resolution. The crisis has become a fast moving target, especially since it is increasingly interacting with an economic recession. Due to the unique, international and complex nature of the crisis, its resolution has been a continuous learning process for policymakers. Over the past 22 months, traditional crisis resolution frameworks have been only partially effective, and the crisis has uncovered some fundamental weaknesses. We need to be critical about the effectiveness of measures, to show flexibility amid changing circumstances, and continue to learn along the way. Let me illustrate this with three examples of advancing insights and lessons learned that have led to adjustments to, and extensions of, existing measures. Initially, authorities addressed the crisis with tailor-made rescue plans for troubled institutions. However, this piecemeal support failed to prevent a rapid erosion of market confidence, especially after the Lehman failure. Authorities reacted by adopting more systemic approaches to prevent bank failures. One example is the Troubled Asset Relief Program in the United States. Another is the common rescue framework adopted by EUcountries in October 2008. Under this framework, the EU countries committed themselves to fight the crisis through explicit government guarantees on retail deposits, guarantees for bank liabilities and capital injections. These programmes succeeded in halting the deterioration of confidence in the banking sector: bank CDS spreads narrowed across the board and reached a permanently lower level from the middle of October onwards. The lesson learned is that system-wide stress demands a systemic approach to reducing the risk of bank defaults. The learning effect is also true of government capital injections into banks. These measures have been much needed to avoid a collapse of the banking system. However, many of the capital injections have been eroded by rising losses on toxic assets. This has prompted a number of governments to announce asset purchase or guarantee programmes. Recapitalisation of troubled institutions is not sufficient unless authorities tackle the asset problem on banks’ balance sheets simultaneously. Central bank measures to address funding pressures by banks have also benefited from advancing insights. Initially, the ECB and other central banks resorted to existing tools to stabilize overnight interbank rates. But the need for longer-term funding operations to address bank’s general unwillingness to lend in term interbank markets quickly emerged. While central banks supported the money markets, the situation in the wholesale and debt funding markets became critical. Lending by non-bank financial institutions and across currencies also started to dry up. This prompted the introduction of new lending facilities, arrange currency swap lines between central banks and widen the range of counterparties beyond conventional frameworks. The lessons from this are twofold. First, during a prolonged liquidity crisis, central banks might need to shift their focus more towards nontraditional bank funding rather than just the money market. And second, when central banks are confronted with setbacks, they need to be pro-active to overcome those challenges. As I said, authorities implemented a number of policies to fight the pandemic. Some of those worked, others didn’t. However, each of the measures has its merits, and I would like to stress that their success or failure are a matter of hindsight. I believe authorities did their utmost in their response to the crisis at the beginning, given the challenges at that point in time. But it got worse, far worse, and new, more drastic measures were needed. That doesn’t prove that initial policies and measures were wrong. Rather, it illustrates the determination of authorities to fight this crisis. But it also shows something else, that fighting this crisis demands international coordination. At best, uncoordinated nationally implemented measures may be effective in solving national problems. But a number of those measures unintentionally triggered problems in other countries. The chain effect of raising the deposit guarantee scheme protection is a clear example. The introduction of higher levels of depositor protection triggered a flow of savings out of other countries, forcing other governments to implement similar policies. Coordination could have prevented negative side effects. Many of the policies implemented to fight this crisis carry the risk of economic nationalism. Uncoordinated national policies fail to take into account the complexity of the financial system. The interconnectedness of the financial world should have made it utterly unthinkable to act unilaterally. This does not just apply to measures targeting the soundness of financial institutions. In our integrated world any uncoordinated policy aiming to boost the economy, might cause negative externalities. However unintentionally, uncoordinated measures could spark a period of real protectionism. The net effect of such “beggar-thyneighbour” policies is a deepening crisis. Supranational authorities could and should play a bigger role. Enhanced coordination is not limited to governments, regulators or supervisors. During the financial crisis we saw several cases, most notably the collapse of Lehman Brothers in September 2008, which had a truly systemic impact. These events have demonstrated that the distinction between macro- and microprudential stability is hypothetical in practice. Both are necessary. Therefore there is an urgent need for close and continuous cooperation between macroprudential supervisors – central banks – and microprudential supervisors. To be frank, I don’t think the crisis is anywhere near its end. But I do think it is time to consider what shape an end to the crisis would take. Fighting this crisis has been tough. Reversing the implemented measures will require exactly the same coordination and determination. And reversing those policies isn’t going to be easy. The same national interests that drove the uncoordinated remedies to fight this crisis are at stake. At the end of the crisis, when it is economically justified to downsize those measures, economic nationalism will be lurking again, albeit unintended. At the end of the crisis we may enter a period in which governments cannot sell their stakes in banks or downsize the coverage of the insurances schemes, without the risk of putting their institutions at a comparative disadvantage to their protected peers abroad. It’s time to start thinking about a credible exit strategy. Again, coordination and timing are important. Selling or reducing stakes in banks too early could reduce investors’ and depositors’ faith in those banks. Getting out too late would cause a prolonged period of market disruption as institutions (partially) owned by governments are at a competitive advantage over privately owned banks. Prolonged government intervention hampers the healthy effects of competition. Normalization of the markets is far more difficult under those circumstances. Even if unintended and socially justifiable, substantial state interests in financial institutions is effectively protectionism. Guarantee schemes are a powerful tool to create confidence in banks and protect depositors, but the downside is that they stand in the way of market normalization. And the threat is not just that some governments may choose to maintain their policies longer than others. The terms and conditions of state withdrawal will materially affect a bank’s competitiveness vis-à-vis its peers. In other words, the level playing field is at risk. Everyone can rationally envision the problems of downsizing crisis policies, and the subsequent reluctance of governments to reverse nationally orientated measures. Especially if this puts their financial institutions at a comparative disadvantage. Since all governments are going to face this dilemma, the only way out is coordinated action. If we fail to coordinate towards the end of the crisis, distortions will emerge and some governments will keep substantial stakes in credit institutions for a long time. While I don’t say governments shouldn’t hold stakes in financial institutions, I think it is time to discuss the terms and conditions, including the exit strategy. Fighting this crisis has been a learning process. And I guess we are still on the steep part of the learning curve. We have definitely experienced that it can always get worse, and to be prepared for that. We have seen that measures labelled as “too drastic” may at some point become the appropriate response. And we have learned that you can’t fight a crisis like this on your own. By many standards this crisis has been, and still is, an extraordinary series of events. Its systemic and complex nature has revealed fundamental weaknesses in the crisis management of financial institutions, policymakers and supervisors alike. It is as if a new aggressive variety of the flu virus has suddenly emerged and is threatening our very existence. So, in the face of this pandemic, it is no surprise that we all had to improvise and to learn as we went along. Authorities have been creative in their responses and have shown great commitment in adjusting to new challenges. In the past few months national governments have acted to protect the interest of depositors of individual financial institutions. Regrettably, but understandably, they did so in a largely uncoordinated way. The crisis has shown that crossborder coordination remains problematic. While governments have emphasized the importance of joint action, initiatives to bring it about are lacking so far. International cooperation well beyond the current level is imperative if we are to put an end to this crisis. | netherlands bank | 2,009 | 3 |
Remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, before the Committee on Economic and Monetary Affairs of the European Parliament (ECON), Brussels, 30 March 2009. | Nout Wellink: Basel Committee initiatives in response to the financial crisis Remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, before the Committee on Economic and Monetary Affairs of the European Parliament (ECON), Brussels, 30 March 2009. * * * Thank you, Madame Chairwoman and members of the Econ Committee, for this opportunity to share with you the Basel Committee’s strategy and initiatives to respond to the present financial crisis as it relates to the regulation, supervision and risk management of the banking sector. The work of the Basel Committee is consistent with and supports the initiatives of the Financial Stability Forum and the Leaders of the G20. In formulating responses to the financial crisis, it is necessary to address both the near term challenges related to the weakening economic and financial situation and the long term regulatory structure issues. The two are linked and we need to manage carefully the transition from current measures to a more sustainable long term framework. With regard to the near term situation, it is clear that the banking sector has been at the heart of the adverse feedback loop between the financial and real side. We have moved from what I would call the mark-to-market and illiquidity phase of the crisis related to legacy assets to the fundamental credit cycle part of the crisis. This is associated with large write downs from corporate and retail lending books, and I believe this phase will continue to play out over the medium term. It is critical that supervisors have a comprehensive strategy to deal with both phases of the crisis and their associated impact on banks. That is essential if we are to restore stability to our financial systems and economies. When it comes to the long term, we need to establish a clear target for the future regulatory system which substantially reduces both the probability and severity of a crisis like the one we currently are working though. By providing clarity about the future regulatory framework, we will help re-establish near term confidence, reduce the risk of competitive distortions and limit the degrees of uncertainty for the public and private sector. Also, by emphasising that these reforms will be phased in over an appropriate horizon, we reduce the risk that our own actions contribute to procyclicality in the system. In this regard our plans are closely aligned with the views expressed in the de Larosière Group’s report. This group’s report has been strongly appreciated by the Basel Committee. Let me now say a few words about the steps the Basel Committee has and will be undertaking to produce a more robust supervisory and regulatory framework for the banking sector. Such a framework needs to have four key components: 1. Strong regulatory capital, 2. Robust standards for bank liquidity, 3. Enhanced risk management, governance and supervision, and 4. Better transparency I would like to say a few words about each of these components. Regulatory capital The Basel Committee, in a press release issued on March 12th following its recent quarterly meeting, underscored the importance of a strong capital base as a necessary condition for a strong banking sector. It stated that the level of capital in the banking system needs to be strengthened to raise its resilience to future episodes of economic and financial stress. The Committee will do this through a combination of initiatives, which I will describe momentarily. Our press release also noted that the Committee will review the regulatory minimum level of capital, taking account of these initiatives. Our objective will be to arrive at a total level and quality of capital that is higher than the current Basel I and Basel II frameworks and appropriate to promote the stability of the banking sector over the long run. This effort will be phased in over a time frame that will not aggravate the current stress. Building on the three pillars of the Basel II framework, we need to develop a more resilient capital framework that has multiple safeguards built into it. First, we need to improve risk coverage. One of the most procyclical dynamics has been the failure of risk management and capital frameworks to capture key exposures in advance of the crisis. For example, risks arising from securitisation activities – especially so-called resecuritisations – as well as certain trading book exposures were not sufficiently captured. I could also point to exposures to complex financial instruments that experienced severe declines in value because of impaired liquidity. The Basel Committee’s response therefore is to enhance the Basel II framework so that risks are more comprehensively and more accurately covered. Second, there needs to be a solid capital base backing these risks. We will achieve this by strengthening the quality, consistency, and transparency of the highest forms of Tier 1 capital. It must be based on a clear definition of capital that needs to be transparent and it must be global to ensure competitive equality. The Basel Committee already has a strong foundation for such a definition, namely common equity and reserves. We now need to deal with the many differences related to definitional issues, such as deductions from capital and the treatment of prudential filters. Third, we need to address procyclicality. Procyclicality is a complex issue and it is the product of many factors. At the most basic level, it is the result of animal spirits, which produce exuberant behaviour in the upswing of the cycle, and fear during the downturn. We cannot change this behaviour, but we can seek to dampen the channels through which it manifests itself. These include accounting and capital frameworks, liquidity regimes, risk management and compensation, margining, basic infrastructure, transparency, and the way supervision is carried out. In the case of the regulatory capital regime, we need to address any excess cyclicality in minimum requirements over the credit cycle while maintaining appropriate risk coverage and sensitivity. The Basel Committee has put in place a process to systematically assess the quantitative impact of Basel II on the level and cyclicality of capital. We will take appropriate steps if the results of our capital monitoring suggest the capital framework is unduly procyclical. But even more importantly, we need to build countercyclical buffers into capital frameworks and provisioning practices. This will help ensure that reserves and capital are built up during periods of earnings growth, so that they can be drawn down during periods of stress. The Committee is working to translate this important principle into a concrete proposal. The approach needs to have robust standards that can be applied at the global level and translated into national contexts. Finally, the capital framework needs to be underpinned by a non-risk based supplementary measure. This is particularly important as the Basel I-based floors are phased out. Just like we expect banks to manage to a variety of measures when they assess risk (such as net and gross exposures, VAR and stress tests), we as supervisors also must not constrain ourselves by evaluating risk through the lens of a single, risk based measure. We need the risk based measure to interact with a simple metric that can act as a floor and help contain the build up of excessive leverage in the banking system, one of the key sources of the current crisis. The Basel Committee is working to develop by year end a specific proposal in this area. Key principles guiding this work are that the measure must be simple and transparent, and it must address issues related to accounting differences and off-balance sheet exposures, among others. Finally, it needs to interact with the risk based measure in a prudent but sensible manner. Once these different streams of work are further advanced, taken together they will form the basis for the Committee’s assessment of the appropriate level of minimum capital that should be put in place over the long term. But whatever we do – and this gets back to my link between the near and long term – we must not raise global capital requirements in the middle of this crisis. Capital buffers are there to be used and we must provide a clear road map where we are headed. Liquidity Let me now say a few words about our work on liquidity. Capital is a necessary condition for banking system soundness but by itself is not sufficient. Of equal importance is a strong liquidity base. Many banks that had adequate capital levels got into trouble because they did not manage their liquidity in a prudent manner. In response to these shortcomings, the Basel Committee last September issued its Principles of Sound Liquidity Risk Management and Supervision. This was a significant step toward setting a new global soundness standard for what constitutes robust liquidity risk measurement, management and supervision. But this was only the first step. The next step is to monitor implementation of the principles and we have put in place a process to do just that. We also are developing benchmarks, tools and metrics that supervisors can use to promote more consistent liquidity standards for cross-border banks. Better risk management and supervision I have discussed the importance of having stronger global standards for capital and liquidity, but this is not enough. If firms have poor governance and risk management cultures or if supervision is weak, then we could again find ourselves with the types of problems we are now facing. We propose to build on Basel II’s supervisory review process – Pillar 2 – to raise the bar for risk management and supervision practices. This past January, the Basel Committee published for comment supplemental Pillar 2 guidance. The purpose of this guidance is to address the flaws in risk management practices revealed by the crisis, which in many cases were symptoms of more fundamental shortcomings in governance structures at financial institutions. The Committee will strengthen its supervisory guidance and the links to the Pillar 2 review process. It is focusing on firm-wide governance and risk management; capturing the risk of off-balance sheet exposures and securitisation activities; more effectively managing risk concentrations; and providing incentives to better manage risk and returns over the longterm, including compensation practices. Moreover, we need to move towards a macroprudential approach to supervision. What does this mean? In our discussions in the Basel Committee, we have emphasised the need to focus supervision not just on the soundness of individual banks but on broader financial stability objectives. This should inform where we focus our limited supervisory resources and how we develop our supervisory and regulatory tools. Transparency One of the main amplifiers of the crisis was the lack of transparency regarding the risk profile of institutions and structured products. Moreover, the process by which these products are valued often lacks rigour. Lack of transparency about the risk profile of products and financial institutions caused a massive retrenchment by investors and counterparties further amplifying the deleveraging process. To help mitigate this behaviour, the third pillar of the Basel II framework – market discipline – sets out a series of required disclosures that are intended to complement the other two pillars of the Basel II framework. This should allow market participants to assess capital adequacy of a bank through key pieces of information on the scope of application, capital, risk exposure and the risk assessment process. The Committee’s January proposals for enhancing Pillar 3 are focused on disclosures related to securitisation, off-balance-sheet exposures and trading activities. We believe that these proposed enhanced disclosure requirements will help to avoid a recurrence of market uncertainties about the strength of banks' balance sheets related to their capital market activities. Conclusion Taken together, the recent and planned initiatives of the Basel Committee should promote a more robust banking sector and limit the risk that weaknesses in banks amplify shocks between the financial and real sectors. Because our measures are far reaching and ambitious, they will need to be phased in over a reasonable timeframe. I should also note the invitation to join the Basel Committee that we have extended recently to the BRIC countries – Brazil, Russia, India and China – as well as Australia, Korea and Mexico. The expansion of our membership will help enhance the global reach and acceptance of our standards. The efforts of the Basel Committee need to occur in a broader context of achieving the right balance between the scope and depth of regulation. Failure to produce adequate regulation for other "bank like" activities means that we in the banking sector will just be “pushing on a string”, and the activity will simply migrate elsewhere. I therefore strongly welcome the activities of other bodies like the G20, the Financial Stability Forum and the Joint Forum to ensure that all sectors are subject to an appropriate degree of regulation, oversight or transparency commensurate with their systemic significance. The Committee will actively contribute to these other efforts Finally, Madame Chairwoman, I would like to thank you and the ECON Committee for holding this important meeting. The official sector is at a critical juncture and the actions we take in response will have a far-reaching and long-lasting effect. | netherlands bank | 2,009 | 3 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the 37th Economics Conference, Vienna, 14 May 2009. | Nout Wellink: A new structure for European and global financial supervision Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the 37th Economics Conference, Vienna, 14 May 2009. * * * Introduction Reporters repeatedly ask me about my thoughts on the economic downturn. How protracted will the economic recession be? Will there be prolonged deflation? These are valid questions – questions we have all been asking ourselves over the past months. Fundamental questions about what we learn from this crisis are less frequently asked, yet these are exactly the questions we should be asking ourselves now. The organisers of this long-standing, excellent economics conference understand that all too well. Today and tomorrow, we will go beyond the crisis and look at the economic policy agenda for the years to come. This morning, I present my views on the appropriate structure of European and global financial supervision. I restrict myself to the institutional lessons to be learned and the institutional challenges to be tackled. European perspective Starting from a European perspective, for some time now there has been widespread agreement that the existing institutional set-up in Europe is unsustainable. The ongoing crisis has strengthened this view considerably. While large European financial institutions are cross-border in nature, the supervisory system in Europe clearly is not. Financial supervision remains the remit of national member states. Differences in financial supervisors’ national mandates threaten the level playing field in Europe. And because financial supervisors operate under strictly national incentives, information-sharing and cooperation between them has not been sufficient. Up to now, macro-prudential supervision, which is aimed at limiting the frequency and severity of financial distress, has not only been too weak in Europe, but also too decentralised. This stands in contrast with other policy areas, in particular monetary policy, where decision-making is centralised and based on a much stricter analytical footing. Finally, most European central banks have published macro-prudential risk warnings. These have been ineffective, however, as has been painfully revealed by the crisis. We have learned that such warnings are not effective unless they are translated into action and that we need to pay more attention to system-wide risks. In light of these and other lessons, a high-level group chaired by Jacques de Larosière recently made specific proposals on the structure for financial supervision in Europe. According to the De Larosière group, a European Systemic Risk Council should be set up to strengthen macro-prudential supervision. Likewise, the group recommends establishing a European System of Financial Supervisors to strengthen micro-prudential supervision. I would like to express my support for a quantum leap with respect to financial supervision in Europe, taking the De Larosière report as the starting point. Recommendation ESRC Let me begin with their proposal for a European Systemic Risk Council, a body that would be in charge of performing macro-prudential supervision, issuing risk warnings and giving recommendations on policy measures. While the idea of such a Risk Council is broadly welcomed, it also has encountered criticism. There have been comments on the Council’s suggested mandate as well as on its institutional design. Regarding the suggested mandate, there is the notion that the Council should refrain from giving binding macro-prudential policy recommendations. While the key pillars of macroprudential supervision are regulation, financial supervision, and monetary and fiscal policy, the Risk Council itself has no responsibility for these tasks, nor any decision-making powers. However, what the Risk Council can and actually should realise is better macro-prudential analysis at the European Level. It should communicate its findings to the competent bodies and monitor the follow up by the relevant authorities. Let me now be a bit more specific. First, we have to come up with a clear definition of macro-prudential analysis. Only when we have agreed on the definition of macro-prudential analysis can we determine the scope of the Risk Council’s mandate. Ideally, the Council’s mandate would be broad. After all, the areas determining system-wide risk are widespread. To be effective, macro-prudential analysis should not be limited to current risks but also examine the systemic impact of general developments in financial innovation, financial regulation and market design. Moreover, the Risk Council should be able to identify how risks are distributed in the financial system, evolve over time and can be amplified within the financial system and by interactions between the financial system and the real economy. The Risk Council should therefore have access to the necessary information, although there are constraints to information-sharing. For instance, sharing firm-specific data could prove problematic. Unfortunately, exactly this type of information is essential to macro-prudential supervisors. Firm-specific data allows for better analysis of the magnitude and distribution of key risks and also provides insight into the inter-linkages between different financial institutions. So, in the interest of macroprudential analysis, we have to find a workable solution to firm-specific data sharing at the European level. Crucial in the whole process is the translation of the macro-prudential risk analysis into Risk Council conclusions. Contrary to what the De Larosière group proposes, these conclusions cannot – for reasons of governance – be binding. For the Council conclusions to be effective, it is important that these are clear, concise and directed to the relevant authorities, such as individual supervisors and Member States but also European bodies like the Council of Ministers and the future European System of Financial Supervision. Needless to say that the Risk Council should monitor and evaluate the follow up given to the Risk Council’s conclusions. The Risk Council should be entitled to give its opinion on the measures taken, if necessary on a confidential basis. The second criticism of the Risk Council is of a more institutional nature. Regarding the composition, a complaint is that EU central banks will be overrepresented and EU supervisors will be underrepresented in the Risk Council. Frankly, I agree. Inviting ECB General Council members to sit on the Risk Council, while national supervisors are only represented by the three presidents of the Supervisory Authorities makes the balance uneven. Equally important is that this proposal does not do justice to the importance of supervisory information for macro-prudential analysis and underestimates the importance of a real dialogue between central banks and active supervisors. However, with more than 50 national supervisors in the EU, it is important to strike a balance between participation of supervisors and the effectiveness of the Risk Council. If membership is extended to national supervisors we can perhaps involve them on a rotation basis. It goes without saying that the chairs of the European level three committees (the future Authorities) should become full and permanent members of the Risk Council. An issue to address is whether the national supervisors should have voting rights. Here I hesitate; after all, macro-prudential supervision is the primary responsibility of central banks. This brings me to the choice for the ECB president as chairman of the Risk Council. Noneuro area EU countries have opposed this, as it would exclude the possibility that one of their representatives would chair the Risk Council. However, I am still of the opinion that the ECB president is best positioned in the EU to chair the Risk Council. Third, there is also still lack of clarity on the working procedures of the Risk Council, including the preparation of its meetings. Here, I see a role for the Banking Supervision Committee, at present an ESCB body, composed of EU central banks and financial supervisors. The Banking Supervision Committee can only play this role if its mandate and composition are changed. The mandate of the BSC would be to present clear risk analyses to the Risk Council, even if controversial. The cross-sectional dimension of the financial system also pleads for expansion of BSC membership to include supervisors of insurance, securities and pension firms. This could be achieved through participation of one representative of CEIOPS and CESR, similar to the current participation of CEBS. Recommendation ESFS The De Larosière group has also given advice on how to address shortcomings in the microprudential supervisory structure. In this respect they propose to set up a European System of Financial Supervision, being a network of national supervisors and so-called European Authorities. These European Authorities would be the successors of the current Level 3 Committees CEBS, CEIOPS and CESR. The Authorities would continue to perform all the functions of the Level 3 Committees but, in addition, would carry out a number of specific new tasks. As there are many, I will not go over them one by one. The crucial point is that these new tasks would bring about a transfer of decision-making powers from the national to the European level. Notably, the group advises the European Authorities to have binding mediation powers in case of cross-border disputes between national supervisors. I fully agree with the group that stronger cross-border supervision in Europe is highly desirable. In fact, I would be in favour of even more far-reaching proposals towards supranational supervision in Europe. But only if the necessary requirements for such a historical move are fulfilled. The most important requirement concerns the issue of burdensharing. Indeed, the Achilles' heel of this part of the De Larosière report is that too little is said about this central issue. Before we can transfer decision-making powers to the international level, we really should first agree on burden-sharing arrangements. So the advice on the European System of Financial Supervision is not sufficiently balanced. I see two solutions to this. One is to decide on EU burden-sharing arrangements, which is of course easier said than done. The other, second-best solution would be to strive for the time being for less decision-making powers at the European level than has been suggested by the group, and working hard on solutions for the burden sharing issue. I am in favour of burden-sharing arrangements at the European level, though fully aware of all the difficulties involved. But if the end goal is European supervision for pan-European financial institutions, there is no alternative. For burden sharing arrangements to be credible, they should be legally binding and preferably enshrined in the Treaty. It is a misconception that effective burden-sharing arrangements can be made in Memoranda of Understanding. Burden-sharing arrangements should also be incentive-compatible. To this end, a mix of general and specific burden-sharing is preferable. Under an arrangement of general burdensharing, all member states contribute proportionally, e.g. to the size of their economy, implying a partial transfer of budgetary responsibility to the EU level. This makes sense, since the stability of the European financial system is a public good and of benefit to Europe as a whole. The proportion of general burden-sharing should be kept relatively low however, as it involves cross-border fiscal transfers. This explains why specific burden-sharing arrangements are also needed. Under such arrangements, only the countries confronted with a financial institution in difficulty contribute. Firm-specific arrangements give member states the right incentives to perform their supervisory duties well. Although a decision on burden-sharing is a necessary condition for a fundamentally new European supervisory structure, we can still make progress without it. In this respect I envisage grey and white areas. White areas refer to tasks that should be performed at the EU level. These tasks include the licensing and supervision of EU-wide institutions, such as credit rating agencies and platforms for over-the-counter derivatives. It is also conceivable that the Lamfalussy process can be further streamlined by transferring certain decisionmaking powers to the Authorities. Close to the white areas, there are grey areas, which relate to tasks that can be transferred to the European level, but only if certain requirements are fulfilled. For instance, under the strict requirement that the confidentiality of supervisory information is guaranteed, the supervisory Authorities could be given the competence to send binding information requests to national supervisors. One last point I would like to make about the new micro-prudential supervisory structure relates to its sectoral design. The group’s advice to start with sector-specific Authorities should be reconsidered. The distinctions between financial sectors and products have become blurred, which makes a sector-based supervisory approach less effective. Indeed, the trend in national supervisory structures is towards cross-sectoral supervision. The new European supervisory structure should follow this trend and therewith reduce the risk for supervisory underlap and overlap. Turning to global perspective So far I have discussed the challenges and trade-offs involved in transforming the supervisory structure in Europe. While necessary, this is not a sufficient step and more needs to be done. The global nature of the crisis underlines that the financial stability of Europe also depends on the quality of financial supervision outside Europe. Let me briefly raise just two key issues regarding international supervision that warrant further attention, without going into detail. Scope of supervision The first issue is the scope of financial supervision, which should be broadened. Key players in the international financial arena, such as credit rating agencies, hedge funds and credit counterparties, are not or only very lightly supervised. Yet, the crisis has demonstrated that their activities could pose system-wide risks, either directly or by triggering excessive risktaking behaviour by financial institutions. Some form of supervision of these institutions is therefore legitimate. But this task won’t be easy as some hurdles are hard to overcome. The European Commission has taken steps to supervise credit rating agencies in Europe. As I mentioned, it appears logical to license and supervise such agencies at the European level. However, given that credit rating agencies are globally active, a global approach may be even more effective. The proposals of the European Commission constitute a first and necessary step towards global supervision of credit rating agencies in the years to come. With regard to hedge funds, it is beyond dispute that they may under certain circumstances have a destabilizing influence, although they did not trigger the present crisis. As indirect supervision of hedge funds, via their regulated counterparties, has proven less effective in limiting the risks these entities pose, direct and tighter supervision of hedge funds is needed. In this respect, the Commission’s recent proposal on a regulatory and supervisory framework for hedge funds and other alternative investment managers can be welcomed. Note however that supervision on hedge funds is complicated by the lack of an encompassing definition of hedge funds and the risk that these entities will move to places with a more hedge fund friendly regime. The first logical step is to register hedge funds, to force them to report on developments in core financial indictors and open positions in excess of certain thresholds and to subject hedge fund managers to a fit and proper test. The second issue concerns the need to improve the cooperation among supervisors. Under the auspices of the G20 quite a few global colleges of supervisors have been established to foster international cooperation between supervisors. It is expected that more global colleges for significant cross-border firms will become active in the near future. While colleges are a sensible approach to dealing with the global nature of the financial industry, they have their limitations, especially in a global context. In contrast to EU colleges, global colleges have no legal basis, and this hampers supervisory cooperation and information-sharing. DNB currently chairs two global colleges. In these colleges we provide for several IT tools to encourage as much information-sharing and cooperation as possible, provided that the confidentiality of supervisory information is assured. Conclusion Ladies and gentlemen, let me conclude. The crisis has reminded us all too well that a new structure for financial supervision in Europe is urgently needed. In a European context, the proposals of De Larosière group are a good point of departure, though specific amendments are required. At the end of May, the European Commission will present its reaction to the De Larosière group proposals. I will give our present position. To improve macro-prudential supervision, the European Systemic Risk Council should be set up as soon as possible. Open issues about its mandate and institutional design should be resolved. Regarding microprudential supervision, I am in favour of more centralised European decision-making, but only if the necessary requirements for such a leap forward are fulfilled. The central issue we need to settle on is burden-sharing at the European level. In a global context, the scope of supervision should be broadened and include all financial systemically-relevant institutions. In line with the G20 declaration, the functioning of colleges of supervisors should be supported. | netherlands bank | 2,009 | 5 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Conference on The Core Principles for Effective Deposit Insurance Systems, Basel, 23 September 2009. | Nout Wellink: Core principles for effective deposit insurance systems – where do we stand? Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Conference on The Core Principles for Effective Deposit Insurance Systems, Basel, 23 September 2009. * * * Introduction It is my pleasure to address this joint conference. As you know, the Core Principles for Effective Deposit Insurance Systems were developed jointly by IADI, the International Association of Deposit Insurers, under the excellent leadership of Marty Gruenberg, and the Basel Committee on Banking Supervision. These two bodies, together with the Financial Stability Institute, organised this conference in order to promote the Core Principles and to contribute to their implementation and further development. Last July, the world commemorated the 40th anniversary of the man-on-the-moon. When Neil Armstrong set foot on the moon 40 years ago, he spoke the famous words “That’s one small step for man, one giant leap for mankind”. Last June, the Core Principles for Effective Deposit Insurance Systems were published. Admittedly, these are different works and I would not dare to put the Core Principles on par with the moon landing and the various countries’ space programs. Nevertheless, the Core Principles are a milestone in regaining financial stability after the current crisis. The question is: where do we stand? Recent events The recent crisis that started in Summer 2007 reminded the wider public once again that banks are susceptible to problems of insolvency or illiquidity. Northern Rock was one of the first victims, following problems in the mortgage credit markets. Once its problems became publicly known, a classical bank run occurred with many customers queuing outside Northern Rock’s branches to withdraw their savings. After the Northern Rock episode, the consensus emerged that deposit insurance systems with low levels of coverage, partial insurance and likely delays in repayment, are not effective in preventing a bank run. One year later, in September and October 2008, this insight became topical once again. The financial turbulence, it was feared, could develop into an international financial crisis as severe as the Great Depression in the 1930s. In several jurisdictions, bank customers were reportedly shifting their deposits to the perceived safety of other banks or instruments. Policy makers had no choice but to respond. Some authorities stated publicly that all bank deposits would be safe or that deposit insurance coverage would be unlimited. Elsewhere, the maximum level of deposit insurance coverage was raised, at least temporarily, or coinsurance arrangements were withdrawn. In some countries without explicit deposit insurance arrangements, these were introduced. All measures were taken to regain and rebuild the public confidence in individual banks and the banking system. In the end, these actions were successful and retail bank runs were mostly avoided. These steps ultimately resulted in an enhanced appreciation of the importance of effective systems of deposit insurance in maintaining financial stability. However, deposit insurance can not be seen in isolation. Deposit insurance systems are part of a wider financial safety net, together with the regulatory and supervisory framework and liquidity or capital support measures. Indeed, wholesale funding guarantees, capital injection plans and asset relief schemes for banks were also necessary as short term crisis management measures in the fight for financial stability. In the longer term, bank regulation and supervision will need to be – and are being – strengthened to restore stability. Yet another qualification regarding the policy actions on deposit insurance during the crisis, is that they were not always well co-ordinated across borders. One minister of finance clearly summarized the situation by saying that “One country’s solution is another country’s problem”. I will come back to this shortly. Supervisory policy responses Let me first explain how the regulatory and supervisory framework will be strengthened. In this process, the Basel Committee plays a pivotal role. The Committee’s strategic objective is to establish a clear road map for a future regulatory system that will reduce the probability and severity of a crisis like the current one. By developing a broad range of measures, we want to improve the resilience of banks and banking systems over time to future shocks. By phasing in these reforms over an appropriate time horizon, we seek to ensure that these measures will not impede the recovery of the real economy. The Basel Committee’s oversight body – central bank Governors and Heads of supervision from 27 countries – recently agreed on quite a substantial package of reforms. These include: • Raising the quality, consistency and transparency of the Tier 1 capital base; • Introducing a leverage ratio as a supplementary measure to the Basel II risk-based framework; • Implementing a minimum global standard for funding liquidity, and • Creating a framework for countercyclical capital buffers. In addition, the Committee’s oversight body agreed to introduce a macro-prudential approach to bank supervision, which is aimed at the stability of the financial system. In this context, the Committee intends to reduce pro-cyclicality, for instance through countercyclical buffers in capital frameworks and more robust provisioning practices. Last week, the Basel Committee issued recommendations aimed at strengthening cross-border bank resolution frameworks. Taken together, the recent and planned initiatives of the Basel Committee in response to the crisis, once implemented should promote a more robust banking sector and limit the risk that weaknesses in banks amplify shocks between the financial and real sectors. The Basel Committee’s work is consistent with and supported by the initiatives of the Financial Stability Board and the G20, which will meet tomorrow and the day after tomorrow in Pittsburgh. Core Principles Another distinct response to the crisis is the Core Principles for Effective Deposit Insurance Systems, developed by the Basel Committee and IADI. The basic idea behind the Core Principles is that they are universally applicable. On the one hand, “they are reflective of, and designed to be adaptable to a broad range of country circumstances, settings and structures”, as the Executive Summary notes. On the other hand, they “are not designed to cover all the needs and circumstances of every banking system”, which would be very difficult indeed. “The Principles are intended to be a voluntary framework for effective deposit insurance practices.” National authorities can adjust them and “put in place supplementary measures that they deem necessary to achieve effective deposit insurance in their jurisdictions”. Taking a closer look at the Principles themselves, they are intended as a basic reference for public authorities internationally. National authorities can use these Principles, either as a benchmark against which they can assess their own deposit insurance schemes or as a tool to implement or reform their deposit insurance systems. A comprehensive self-assessment should identify strengths and weaknesses in the existing deposit insurance system and form a basis for remedial measures, where needed. The Principles will also be used by the IMF and the World Bank in the context of Financial Sector Assessment Programs to assess the quality of deposit insurance. In order to facilitate such assessments, IADI with the support of the Basel Committee is currently developing a Core Principles Methodology. As part of these assessments, specific country circumstances can be more appropriately considered, in close dialogue with national authorities. Any assessment should aid the deposit insurer and policymakers in improving the deposit insurance system, as necessary. In short, the Basel Committee believes that the use and implementation of the Core Principles will provide a starting point for more advanced deposit insurance systems and contribute to enhancing financial stability. We have set off on this journey with this conference! Future challenges The more difficult question is how deposit insurance systems will develop. Unfortunately, the answer is still “up to the stars” – and I am not an astrologist. The events during the recent crisis, however, may indicate which issues may need to be addressed. The first one is the optimal level of coverage, which comes down to the right balance between consumer protection and moral hazard. Clearly, the recent increases in the level of coverage during the crisis were necessary in order to protect consumers and to restore financial stability. But these measures have given rise to moral hazard, particularly when the coverage became unlimited. The perception may be that higher government guarantees will be available in future crises as well. The risk of moral hazard is explicitly recognised by the Core Principles, as well as the need to strike a balance in setting the coverage level. Meanwhile, many countries that increased their depositor protection during the crisis have announced or have planned to unwind the temporary protection measures. A notable exception is the EU, where the level of coverage was raised in October last year and will, most likely, soon be further increased. One might argue that the EU levels of coverage were too low previously. However, to the extent that the great majority of retail deposits in the EU will be fully covered, depositors will lose the incentives to critically assess banks’ soundness and market discipline will be eroded. As this would be unfortunate from a prudential point of view, I invite the European Commission to substantiate the need for further increases. Another important challenge to the Core Principles will be to better arrange the cross-border relationships between deposit insurance systems. Many banks increasingly operate internationally, but the safety nets are still organised along national lines. In a crisis affecting such banks, cross-border cooperation is necessary. However, there is very little experience of cooperation between deposit insurers. Similarly, there is little evidence that deposit insurance authorities have mutually well-understood plans for handling the failure of internationally active banks. In such cases, controversial issues are the distribution of responsibilities between the deposit insurance schemes, differences in legal arrangements, such as insolvency laws, as well as large cross-border liabilities. Allow me, by way of illustration, to refer to the EU system once again. Clearly, in terms of market integration the EU’s Internal Market is most advanced and may serve as an example worldwide. Under the home country control framework, the deposits of a bank and its branches in the European Economic Area (EEA) are covered by the deposit insurance scheme of the home country. The political reality is different, though. When a few Icelandic banks failed last Fall, the funds to cover deposits at these banks’ foreign branches were not available and many host country authorities had to intervene, not only because of the socalled topping-up arrangement, whereby the host country provides additional cover. Although the latter will, practically speaking, soon disappear, the current European system of deposit insurance needs to be fundamentally reconsidered. A situation in which regular retail deposits in a country are not adequately covered should be avoided, not only in the EU, but worldwide. In terms of the Core Principles, this means that further attention needs to be given to deposit insurance coverage for internationally active banks, as well as to the operational arrangements which should support it. The first issue in particular is a great challenge, indeed, even when banks are just doing well. A final theme is the role of deposit insurance systems in the financial safety net and in crisis resolution. As we all know, the roles of deposit insurers may vary, but the key question, whether or not there is in fact a single “best” approach to safety net design, including one ideal model for deposit insurance and bank resolution, has not been resolved. Since banking systems differ, the role played by deposit insurance in ensuring financial stability, and the design of that and other elements of the safety net may differ. This institutional variety is allowed by the Core Principles, but the issue will remain on the agenda. Summing up Let me sum up. One of the lessons of the financial crisis is that deposit insurance is instrumental in recovering and maintaining financial stability. The Core Principles were a timely response to the crisis. They will act as a basic reference for countries to use in establishing or reforming their deposit insurance system. However, our experience with the Core Principles on Banking Supervision, as well as Basel II, is that truly effective Core Principles are not a static document, but a dynamic framework. It is not the document as such, but the process – of implementation, assessment and improvements – that counts. The Basel Committee – and, I am sure, IADI as well – stand ready to contribute to implementing these principles and improving deposit insurance systems everywhere. When I started, I called the Core Principles a milestone. Milestones were a simple but effective device by which the Romans orientated themselves. But the Core Principles are more than that. I would rather consider them to be a Global Positioning System. They are not a product of rocket science, but they are useful and valuable, all over the world! I wish all of you a stimulating conference! | netherlands bank | 2,009 | 10 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the NautaDutilh seminar, Bussum, 10 November 2009. | Nout Wellink: Managing complexity Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the NautaDutilh seminar, Bussum, 10 November 2009. * * * I have been informed that the topic for discussion will be the new balance between banks and supervisors in the financial system. This is an issue I’m happy to address. However, before doing so, let me first say a thing or two about complexity in the financial system. How should we treat complexity? Let me start by stating the obvious. A solid financial sector is crucial to the functioning of our economy. Its existence allows the efficient allocation of capital between different activities and across time, and promotes the efficient spreading of risk within society. Today, it is hard to think of any form of economic activity that is not in some way dependent on its existence. Therefore, the stakes are high in the current debate on financial sector regulation. After the events of the last two years, everyone agrees that change is needed. However, opinions differ about the kind of change we need. First, there are those that see the complexity of the financial system as the root of the problem, and therefore propose to constrain finance much in the way it was until the 1980's. Some suggestions along this line are narrow limits on the activities of banks, splitting supposedly “safe” banks from banks engaging in capital market activities, or constraining specifications of financial products to those pre-approved by authorities. Second, there are those who think that complexity itself is not the root of the problems, but rather circumstances allowed the complexity of the financial system to contribute to the crisis. They believe that the goal of regulatory changes should not be to decrease complexity per se. Rather, they think complexity should be made more manageable. In this debate, I find myself squarely backing the second view. The reason for this is that I do not believe complexity in itself to be a bad thing. Complex systems are designed, in many cases, to be more useful and efficient than simple ones. Radios from the 1950s – of the kind I used when I was an amateur broadcaster – are much simpler than the ones we have today. Yet today, thanks to innovation and rising complexity, radios have become cheaper and more reliable. And, on top it all, they offer a much wider range of functionality and are easier to use. Cars are another example where complexity and technology has been used to make them safer, rather than more hazardous. Wonderfully named features as ABS and ESC are only possible because of innovation driving growing complexity in car-making. This is the kind of complexity that keeps drivers safe every day. The finance industry also offers us some wonderfully names symbols of complexity, such as RMBS and CDS. Unfortunately, unlike their counterparts in the car industry, these are not currently associated with safety and reliability. So it is clear that innovation and complexity may have improved the system’s ability to allocate capital efficiently in many cases, but certainly not in all. This implies we should go back to the drawing board to improve the resilience of the financial system. But it does not mean we should go back to the past. Innovation cannot be undone and the idea that tomorrow’s problems can be solved by yesterday’s regulation strikes me as overly simple and even dangerous, as it could constrain the possibilities for financial system to allocate capital around the world and transfer risk efficiently. While we are at the drawing board, we also need to address the issue of containing systemic risk. The new financial system as a whole, as well as its individual institutions, will need to be more resilient to shocks. The present-day financial system is a complex system, characterized by a high level of interconnectedness. Therefore, monitoring the financial system as a whole, and the linkages between its elements, has become all the more important. Such “macro-prudential” supervision mechanisms help to spot sources of financial instability at an early stage. A positive development in this regard is the establishment of the European Systemic Risk Board next year. But changes are also at hand to strengthen each financial institution individually. And some of these changes will have a profound effect on the balance between banks and supervisors. Managing complexity This brings me back to our topic of discussion. The balance between banks and supervisors. What changes are necessary for individual banks and supervisors, in order to strengthen the resilience of the financial system and manage its complexity? Let’s start by looking at changes for individual banks. Some policy proposals have received ample attention in the debate. In order to make the financial system more resilient to shocks, each individual bank will need to hold a bigger capital buffer than before. This can be achieved through higher overall buffers, increases in capital charges for specific activities, or a combination of the two. Furthermore, the quality of capital buffers needs consideration to ensure that they can absorb shocks while the bank is still functioning. Banks’ leverage will have to be limited in some shape or form. Banks also have a responsibility to actively manage their own complexity. In this regard, I think a proposal that is rightly being considered is that of “living wills”. Living wills are plans drawn up by banks for an orderly wind-down of operations, in case they are not able to continue operating on a going-concern basis. This would be very beneficial to financial stability in case of a large-scale default. Lehman Brothers, for instance, was composed of over 3000 legal entities at the time of its demise. Better guidance on how the organization could be properly wound down would have made life considerably less stressful for its supervisors, counterparties and administrators, as well as the financial system as a whole. As an aside, the legal profession has a role to play here as well. The number of entities may be one useful proxy for the level of complexity in an organization, but the combined length of all the contracts determining the mutual obligations between these entities surely is another. At the end of the day, one of the key qualities of the legal profession is to make complexity more manageable by providing market participants with clear, unambiguous and concise contracts rather than the opaque, heavily cross referenced and nearly inaccessible piles of paper that one too often encounters in practice. Here, as always, more is less, less is more. True craftsmanship produces documentation that even a layman can appreciate and more importantly, understand. By comparison, I think the changes needed in the supervisor’s toolbox have not always received the same amount of attention. These changes are crucial, though, to ensure that supervisors are well-equipped to ensure the resilience of the financial system in a complex world. Recent events have again confirmed that in some cases, our options for intervention are limited and can only be exercised at a late stage. For the supervisor to be effective in an increasingly complex and interconnected world, it will need more power to intervene at an earlier point in time. Internationally, promising policy has already been implemented in this regard, such as the Special Resolution Regime in the United Kingdom. Making it work As I see it, banks should welcome all these measures. Bigger capital buffers and the existence of living wills enhance the stability of the financial system. So does the existence of a more powerful supervisor with an enhanced toolkit. Financial instability in the end threatens the survival of all banks, not just the ones that spark a crisis. Therefore, a more effective design and supervision of the financial system is in the interest of every individual bank. Finally, banks should also be keenly aware that the option to manage complexity will not be on the table forever. Society’s patience with the financial sector has already been put to the test, and is not unlimited. It can perhaps accept that a complex system fails once; it would be unlikely to accept the risk of another failure. If banks do not take their responsibility to show that lessons have been learned from the crisis, a serious threat exists that legislators may opt for overly simple solutions that try to reduce complexity at any price and, from a societal perspective, are suboptimal. Therefore, all parties in the financial system should work together to show that complexity can be properly managed for the benefit of society. | netherlands bank | 2,009 | 11 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the workshop "Towards a new framework for monetary policy? Lessons from the crisis", Amsterdam, 21 September 2009. | Nout Wellink: Towards a new framework for monetary policy? Lessons from the crisis Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the workshop “Towards a new framework for monetary policy? Lessons from the crisis”, Amsterdam, 21 September 2009. * * * Over the past two years, we have all been surprised by the fast pace at which events have unravelled. But ideas have also evolved rapidly. Only one year ago, at our monetary policy workshop we were discussing whether financial imbalances ought to be incorporated in monetary policy making. Since then, there has been an increasing consensus that monetary policy should lean against the wind. At today’s workshop, we will not focus on whether but on how monetary policy can be used to lean against the wind. In my remarks, I want to address three questions. First, what have we learned about the runup to the crisis? Second, why did monetary authorities not lean against the emergence of massive financial imbalances, which turned out to have disruptive macro effects? And third, how can we use the answers to the first two questions to think about the next approach to monetary policy? What have we learned about the causes of the crisis? Let me start with what we have learned about the run-up to the crisis. Looking back at the years before this crisis – and more in general at all major crisis episodes in industrial countries – five main, interrelated ingredients of an accumulating imbalance stand out. 1. The first – and in my opinion root – ingredient of the crisis lies in the large US external imbalance and the high levels of US international debt. I consider these to be a reflection of a country having lived beyond its means and, in particular, an overleveraged private sector. 2. Second, low interest rates relative to a natural rate of interest – especially in a context of a buoyant economy and low inflation – suggested that monetary policy had been too easy in the years before the crisis. Fiscal policy was probably also too easy. 3. Third, global imbalances and too low interest rates supported very strong credit growth and excessive risk taking. 4. Fourth, asset prices rose sharply, particularly in equity and housing markets. 5. Fifth, a high level of private debt resulted from a prolonged period of strong credit growth. What we have learned is that it is necessary to recognize that the combination of these five elements can have catastrophic consequences and to act upon this recognition. Why did monetary policy not lean against the wind? In the past, I have stated that “many of the risks that crystallised in the past year were on our radar screen long before the crisis started”. 1 At the same time, I argued that these risk Nout Wellink (2008) “It’s the incentive, stupid!” Speech at the conference on “Integrating micro and macroeconomic perspectives on financial stability”, University of Groningen, 26 May 2008. assessments were not translated into an efficacious preventive action – at least not by monetary authorities. But why did we not lean against the wind? I believe that this happened for five main reasons. 1. First, there was an inability – by both academic researchers and analysts in the policymaking world – to pay sufficient attention to the role of stocks. In 2007, high levels of debt had resulted from a prolonged period of strong credit growth and excessive risk-taking. These made the economy vulnerable to negative shocks, such as the collapse of the US subprime mortgage market. The importance of the stock of debt in the lead-up to the crisis is a manifestation of a more general phenomenon, whereby in a context of disequilibrium – such as the accumulation of financial imbalances – stocks dominate flows as determinants of macroeconomic dynamics. This phenomenon cannot be captured in standard macroeconomic models based on linear relationships. In tranquil times, the relevance of stocks is modest, and flows as well as prices of flows matter. Under these circumstances, policy is about fine tuning – mostly through the anchoring of expectations. However, “ordinary” monetary policy that is based on flows (monetary flows) and prices (inflation) cannot deal with the implications of stocks that are typical of periods in which massive financial imbalances can accumulate. We now know that looking after stocks is necessary during good times as a means to prevent financial crises. 2. Second, macroeconomics and policymaking have focused on decision-making in conditions of measurable risk, rather than immeasurable risk or what is known as Knightian uncertainty. The concept of measurable risk may be appropriate during “normal” times. But when we face a build-up of massive financial imbalances, it is impossible to measure risks correctly because, like Keynes said, “we simply do not know” the future. The crisis has taught us that there are always events that – although possible – are not accounted for in policy analysis. In the years before the crisis, the historically low volatility observed in financial markets was seen as equivalent to no uncertainty. And successful monetary policy – in the sense of low and stable inflation – was seen as a guarantee of stability. In such a context, a global recessionary trend, such as the one we have experienced this year, was unthinkable. Accounting for such immeasurable risk would require a marked change to macroeconomics. It implies moving away from the principle of optimizing agents, to one of agents that would aim to insure against uncertain events. Rather than aiming at identifying the best solution to a given problem, the aim would be to do “well enough” – across a series of different problems irrespective of how likely they maybe. This would not be without costs: it would insure against the effects of undesirable events at the expense of a better performance in normal times. 3. Third, the existing monetary policy framework focuses on medium-term price stability – defined over a horizon of two years. In the run-up to the crisis, this meant that financial imbalances were left to be handled by micro prudential policy. But financial imbalances are procyclical, and also have strong macro-dynamics and implications for the macroeconomy. This calls for a macro prudential policy in addition to a micro prudential response – a theme that will be picked up by some of today’s policy panellists – and, in addition, a role for monetary policy. 4. Fourth, it is important to acknowledge that policy makers are part of the environment in which they operate. We now know that the prevalent behaviour in the years before the crisis embodied an important element of irrationality. Like all members of society, policymakers are partial to the prevalent consensus, and share its key values and behavioural characteristics. 5. Finally, from a political economy point of view, it was hard for policymakers to sell an unconventional line of action in a situation where inflation was well-behaved and there was no firm proof that something was actually going severely wrong in the financial sector. How can we draw lessons for monetary policy? I believe that monetary policy requires two fundamental changes. First, we need a new culture that puts more emphasis on the role of stocks in creating potential macro-risks – in particular for monetary authorities, risks for price stability in the medium-run. The new culture would also focus on decision-making under uncertainty. Second, central banks either need a shift in their monetary policy framework to deal explicitly with financial imbalances, or interpret their current framework in a way that gives them more freedom in pro-actively trying to avoid that financial imbalances burst, with major macroeconomic consequences. One approach would be to keep a mandate of price stability – that is not introduce financial stability or asset prices as a second goal for monetary policy – but follow a two-track approach to monetary policy. The first track would be a sufficient guide of action when no imbalances accumulate. Under these conditions, the “traditional” monetary policy could be followed. The second track would focus on monitoring the build-up of stocks (for example the debt to GDP ratio) and associated potential macro-risks (in particular risks for price stability) in the medium-run. This approach would require greater flexibility, since at times the policy rate could be changed even if inflation looks perfectly anchored. It would also require a horizon longer than two years, since the cycle of accumulation and unwinding of imbalances typically draws out further than two years. Greater flexibility and a longer horizon imply a more challenging role for communication. How should we communicate a tightening of monetary policy when inflation is low but there are some concerns that financial imbalances are accumulating, which have a very small chance of unwinding in a very disruptive way five years ahead? Another important ingredient of this approach is the close coordination, both with supervisory authorities and, once a crisis erupts, with fiscal authorities. Do central banks need to abandon their current monetary framework to follow the approach I have outlined? I believe not. In practice, both the ECB’s second pillar and the Bank of Japan’s long-term perspective can lend themselves to – and in fact already capture elements of – this new approach. The same might be true for a flexible inflation targeting framework as it is currently followed by the Reserve Bank of Australia. I hope that the academic scholars, policymakers and market participants that are joining us today for this workshop, will help us gain further insights into these important issues. | netherlands bank | 2,009 | 12 |
Speech by Mr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Dutch Embassy, London, 19 February 2010. | Nout Wellink: Working on the future of the financial sector Speech by Mr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Dutch Embassy, London, 19 February 2010. * * * I will first briefly share with you my view of the recent developments in the financial sector and on the crisis. Second, I will discuss what the future role of supervision will be in order to minimize future crises. I will speak about some of the initiatives of the Basel Committee, and why these alone will not be enough. And finally, I will speak about the role of the financial sector itself. Let me first of all start by saying that although the financial sector has been hit severely, and probably none of us has ever experienced something like this before, it is not a unique situation from a historical perspective. In The Netherlands and the United Kingdom there have been a significant number of large financial and economic crises throughout history. One famous example of this is the Dutch tulip mania in the early 17th century, when the prices of tulips fell dramatically after an excessive speculative bubble period. Or, the collapse of Overend & Gurney bank in 1866 London, which triggered a series of bankruptcies of several smaller, but otherwise solvent British banks. We struggled, but came out stronger after each. Just as what must have been said after each of those events, let me assure you that this crisis will also not be the last. All of our measures and good intentions aside, we are of course always perfectly prepared for the most recent crisis. The next crisis is a different story. What we can do is learn from each crisis and try to prevent and mitigate a similar crisis, and to do our best to diminish the likelihood and impact of any future crisis. Our recent crisis is, in my opinion, the result of many problems. Let me mention some. One is undoubtedly the search for yield that has often led to excessive risk taking. Or the compensation schemes and bonuses in the financial sector that by leading to a strong public outcry, have laid the foundations for a lack of trust in the financial sector. Supervision and the regulatory system must take responsibility for the crisis too. Despite the continuous improvement of regulatory practices throughout the years, certain risks were built up due to regulatory arbitrage opportunities. But this crisis also showed a fundamental lack of transparency. Customers (private and institutional alike) did not know anymore just what exactly they were buying; supervisors found it increasingly difficult to assess which risks financial institutions where subject to, and institutions had more difficulty with valuing their products. Transparency was gone, which not only contributed to the lack of trust between financial institutions, but also between client and institution. You will therefore understand that we, as supervisors, had to act quickly and act decisively. As chairman of the Basel Committee, let me mention some of the measures that the committee proposes. And I would also like to use this opportunity to convince you that these measures are really necessary. Despite being a significant improvement over the previous accord, Basel II has shown to still contain some significant weaknesses and shortcomings. Of many of these we were aware, but we were not able to adequately address them. However, now, under the pressure from the crisis, many of these issues are open for debate again. Let me talk about some of these measures in more detail. First, we are going to improve the level and quality of capital. We have seen during the crisis that the current levels are not adequate and that in the end it is only the capital of the highest quality that counts in adverse conditions. An extension of this measure is that we will make capital requirements less cyclical, by means of additional capital buffers that are built up during economic upswings. This might imply that less profit can be used to pay out dividends or bonuses, as it is instead used for increasing the firm’s capital buffers. Second, we want to make sure that we really cover all risks and allocate adequate capital to each. A key aspect of this is to prevent regulatory arbitrage opportunities, particularly with securitizations and between banking activities and trading activities. Third, we will work on an international accord on liquidity buffers and supervision, instead of the current fragmented, national rules. Furthermore, the Basel Committee proposes to supplement these risk-based measures with a non risk-based measure that acts as a backstop in order to prevent an excessive build-up of leverage during favourable economic periods. The design of the leverage ratio as a simple, transparent, and supplementary measure of capital that is based on gross exposures, will therefore serve as a safeguard against attempts to game the risk-based requirements and address model risk and measurement error. By the end of 2010 we hope to have fully calibrated these measures such that they can be phased in as economic conditions improve, with the aim of implementing them by end-2012. I would like to stress that these measures are really necessary. Not only to prevent further harm, but also to restore trust in the financial sector. Trust is an extremely important aspect of any services sector, and the financial sector is a services sector pur sang. If a feeling of uneasiness remains among clients and investors, or financial institutions cannot trust each other as they should, then financial (and consequently economic) development grinds to a halt. So restoring trust in the financial sector is an absolute priority and we have to go great lengths to achieve this. At the same time it seems as if the sense of urgency for change among bankers and politicians has somewhat diminished lately, now that we see the first signs of recovery. Opposition against the proposals from the Basel Committee is growing, through lobbies from the financial sector. For this reason, we, as supervisors, have to do our utmost best to uphold these proposals, because otherwise countries may be forced to implement measures on their own. The result of this will be a distortion of the international level playing field, which in the end will not benefit the financial sector. It is for this reason that we will organise a comprehensive quantitative impact study in the first half of this year. With this impact study we can see what the impact of all individual proposals will be, as well as the aggregate impact of all proposed measures combined, so that we can implement measures with care, in a responsible and well-considered manner. And all of these measures will be considered in the light of the economic recovery, making sure that they will not harm the recovery process. I am aware of the current debates about reducing the size of the sector, adding taxes, cutting bonuses, and the like. It is true that there are indeed excesses which are not acceptable anymore, and these have to be dealt with. At the same time, we should refrain from overreacting and take care to not implement measures which we have not fully thought through. Beside all these new regulatory measures we have realised that there is also an urgent need for closer international supervisory cooperation. The rapid development in cross border banking has shown us supervisors that our current organisational structure is no longer adequate and limits our ability to rapidly respond to developing situations. A shift towards a more unified regulatory framework has therefore slowly been set into motion, for instance in Europe with the new structures for CEBS or CEIOPS, or through the intensified use of supervisory colleges. Crucial, though, in this process, is full and mutual openness and willingness to share information. But there are limits to what supervision can do. We cannot supervise everything, even if we want to. Do we have to double our number of supervisors, or triple them? Will that be enough? And we have to realise that more supervision and rules also creates a moral hazard problem, because we take away the incentive for institutions and clients to take their own responsibility and use common sense when engaging in financial products. A good example of this is the deposit guarantee scheme. If one would keep on increasing the guarantee level, clients eventually become less alert and institutions might lower liquidity buffers. Both dangerous developments. It is therefore that I would like to stress today the fact that market participants have to recognize their own responsibilities too, and act more according to them. This applies to institutional managers, traders, fund managers, accountants, and even customers. More than ever before should all market participants consider the consequences of their actions and continuously ask oneself questions about everything one does. In answering such questions I think that a prudent attitude must be taken and greater awareness of one’s social responsibility, and ask one every time whether the right thing has been done and whether the actions are not harmful to vulnerable parties. I think that an important step in the awareness of one’s own responsibility is aiming for greater openness. Transparency is really something that should be improved. Because only when customers really understand financial products; or when the public understands compensation decisions, or bank managers and supervisors really know which risks an institution is subject to, will trust in the sector be restored. In the end, we may not forget that the financial sector is above all a services sector and this requires a great deal of responsibility and care from the side of all. I would therefore very much invite you to help in bringing greater openness and social responsibility to the financial sector. I hope that I have been able to convince you that there is truly a need for change in the financial sector. Not only in terms of regulatory practices but also in terms of attitude and culture. I therefore welcome every initiative from the sector in order to achieve this and I look very much forward to a fruitful debate. | netherlands bank | 2,010 | 2 |
Introduction by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the press conference on the Bank's Annual Report 2009, Amsterdam, 25 March 2010. | Nout Wellink: Lessons to be learned from the crisis Introduction by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the press conference on the Bank’s Annual Report 2009, Amsterdam, 25 March 2010. * * * A few words by way of introduction. We are facing extraordinary challenges and painful adjustments. Moreover, many lessons can be drawn from the crisis: by bank managements, regulators, supervisors, but also by customers of financial institutions. By pursuing an extremely expansionary monetary and fiscal policy, monetary authorities and governments have prevented the world economy from moving into a downward spiral. But the remedy also carries risks. To ward off a future wave of inflation, central banks need to return to more normal monetary conditions. Furthermore, in a great many countries, the huge budget deficits run up must be resolutely scaled back to avoid generating such a strong upward pressure on inflation rates as to stunt economic recovery. Decisive and rapid scalingback of budget deficits is also essential to avert an explosion in governments’ debt positions. Monetary authorities worldwide have taken the first steps towards normalising monetary conditions. So has the ECB. The restoration of confidence is key to economic recovery. A government that convincingly tackles its budgetary problems is an overriding factor in rebuilding confidence. A recent DNB survey shows that Dutch citizens acknowledge this necessity. The European agreement to narrow the deficit back to below 3% of GDP by 2013 enjoys broad support. But that alone is not enough. In addition, the Netherlands should at least aim to bring the budget close to balance by the end of the new cabinet period. Also, the rules under the Stability and Growth Pact must be tightened. The experiences with the Greek fiscal deficit have made this painfully clear. The badly-hit financial sector faces a fundamental adjustment over the next few years. It is in everyone’s interest that the sector emerges stronger from this process. The timing and method of the government’s retreat from the banking and insurance world is crucial. But it is equally important that the sector regains the confidence of society. Adjustments in the pension system are needed too. The more difficult it becomes to increase contributions, the more uncertain the pension results and the greater the incentive to lower the pension target. Raising the retirement age would significantly advance the sustainability of the system. The delay arisen is therefore regrettable. Financial stability hinges on international agreements and coordination. Major progress has been realised both globally and within Europe. Nonetheless, plenty of room for improvement remains. Authorities need wider powers to acquire or relaunch flailing institutions. Supervision should be tightened too, to ensure that a closer watch is kept on the strategy and corporate culture of supervised institutions, but also that more account is taken of the macro-environment in which financial institutions operate. Let me conclude. People are understandably disappointed that, nationally and internationally, the supervising central banks were unable to protect financial institutions from the storm in the financial markets that blew up in August 2007. The recognition that the world is less formable than commonly thought, and that supervision can provide no guarantee that a bank will never fail, cannot allay this disappointment; nor can the notion that we were not dealing with a typically Dutch phenomenon, but that there were banks all over the world that collapsed in the wake of the credit crisis. Our response at DNB can only be that we will in future intensify our efforts to prevent misfortunes in the financial sector. And that, along with our colleagues in other countries, we will to this end do all that is humanly possible to draw every last lesson from the credit crisis. | netherlands bank | 2,010 | 4 |
Remarks by Mr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Institute of International Finance 2010 Spring Meeting, Vienna, 11 June 2010. | Nout Wellink: The Basel Committee and regulatory reform Remarks by Mr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Institute of International Finance 2010 Spring Meeting, Vienna, 11 June 2010. * I. * * Introduction I wish to thank Charles Dallara and the Institute for this opportunity to discuss the work of the Basel Committee and its role in reforming the regulatory framework. All of us in the financial community are now at a pivotal junction that will significantly re-shape how banks and supervisors alike conduct their business. In my remarks this morning I would like to explain the rationale for the Basel Committee’s reform programme and describe its key elements. I will then detail for you the benefits of our programme and my expectations for finalising our work. II. Rationale for the Basel Committee’s reform programme I will begin by discussing why we are doing what we are doing. The Basel Committee’s reform programme includes the measures finalised by the Committee last summer dealing with stronger trading book capital standards along with higher requirements for complex securitsations and exposures to off-balance-sheet vehicles. In addition, the measures proposed last December represent a fundamental strengthening of the Basel II framework and introduce for the first time minimum global standards for liquidity risk. These reforms are designed to respond to key pre-crisis shortcomings, which became painfully evident during the crisis. The banking sector entered the crisis with too much leverage and inadequate liquidity buffers. These were accompanied by poor governance and risk management as well as inappropriate incentive structures, especially related to compensation. The combination of these factors was manifest in poor underwriting, the mispricing of credit and liquidity risk, and excess credit growth. When the crisis hit, these shortcomings and weaknesses in the banking sector amplified and deepened the downturn. You know the outcome: huge, rapid deleveraging; big losses by banks; a deep recession; and massive direct support from the public sector in the form of capital injections, guarantees and liquidity. While not every bank required this direct support, all banks and counterparties benefited indirectly from these efforts and the broader fiscal and economic stimulus of the economy. Now, in the face of this experience, minimum standards for capital and liquidity need to be raised substantially so that the banking sector can withstand future periods of stress, thus enhancing financial stability and promoting more sustainable growth. The banking sector must serve as a stabilizing force and not as an amplifier of shocks. It is precisely this mandate that the G20 finance ministers and central bank governors endorsed this past weekend when they met in Korea. They voiced their full support for the work of the Basel Committee, which forms the core of the G20’s financial and regulatory reform agenda. At present, the minimum standard for the highest quality capital is just 2% of common equity to risk weighted assets – it is even less when you factor in necessary deductions from capital. And with respect to liquidity, no global minimum standard currently exists. Leading up to the crisis, liquidity buffers were inadequate and excessive reliance was placed on short-dated wholesale money to fund long term illiquid assets. Banks have made progress to strengthen capital levels and liquidity buffers but more needs to be done. In addition, when competitive pressures reassert themselves, there is the risk of a renewed race to the bottom to the unacceptable pre-crisis status quo. Moreover, public sector finances have been stretched and must be consolidated. There is no public sector appetite to engage in the types of banking sector support measures of the past three years. Banks therefore must use their return to profitability – which is due in part to public sector support – to boost capital and liquidity buffers. Significant risks remain in the economy and the financial system, and it would be unacceptable if banks did not use this opportunity to bolster their resilience to future shocks. Finalising the Basel Committee capital and liquidity reforms will raise resilience and provide greater certainty and stability in the markets as to the new standards towards which the sector must move. It would be unwise to think that this crisis only holds lessons for a limited class of banks, business models or regions. All countries need to build bank sector resilience because shocks have originated from all regions of the world, from all types of asset classes, and from all kinds of business models. III. Key elements of the BCBS reform programme It is for these reasons that we have proposed our reform programme. Now let me tell you what it is we seek to achieve. Capturing all the risks The first objective must be to capture all significant risks in the capital framework. During the initial phase of the financial crisis, the majority of losses and the build up of leverage occurred in the trading book. At the same time, the trading book rules did not adequately capture all of the key risks to which banks were exposed. As a consequence, capital for trading book exposures was distressingly inadequate. In response, the Committee finalised last year a series of enhancements to the trading book rules. These higher capital requirements capture the credit risk of complex trading and derivative activities and require banks to calculate a stressed value-at-risk. The crisis also exposed weaknesses in banks’ risk management and measurement of securitisation and off-balance-sheet exposures. This shortcoming resulted in large, unexpected losses. The Committee’s July 2009 enhancements included new rules to strengthen the treatment for certain securitisations in Pillar 1 by introducing higher risk weights for resecuritisation exposures. Counterparty credit risk is another key risk for which the regulatory capital improvement is needed. The December enhancements proposed by the Committee are meant to strengthen the resilience of individual banking institutions and reduce the risk that shocks are transmitted from one institution to the next through the derivatives and financing channel. Raising the quality of the capital base The Committee’s efforts to improve risk coverage are a crucial element of the capital adequacy equation but this is only half the story. The other half relates to the quality of the capital base backing banks’ risk exposures. The Committee has proposed a series of measures that would overhaul the definition of capital. This is the second objective of our reform programme and it is set out broadly along two lines. First, the level and the share of the highest quality capital in Tier 1, namely, common equity and retained earnings, will rise substantially. During the crisis, losses came directly out of retained earnings but because of other forms of financial instruments in the capital base, some banks maintained deceptively high Tier 1 capital ratios. Moreover, in the case of many banks, non-common Tier 1 capital instruments ultimately had to be converted into common equity before confidence was restored. Second, and just as important, our proposal introduces a rigorous set of deductions and exclusions from common equity to arrive at a more transparent, meaningful definition of capital and to restore the credibility of the Tier 1 capital base. Leverage ratio as a backstop to the risk based requirement A third objective is the introduction of a leverage ratio to backstop the risk-based system. At the micro, firm-specific level, many firms were too aggressive in gaming the system. The risks that built up in the trading book with inadequate regulatory or economic capital were a case in point. Many firms engaged in hedging strategies where the risk magically disappeared from internal risk reports and capital, only to reappear as basis risk, counterparty credit risk or illiquid positions that could not be sold. Many supervisors did not do enough to prevent this compression of risk-weighted assets. From a macro prudential perspective, we again saw a cycle of leverage building up in the banking system, which the market forced down in the most destabilizing manner, amplifying procyclicality and the downturn of the real economy. Moreover, market participants piled into what were perceived to be the lowest risk-weighted assets, such as repos, sovereign lending, and triple-A asset backed securities. While these assets may have been viewed as low risk at the bank level, we instead saw the build-up of system wide risks in these asset classes, which ultimately came back to haunt many institutions. Buffers to withstand shocks Another objective is the need to build greater buffers into the banking sector to withstand severe shocks. Banks are at the centre of the credit intermediation process, both in bank dominated countries and those where capital markets are more developed. Greater buffers will help prevent the amplification of shocks between the financial and real side of the economy. These buffers need to take various forms. First, we need to introduce more forward-looking provisioning. The Committee is promoting stronger provisioning practices through a number of channels. It is working closely with the accounting standard setters to develop a robust and operational expected loss approach for provisioning. Second, we need to introduce more, prudent valuation practices for financial instruments. The Committee last year issued guidance to banks and banking supervisors to strengthen valuation processes. The Committee also continues to work with the accounting standard setters to develop sound valuation standards. These should provide for valuation adjustments to avoid the misstatement of both initial and subsequent profit and loss recognition when there is significant valuation uncertainty. Third, there needs to be a capital conservation buffer as proposed in our December reform package. At the onset of the financial crisis, a number of banks continued to make large distributions in the form of dividends, share buy backs and generous compensation payments even though their individual financial condition and the outlook for the sector were deteriorating. More recently, many banks have returned to profitability but have not done enough to rebuild their capital buffers to support new lending activity. This dynamic does not help to make the system more resilient and it amplifies procyclicality. Much of this is due to a collective action problem, which the conservation framework seeks to address. The proposed framework promotes the conservation of capital and the build-up of adequate buffers above the minimum that can be drawn down in periods of stress, subject to appropriate measures that are coordinated with the national supervisor. The approach is not intended to take away freedom from a well-governed board, but rather to provide more clarity regarding the supervisory response. The Committee is also working on a countercyclical buffer framework to protect the banking sector from excessive credit growth. It will follow up with more detail on the design of this framework. What is clear from history is that the banking sector is most vulnerable during periods of excessive credit growth. Finally, we need to address the problem of systemic risk arising from excess interconnectedness and the perception that some banks are too big to fail. This is being addressed through a variety of means. First, we are introducing capital incentives to use central counterparties for OTC derivatives; Second, there will be higher capital for trading and derivative activities, as well as complex securitisations, which are associated with systemic risk and interconnectedness; Third, there is a need for more capital for inter-financial sector exposures which are more correlated; Fourth, the Committee is reviewing the appropriate capital treatment of systemic banks (in coordination with the FSB); and Fifth, the Committee’s recent recommendations for cross-border bank resolution provide a practical way to begin addressing the systemic risk issue at cross-border banks. Liquidity Strong capital is a necessary but not sufficient condition for banking sector stability. Many banks got into trouble because they were financing long dated, illiquid assets with short-term wholesale funding. Other banks simply did not have an adequate buffer of highly liquid assets to ride out a period of severe stress. Many institutions, in their liquidity planning, assumed that they would experience difficulties, but that this would occur in an overall benign environment. Our response is to introduce a global liquidity framework which establishes minimum standards for funding liquidity risk, thus preventing another race to the bottom in this area. Banks must hold a stock of high-quality liquid assets that is sufficient to allow them to survive a 30-day period of acute stress. This is complemented by a longer term, structural ratio to promote the funding of activities with more stable sources of funding on an ongoing basis. Banks can meet these standards by changing their funding profile, making them less vulnerable to liquidity shocks. Better supervision, risk management and transparency The measures I just outlined will help improve bank and bank system resilience. At the same time, they need to be accompanied by better supervision and risk management. An important lesson from this crisis is the need for better, more rigorous supervision and this key theme pervades the Committee’s work. Just a glance at our recently published work would highlight the Committee’s drive to raise the bar for both supervision and risk management: last year’s supplemental Pillar 2 guidance, our liquidity risk management sound principle, methodology for assessing compensation practices, valuation practices, stress testing and bank resolution are just a few examples. The Committee is putting in place rigorous mechanisms to follow up on its standards to ensure that they are implemented across the membership. Finally, we need to do a better job at system wide supervision. Most banking crises emerge when there are common vulnerabilities and concentrations across the banking sector and other financial firms. It therefore is critical that we integrate bank level supervision with a broader understanding of financial sector and macroeconomic vulnerabilities. As we roll out these reforms, it will be important that we ensure the perimeter of regulation keeps up with financial innovation. Activities which combine substantial maturity transformation and liquidity risk should be subject to more bank-like regulation. We also need to be vigilant about major regulatory differences for like activities that could put pressure on the soundness of the regulated sector. IV. Impact assessment, calibration and implementation and conclusion Before I conclude let me say a few words about the Basel Committee’s process for finalising its reform package. I would like to emphasise three key features of the Committee’s work that help ensure that all the parts work together and that the new regulatory package succeeds. First, there is public consultation. The Committee is conducting a thorough analysis of the nearly 300 comments received covering thousands of pages. We are carefully reviewing the comments and this will help further inform the final design and calibration of the Committee’s proposals. Second, there is calibration. The Committee is conducting a comprehensive quantitative impact study to assess the effect of its reform package on individual banks and on the banking industry as a whole. The Committee is also conducting a so-called top-down impact assessment, which will complement the bottom-up, firm-specific QIS work. The top-down calibration work will help inform the overall calibration of the capital requirements, minimum and regulatory buffers, factoring in the cumulative impact of the July and December 2009 reform measures and any adjustments to them. Any analysis of appropriate minimum levels must recognise that, to be credible, they need to cover historically severe losses. Buffers need to be sufficiently high to withstand sector wide stress while remaining above a credible minimum. The calibration needs to be set at a level that is appropriate to promoting long term stability. Where there are tradeoffs, these should go in the direction of giving banks the time to reach the new standards instead of watering down the standards themselves. Failure to put in place high quality standards for the long term simply sets the system up for another banking crisis down the road. Third, we are assessing the benefits and costs of the Basel Committee standards and I think it fitting that I close on this note. The past three years should serve as a strong reminder to us all of the benefits of mitigating banking crises. The costs of a banking crisis include the direct losses borne by security holders, the massive scale and diversity of public sector intervention measures which have strained public finances and will need to be scaled back over time, and the large fall in national and global economic output and employment. Unfortunately, such episodes are not confined to recent history and occur much more frequently and have much greater economic impact than any of us feel comfortable with. Moreover, the history of crises also shows that some of these costs are persistent. Raising capital and liquidity standards will reduce the probability and impact of crises, and bring with it large benefits. These benefits include: avoiding both the temporary and additional permanent reductions in output and employment that occur during banking crises; greater stability of economic output and associated increases in welfare that result from lower output volatility during non-crisis periods; a more stable banking system that is able to withstand shocks from outside the banking sector rather than amplifying the effects of such shocks on the real economy; lower risk premia; and more efficient allocation of resources and the avoidance of excessive credit growth that is often allocated to certain sectors leading up to a crisis. As with the benefits, the costs of raising capital and liquidity requirements can have both temporary and permanent elements. The temporary costs we believe can be managed through appropriate transition periods – in some cases there has already been very significant adjustment forced by the market and supervisors. The Basel Committee and the FSB are in the process of assessing these temporary costs and the results of this work will help inform the appropriate transition period to the new standards. We will ensure that the banking sector can move to the new standards through earnings retention and reasonable capital raising. We will also ensure that banks can move to the new liquidity standards in an orderly manner. When it comes to the long term costs, the impact is not clear. On the one hand, higher capital requirements and liquidity standards could increase the cost of funding. On the other hand, more stable, less leveraged banks would raise average ratings, improve the terms on which banks could raise funds, and lower the required return on equity. Moreover, in a competitive market, it is not at all clear that most of the costs of higher capital and liquidity requirements would be passed on to the consumer. One thing however is clear. Raising minimum capital requirements from their current levels will involve large and permanent net benefits by raising the stability of the system and promoting more sustainable growth. Moreover, these benefits accrue immediately for every additional dollar (or Euro) of capital and liquidity. This is critical in an overall economic and financial environment of continued uncertainty and risk. It is absolutely essential – indeed it is our duty to shareholders, taxpayers and future generations – to reflect on the lessons of this crisis to safeguard against something like this happening again. We have a common goal and we must work together to achieve it. | netherlands bank | 2,010 | 6 |
Remarks by Mr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Korea-FSB Financial Reform Conference: An Emerging Market Perspective, Seoul, 3 September 2010. | Nout Wellink: Fundamentally strengthening the regulatory framework for banks Remarks by Mr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Korea-FSB Financial Reform Conference: An Emerging Market Perspective, Seoul, 3 September 2010. * I. * * Introduction and background Let me start by thanking our Korean hosts and the Financial Stability Board for organising this conference. The timing could not have been better as the Basel Committee has entered the final phase of completing its reform programme. It is especially fitting that this meeting is hosted by the Republic of Korea, given the importance and continuing growth of the South Korean economy, its membership on the Basel Committee, and of course its key role as current chair of the G20. As you know, the Basel Committee’s reform programme will be presented to the G20 leaders for their endorsement when they meet here in November. A number of commentators have questioned whether the Basel Committee’s reforms of global banking standards are really necessary for countries that neither “caused” the crisis nor were directly affected by it. However, I should point out that all were affected indirectly through the global economic downturn. This includes emerging market economies. To me, at least, it is clear that we all have a lot to learn from both the recent and past financial crises. History has shown that crises have emanated from all regions of the world and have a range of causes. None of us knows what will be the source of the next crisis. What we do know, however, is that in a dynamic, ever changing global economy, there will be future crises and that it will be hard to predict them in advance. Moreover, as banks are at the centre of the credit intermediation process, it comes as no surprise that the deepest and most prolonged downturns occur when the banking sector ceases to perform its central role in the economy. We therefore must increase the resilience of the banking system to financial and economic shocks, in particular through higher capital and liquidity buffers, but also through a more resilient infrastructure. We also must change incentives in areas such as governance practices, compensation and the moral hazard associated with too-big-to-fail institutions. This is the best form of preparation and will contribute to increasing our long term growth and welfare. The reforms of the Basel Committee are intended to address these identified shortcomings by promoting a more resilient banking sector that can support more sustainable growth over the long run. Let me elaborate on our reform programme, which is nearing its final stage of completion. My focus will be on strengthening the global capital framework and introducing a global standard for liquidity. II. Capital reform Quality of capital base I will start with capital since raising the level, quality, consistency and transparency of the capital base is one of the Committee’s primary objectives. It is only through higher levels of loss absorbing capital that the banking sector will be in a stronger position to shield the economy from future shocks. The thrust of our work is to improve the level and proportion of the core elements of Tier 1 capital, namely common equity and retained earnings. Under the existing standard, banks could hold as little as 2% of risk-weighted assets as common equity. It is even less if you consider the need for additional regulatory adjustments. This situation is unacceptable and must change. At its meeting on July 26th, the Basel Committee’s governing body – the Group of Central Bank Governors and Heads of Supervision – reached broad agreement on a fundamental strengthening of the definition of capital, with a focus on the core elements of capital instead of debt-like substitutes that are of questionable quality. Moreover, virtually all deductions from capital will now occur at the level of common equity, instead of Tier 1 capital, as has been the case under the current standard. This will ensure that banks cannot show strong capital ratios and, at the same time, recognise assets that diminish the quality of capital. Let me be clear: The change to the definition of capital represents – by itself – a substantial strengthening of the global capital regime. This is the case before we even begin to discuss an increase in the level of minimum capital requirements or the introduction of buffers. Capturing all the risks In addition to raising the quality of the capital base, we need to ensure that all risks are captured. During the crisis, we learned that many risks were not covered in the risk-based regime. In particular, these include the complex, illiquid credit products which found their way into banks’ trading books without a commensurate increase in capital to support the risks. The Committee has since strengthened substantially the rules that govern capital requirements for trading book exposures as well as for complex securitisations and exposures to off-balance sheet vehicles. The revised trading book framework, on average, requires banks to hold around three to four times the old capital requirements. Controlling leverage An additional and – as recent history has demonstrated – critical element to the regulatory capital framework is a backstop to the risk-based capital requirement. I am talking, of course, about the newly introduced leverage ratio. In the lead up to the last crisis, banks managed to comply with the risk-based regime: they reported brilliant Tier 1 risk-based ratios, while building up massive levels of on- and offbalance-sheet leverage. In good times, the market did not seem to care about this, but when the crisis hit, market participants required banks to meet basic measures of leverage. The subsequent process of deleveraging resulted in a downward spiral between the financial sector and real economy. To contain these cycles of boom and bust leverage and the gaming of the risk-based regime, the Basel Committee’s governing body agreed recently on the design of the leverage ratio and an indicative calibration of 3%. It is important to understand that the new leverage ratio not only includes on-balance sheet positions but also off-balance sheet items and derivatives, like credit derivatives. For global banks with significant capital market activities, this 3% calibration is likely to be more conservative than the traditional measures of leverage that have been in place in some countries. The proposed minimum of 3% will serve as the basis for testing during a parallel run period that will begin in January 2013 with full disclosure starting January 2015. The reason for the parallel run period is not to prolong the implementation. Rather, we want to make sure that the risk-based requirement and the leverage ratio floor interact in a manner that makes sense. And this can only be done when observed over different points of the economic cycle, taking into consideration the impact on different types of business models. Buffers The next essential element of the new regulatory capital framework is the build up of buffers in good times that can be drawn down in periods of stress. To achieve this, the Committee has proposed a capital conservation buffer. During the crisis, some banks that were under stress – in an attempt to signal their financial strength – continued to pay out dividends instead of retaining their profits, which would have replenished their capital. This behaviour was partly driven by a collective action problem: a reduction in dividends, it was feared, would be viewed as a sign of financial weakness. As a bank’s capital levels move closer to minimum requirements, the conservation buffer would impose a constraint on a bank’s discretionary distributions. These include dividend payments, share buy-backs and bonuses. Retaining a greater proportion of earnings during a downturn will help ensure that capital remains available to support the bank’s ongoing business operations during the period of stress. In addition, the Committee recently issued a proposal for a countercyclical buffer. This would be imposed when, in the view of national authorities, excess aggregate credit growth is judged to be associated with a build-up of system-wide risk. The countercyclical buffer would extend the conservation buffer range during such periods of excess credit growth. Conversely, the buffer would be released when, in the judgement of the authorities, the released capital would help absorb losses in the banking system that pose a risk to financial stability. This would help reduce the risk that available credit is constrained by regulatory capital requirements. Taken together, this framework of buffers will increase banking sector resilience and mitigate procyclicality. III. A new liquidity framework The reform measures I just described will radically transform the regulatory capital framework. In a similar way, the Committee has introduced a liquidity framework which is even more far-reaching since a global standard does not currently exist. For the first time, banking supervisors around the world will have a common international standard which they can apply to their banks. The liquidity phase of the crisis was characterised by the speed with which funding dried up and the extended period of time during which banks suffered from that shortage of liquidity. In response the Committee proposed global minimum liquidity standards that include measures to promote both the short-term resilience of banks to potential liquidity disruptions and longer-term structural liquidity mismatches. The Liquidity Coverage Ratio – the LCR – will require banks to have sufficient high-quality liquid assets to withstand a stressed funding scenario that is specified by supervisors. This is complemented by the Net Stable Funding Ratio – the NSFR – which is a longer-term structural ratio designed to address liquidity mismatches. It covers the entire balance sheet and provides incentives for banks to use stable sources of funding. Introducing a new set of standards is a complex process. Unlike the capital framework, for which there is extensive experience and data that help inform calibration, there is no similar track record for liquidity standards. The Committee is therefore taking a carefully considered approach to refine the design and calibration and we will review the impact of these changes to ensure that they deliver a rigorous overall liquidity standard. But let me be clear on this point: the Committee is committed to adopting both the LCR and the NSFR as the international standards for liquidity. IV. Systemic risk and interconnectedness I now turn to systemic risk and interconnectedness. The capital reforms and new liquidity standards that have been developed by the Committee will help improve the resilience of individual firms to stress. While it logically follows that stronger individual banks will lead to a stronger banking system, this firm-specific approach by itself may not be sufficient. Broader measures to strengthen the resilience of the entire banking system are equally important. This will also help address excess interconnectedness and the perception that some banks are too big to fail. The Committee has taken several measures to address the risks arising from exposures among global financial institutions that include: Capital incentives for banks to use central counterparties for over-the-counter derivatives; Higher capital for trading and derivative activities, as well as complex securitisations, which are associated with systemic risk and interconnectedness; Higher capital for inter-financial sector exposures as these are more correlated; and Cross-border bank resolution recommendations as a practical way to begin addressing the systemic risk issue at global banks. An additional way in which the Committee is addressing the too-big-to-fail problem relates to the use of contingent capital. The Committee recently published a proposal based on a requirement that the contractual terms of capital instruments will allow them – at the option of the regulatory authority – to be written-off or converted to common shares if the bank is judged to be non-viable by the relevant authority. We are also reviewing the potential role of “going concern” contingent capital in the capital framework. The Committee will review a fleshed-out proposal for the treatment of such going-concern contingent capital before year end. Finally, in collaboration with the FSB, the Committee is assessing the need for a systemic capital surcharge to mitigate the risk that certain banks perceived as too-big-too fail could pose on the system as a whole. This is an area where contingent capital could play a future role. V. Next steps After having agreed on the key design elements of the new capital framework and the definition of capital, the final remaining issue is to determine the calibration of the minimum requirements and regulatory buffers. Next week, the Committee will meet to discuss concrete calibration proposals. The Committee’s oversight body, the Group of Central Bank Governors and Heads of Supervision, will meet shortly after that. Our goal is to present to the G20 Leaders in Seoul a fully calibrated set of proposals for their endorsement. A final rules text would be issued at the end of this year. As part of this process, we also will make recommendations for a smooth transition to the new standard. VI. Benefits and conclusion I think an appropriate way to conclude my remarks is with the benefits we expect these reforms to confer. A few weeks ago, the Committee and the FSB published a report on the macroeconomic implications of the proposed higher regulatory standards during the transition to these new standards. This report was accompanied by an additional study conducted by the Committee on the long-term economic impact of the new standards. I will readily admit that existing macroeconomic models for understanding the links between the financial sector and the economy are not as well developed as they could be. In the face of this uncertainty, we have drawn on a wide range of models and assessed the central tendency and the variation across countries and methodologies. Moreover, we have considered factors that might overstate the economic impact and those that understate it. Our bias was to be conservative. Our work concluded that the transition to stronger capital and liquidity standards is likely to have only a modest impact on economic growth. If higher requirements are phased in over four years, we estimated that the level of GDP would decline by 0.19% for each one percentage point increase in a bank’s capital ratio once the new rules were in place. This means that the annual growth rate would be reduced by an average of just 0.04 percentage points over a four and a half year period. With respect to the impact of stronger liquidity standards, the study also found these are likely to have only mild transitional effects. In all of these estimates, GDP returns to just below its baseline path in subsequent years. With regard to the long-term implications, the Basel Committee’s assessment found that there are clear economic benefits from increasing the minimum capital and liquidity requirements from their current levels. The benefits of higher capital and liquidity requirements accrue from reducing the probability of financial crisis and the output losses associated with such crises. The benefits substantially exceed the potential output costs for a range of higher capital and liquidity requirements. The balance of evidence suggests that there is substantial room to strengthen capital and liquidity standards in a way that does not jeopardise near term growth, but enhances long term stability and economic output. Moreover, we need to understand that we continue to live in an economic environment with downside risks. In such circumstances, we cannot afford to continue to operate with such thin minimum regulatory capital and liquidity requirements. The system does not have the capacity for another round of bail outs, nor does the public have the tolerance for it. | netherlands bank | 2,010 | 9 |
Speech by Mr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the expert round table, World Legal Forum, Den Haag, 25 October 2010. | Nout Wellink: Towards an international dispute resolution facility for the financial markets Speech by Mr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the expert round table, World Legal Forum, Den Haag, 25 October 2010. * * * Ladies and gentlemen, it is a great pleasure to address you in this magnificent venue. The Peace Palace is a symbol of peace that – at the time of its opening in 1913 – was acclaimed to be a “dream palace as big and mighty as the idea of world peace itself”. The ambitions of world peace were embodied by contributions of numerous nations in the form of works of art, furniture and building material that today still decorate this building. This is a striking entourage to discuss new initiatives aimed at maintaining another global ambition, the ambition of financial stability. Financial innovation, advantages Over the past decades we have witnessed a huge growth in complex and innovative financial products, including in the over-the-counter (OTC) derivatives markets. According to the latest BIS estimates, the notional value of outstanding OTC contracts exceeded the staggering amount of 615 trillion USD by the end of 2009 1 . I believe that financial innovation has brought us real benefits. Financial products like credit derivatives have increased the possibilities to spread and manage risks. And indeed, the financial system proved to be better capable of absorbing shocks, as was demonstrated when the dot.com bubble burst or after 9/11. However, clearly, financial innovation has not prevented the financial crisis from happening. In fact, financial innovation is often pointed out as one of the root causes. Risks associated with financial innovation The risks associated with financial innovation are real. First of all, not only size, but also complexity in the markets for sophisticated financial products increased rapidly. This came at the cost of transparency. At the outset of the financial crisis, hardly anyone seemed to know what the true risks and value of complex financial products were and who would in the end bear the losses. In many cases, this was even true for the parties who created them in the first place. Risk management systems of financial institutions could hardly keep up with product innovation. Furthermore, the increased interconnectedness of financial markets made that not only gains, but also losses were transmitted through the system easily, hardly hampered by time or national borders. Although the system was less vulnerable to shocks, it turned out that it was at the same time prone to large accidents and sudden loss of confidence. By implication, the risks associated with financial innovation is nowadays a topic of heated debates among policy makers, market participants and academics worldwide. However, consensus exists that OTC derivatives markets have to become safer, more resilient and more transparent. Regular OTC Derivatives Market Statistics 11 May 2010. Derivatives can pose systemic risks One of the key risks associated with OTC derivatives is counterparty risk. Counterparty risk depends on a complex set of factors including the underlying value of the asset, the creditworthiness of the counterparty, and the interaction between the two. Optimal models that can properly assess these risks remain under construction. Furthermore, the lack of transparency of these markets plays an important role. With the strong growth of derivatives a complex network of bilateral dependencies has been created, opening up a web of interlinkages and contagion channels. This lack of transparency also makes it complicated to properly assess counterparty risk. Legal certainty supports financial stability Furthermore, OTC derivatives do form part of a sometimes highly complex legal framework. Over the last decades various branch organisations have undertaken the standardization of derivatives contracts, which is a means of diminishing legal risk of transactions. An international dispute resolution facility could in my view be a logical next step in these standardization efforts. It can lead to a further improvement of legal certainty and thereby – at least in an indirect way – support financial stability. Improvement of stability through legal certainty How would legal certainty be achieved? The fact that the same contractual terms are used across the world implies that a decision in a dispute between two parties may have implications that go beyond their specific contractual relation. The interpretation of a local court of a standard contract term might differ significantly from what the parties involved and the market would expect. The result: legal uncertainty for other transactions. This would also be true for disputes regarding transactions for which a court in another jurisdiction is competent; in the end, the same contractual terms are at stake. Therefore, the standardization efforts in the globalised markets can be partly hampered by decentralized and non-coordinated dispute resolution and interpretation of contractual terms. One universal court with judges and arbitrators specialised in this specific subject matter could reduce legal risks. But what should such a universal financial court look like? And how should it function to promote financial stability? These specific legal issues obviously are not the core business of a central bank, but I am happy to share some thoughts on this matter. The basic idea behind this is actually quite simple: legal certainty. Tribunal of public or private nature? The first question is: should this international dispute resolution facility be of a public or private nature? Full standardisation of the dispute resolution process in the financial markets could only be reached if states would transfer part of their jurisdiction to an international court on the basis of a treaty. At this moment there is no initiative to prepare a treaty like this, nor is there any indication that enough states would be willing to adhere to it. I will therefore focus on the standardization of the judicial process by private initiative. There are four features that an international dispute resolution facility should have from the perspective of stability. Swift and final end to disputes First of all, dispute resolution should be quick and final. Legal proceedings that last for years can be a burden to legal certainty. That does not only affect the parties to a dispute, but also the market as a whole. The fast resolution of disputes can for example prevent other institutions from engaging in litigation on the same standard contract terms. Therefore, a court decision can prevent procedures from being duplicated. Although arbitration procedures are not necessarily faster, the procedural rules could be shaped in such a way that parties can be forced to proceed swiftly. Between two parties engaged in the arbitration, a decision will normally mean an end to the dispute. An arbitral decision will also be recognised in most states under the New York Convention of 1958. A more challenging aspect is the voluntary nature of arbitration. No-one can be brought before the court without consent, implying that other parties cannot easily be joined in the same litigation. Responsiveness to party and market expectations Second, decisions should meet justified market expectations. Disputes on derivative contracts differ from other disputes for the reason that standard contracts are used across many jurisdictions worldwide. Parties to a contract may have agreed on its terms without having contemplated the economics or the history behind them. In some respects, the interpretation of such standard terms resembles statutory interpretation. To mitigate the risk of unexpected decisions, an international dispute resolution facility should consist of arbitrators with extensive knowledge of the specific market environment in which the transactions take place. Insight in conflict of law issues Third, financial markets are global, but their legal frameworks are of a regional or even national nature. This may make it hard to establish which jurisdictions apply in each case. Arbitrators would need to have a very good understanding of the conflicts of law this brings about. Therefore, it would be desirable to involve arbitrators with different legal backgrounds, depending on the matter at hand. In this way, the legitimacy of the court would be ensured, both towards the market and public stakeholders. Public availability of awards A last important feature is the public availability of judgements. The creation of a body of decisions on standard terms used in financial transactions would improve legal certainty, thereby enhancing the stability of the derivative markets. Yet, this goal would only be reached if the market would get to know the outcome of disputes and if the decisions rendered by the tribunal would be public. Any reluctance of market parties to go public with their disputes can be taken away by making the court decisions anonymous. Of course, different laws may be applicable to the relevant master agreements, and the regulatory regime in which the transactions take place may differ. However, if they are of a high quality and well motivated, the decisions may de facto be authoritative across the world by the power of persuasion of their content and the stature and prestige of the institution by which they are rendered. Other initiatives: central counterparties The idea of an international dispute resolution facility for the financial markets fits well in a rapidly changing environment. Both in the United States and in Europe, central counterparties [CCPs] for the central clearing of derivatives have been launched. ICE Clear Europe for instance clears credit default swaps and SwapClear is a CCP for interest rate swaps. This is a significant development, since for instance SwapClear claims to clear currently more than 40% of the global interest rate swap market, with a total notional principal of 229 trillion USD. Central clearing by CCPs not only mitigates counterparty risk, but also minimises the cash flows between counterparties. In addition, a CCP increases transparency, as it registers all transactions. Also, CCPs require daily collateralisation of open derivative positions which reduces the leverage in the financial system and contributes to financial stability. Legislative initiatives It is not surprisingly, therefore, that the G20 leaders committed in September 2009 that all standardised OTC derivatives should be cleared through CCPs by end – 2012 at the latest. Also, it decided that OTC derivatives contracts should be reported to trade repositories. In the US this resulted in the Dodd-Frank Wall Street Reform and Consumer Protection Act. In the EU, the European Commission recently proposed a Regulation that creates a framework for the regulation of CCPs and trade repositories. Both the EU and the US regimes aim to impose clearing and reporting obligations on a broadly defined class of derivatives. There are differences though at a more detailed level. In the US there is only a narrow exemption from the clearing obligation for non-financial entities that enter into certain hedging transactions. In the EU the clearing obligation applies to financial counterparties when dealing with other financial counterparties; non financial counterparties only become subject to the clearing obligation when their positions exceed a certain threshold. Nevertheless, an obligation to clear eligible derivatives through CCPs can only mitigate part of the risk associated with derivatives. After all, there will always be a need for bespoke contracts that cannot be standardised. By implication, there will be an OTC derivative market for tailor made or more complex products. Therefore, improvements of risks management systems are desirable, also for institutions outside the banking sector. Requirements to register derivatives contracts in central repositories, especially those that are not cleared through central counterparties, will contribute to transparency. Also, national authorities will have to cooperate closely and share relevant information in order to assess where systemic risk might be building up. Certain capital requirements / BASEL III Another recent initiative to mitigate counterparty risk in the derivatives markets is a proposal of the Basel Committee for Banking Supervision. The basis idea is straightforward: the capital weight for derivatives that are bilaterally cleared will be higher than those for derivatives cleared through CCPs. In this way, the additional risk for these trades can – at least – to some extent be taken into account. It also provides an incentive to clear derivatives through CCPs. The costs associated with the use of a CCP might be a lesser burden if capital needs to be reserved for bilaterally traded derivatives. In addition, the requirements for banks to use internal models for calculating capital requirements for derivatives will be tightened. This proposal also includes a reconsideration of the zero risk weight for CCPs, even when the CCP complies with international standards. CCPs will become systemically important, as more and more derivatives will be cleared through CCPs. There will be a concentration of risks on CCPs. Therefore, the Basel Committee also proposes to increase the capital charge for exposure on CCPs [the current charge for CCPs is 0%]. The capital charges will be calibrated in such way that the incentive to use CCPs will be preserved. The establishment of an international dispute resolution facility that contributes to legal certainty in the OTC derivatives markets, fits well in a broad range of initiatives to enhance financial stability. DNB therefore welcomes this initiative. Conclusion I started by saying that this is an inspiring place to discuss an international dispute resolution facility for the financial markets. It might even be worth to consider establishing this facility just here as well. Although the concept of a world financial tribunal is of greater importance than the question of where it is located, I believe the tribunal would find a perfect home in The Hague. The first world peace conference was held in 1899 in The Hague and resulted in the establishment of the Permanent Court of Arbitration. The idea of adding private dispute resolution in the financial markets to this landmark decision would fit perfectly in The Hague’s international judicial tradition. | netherlands bank | 2,010 | 10 |
Remarks by Mr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the 16th International Conference of Banking Supervisors, Singapore, 22 September 2010. | Nout Wellink: A new regulatory landscape Remarks by Mr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the 16th International Conference of Banking Supervisors, Singapore, 22 September 2010. * * * Introduction and background Good morning and welcome to the 2010 International Conference of Banking Supervisors. I will start by thanking our host – the Monetary Authority of Singapore. I would like to thank in particular MAS Managing Director Heng Swee Keat and his deputy, Teo Swee Lian, and the staff of MAS for doing a marvellous job of organising and hosting this ICBS. It has been two short years since we last met in Brussels at the 2008 ICBS. In my opening remarks at that conference, I used the occurrence of storms and the need to build strong dikes as metaphors for the financial crisis and the need for a strong supervisory response. This morning I will reflect on our response to the recent financial storm, which is designed to protect against future crises. Consider the extraordinary financial landscape around the time of the last ICBS. In September 2008 alone: Lehman Brothers declared bankruptcy, the other large US investment banks converted to bank holding companies, Fannie Mae and Freddie Mac were nationalised, AIG was brought back from the brink of collapse, Fortis, the financial conglomerate, was broken up and sold, Iceland’s largest commercial bank – and subsequently the banking system – collapsed, and many countries had to step in to provide massive support to their banks. This was the height of the crisis. Since then, the financial and banking system have been stabilised and we are on the road to recovery. But this has come at a high cost: many government budgets have been stretched due to massive amounts of official sector support. There was a fundamental spillover from the financial crisis to the real economy. This resulted in lost wealth and a loss of jobs. It is not yet over and risks remain. While painful and costly, the crisis has nonetheless presented an opportunity to put in place longer term reforms that are needed to make banks and the financial system more resilient to future periods of stress. The Basel Committee has been at the core of this reform agenda, which was crystallised at the G20 Leaders summit last year in Pittsburgh. Last year we also expanded our membership by doubling in size to 27 jurisdictions. We have benefited immensely from this broadened membership, both in terms of wisdom and legitimacy. This morning I would like to describe ways in which the Committee has responded to this financial storm and to prepare for the next storm. I will start first by talking about the Committee’s bank-specific reforms, the goal of which is to make banks more resilient to shocks. But a bank-specific approach is not enough. The Committee is also addressing system wide risks and I will also say a few words about this. Making the banking system more resilient The core of our bank-specific reforms is stronger capital and liquidity regulation. The Basel II framework was bolstered significantly in July 2009 and the Committee’s December 2009 proposals, which were signed off-on in September, will further strengthen existing Basel II capital treatments. In other respects, the December 2009 proposals introduced global standards where none currently exist (eg a leverage ratio and liquidity requirements). Collectively, the revised Basel II capital framework and the new global standards have been commonly referred to as “Basel III”. With the benefit of hindsight, pre-crisis capital standards were too weak for the types of risks that were building up in the system. Keep in mind that the effects of the crisis became manifest in 2007 and built-up prior to the implementation of Basel II. Many countries that have adopted Basel II did so in 2008 or later. So this was not a Basel II crisis. The deficiencies leading to the crisis were numerous and attributable to many. This includes bankers, investors, rating agencies and supervisors. From the regulatory perspective, the main inadequacy related to the level and quality of capital. Instead of 8% of hard capital backing risks, many banks typically held 2%. And if you consider that regulatory adjustments, such as goodwill, are deducted from Tier 1 or Tier 2 capital, then it was possible for banks to have even lower levels of tangible common equity. The set of capital rules governing trading book exposures was another regulatory deficiency. Banks had built up massive illiquid credit exposures in these portfolios. The VAR-based capital regime, with its 10-day liquidity horizon was not designed for this. Banks abused this regime, and warehoused highly illiquid, structured credit assets in the trading book for which there was no market, which were impossible to value when liquidity broke down, and for which too little capital was held to protect against risks. This is where the first wave of losses hit. These were two important deficiencies but there were others, like liquidity. Many banks relied excessively on wholesale funding to finance securitised, illiquid assets. In addition, there were poor incentives and governance at the firm level along with a lack of transparency, which made it nearly impossible to understand a bank’s exposures or the quality of the capital backing them. So what has the Committee done in response? First, we have strengthened the capital base. Raising the quality, consistency and transparency of the capital base has been one of the primary objectives of the Committee’s reform programme. Overall, these rules that will govern the capital structure represent a substantial strengthening of the definition of capital. By itself, the new definition of capital is a significant improvement to the global capital regime, which will be enhanced further by better risk coverage, the introduction of buffers and higher minimum capital requirements. On top of this comes the higher level of capital. In addition to raising the quality of the capital base, the Committee has improved risk coverage of the regulatory framework and more improvements are on the way. Our goal is to ensure that all material risks are captured. During the crisis, many risks were not reflected in the risk-based regime. The Committee has substantially strengthened the rules that govern capital requirements for trading book exposures as well as for complex securitisations and exposures to off-balance-sheet vehicles. The revised trading book framework, on average, requires banks to hold around three to four times the old capital requirements. We are now finalising rules that will strengthen the capital requirements and risk management standards for counterparty credit risk. An additional element to the regulatory capital framework is a leverage ratio, which will serve as a backstop to the risk-based capital requirement. In the lead-up to the crisis, many banks reported very strong Tier 1 risk-based ratios while, at the same time, managed to build up high levels of on- and off-balance sheet leverage. The use of a supplementary leverage ratio will help contain the build-up of excessive leverage in the system. It will also serve as an additional safeguard against attempts to “game” the risk-based requirements and will help address model risk. In July, the Committee’s oversight body of Governors and Heads of Supervision agreed on an indicative calibration of 3% as a minimum for the leverage ratio to be tested during the parallel run period, with a view to be implemented on January 1st, 2015. For global banks with significant capital markets activities, this 3% calibration is likely to be more conservative than the current measures of leverage in place in some countries. The new definition of capital and the inclusion of off-balance-sheet items in the calculation of the leverage ratio are the main factors. The reform measures described above radically transform the regulatory capital framework. The Committee’s proposed liquidity framework will have as profound an effect since a global liquidity standard does not currently exist. During the crisis, funding remained in short supply for an extended period. In response, the Committee has proposed global minimum liquidity standards to make banks more resilient to potential short-term disruptions in access to funding and to address longer-term structural liquidity mismatches in their balance sheets. The Liquidity Coverage Ratio (LCR) will require banks to have sufficient high-quality liquid assets to withstand a 30-day stressed funding scenario that is specified by supervisors. This is complemented by the Net Stable Funding Ratio (NSFR), which is a longer-term structural ratio designed to address liquidity mismatches. Introducing a new set of standards is a complex process. Unlike the capital framework, for which extensive experience and data help inform calibration, there is no similar track record for liquidity standards. The Committee is therefore taking a carefully considered approach to the design and calibration and will review the impact of these changes to ensure that they deliver a rigorous overall liquidity standard. It will introduce the LCR as a minimum standard in 2015 after thoroughly assessing its behaviour. In a similar way, the Committee will also carry out an “observation phase” to address any unintended consequences across business models or funding structures before finalising and introducing the revised NSFR as a minimum standard by 1 January 2018. The Committee will revise the NSFR by the end of this year and will test it during the observation phase. These initiatives – higher and better quality capital, improved risk coverage, introduction of a leverage ratio and new global liquidity standards – are the foundation for the Basel Committee’s response to the crisis. But they are not the whole story. The Committee has also developed supervisory guidance on other important bank-specific initiatives. These include stress testing, valuation, corporate governance, compensation, supervisory colleges, and high level principles for financial instruments accounting. Addressing systemwide risks While stronger individual banks typically lead to a stronger banking system, this firm-specific approach by itself may not be sufficient. Broader macroprudential measures to address procyclicality and to strengthen the resilience of the entire banking system are equally important. A systemwide focus addresses problems related to interconnectedness and the perception that some banks are too big to fail. An essential element in addressing systemwide risk is the build up of buffers in good times that can be drawn down in periods of stress. To help achieve this, the Committee has introduced a capital conservation buffer. As a bank’s capital levels move closer to minimum requirements, the conservation buffer will impose a constraint on its discretionary distributions. These include dividend payments, share buybacks and bonuses. Retaining a bigger proportion of earnings during a downturn will help ensure that capital remains available to support the bank’s ongoing business operations and lending during the period of stress. This buffer of 2.5% will be comprised of common equity and will be fully phased in by the end of 2018. In addition, the Committee in July 2010 issued a proposal for a countercyclical buffer which would be imposed when, in the view of national authorities, excess aggregate credit growth is judged to be associated with an excessive build-up of system-wide risk. The countercyclical buffer would increase the conservation buffer range by up to an additional 2.5 percentage points during such periods of excess credit growth. Conversely, the buffer would be released when, in the judgment of the authorities, the released capital would help absorb losses in the banking system that pose a risk to financial stability. This would help reduce the risk that available credit is constrained by regulatory capital requirements. Taken together, this framework of buffers is intended to increase banking sector resilience and mitigate procyclicality. The use of “gone concern” contingent capital would increase the contribution of the private sector to resolve future banking crises, thereby reducing moral hazard. The Committee recently published a proposal for consultation based on a requirement that the contractual terms of capital instruments will allow them – at the option of the relevant authority – to be written off or converted to common shares if the bank is judged to be non-viable by the relevant authority. The potential role of “going concern” contingent capital in the capital framework is also currently under review. The objective here is to decrease the probability of banks, or the banking system as a whole, reaching the point of non-viability. Several initiatives discussed above will help reduce procyclicality. These include the leverage ratio, capital conservation buffer and countercyclical capital buffer. In addition, the Committee is reviewing different approaches to address any excess cyclicality of the minimum capital requirements. It has also developed a concrete proposal to operationalise an expected loss approach to provisioning that was proposed by the IASB. While procyclicality amplified shocks over the time dimension, excessive interconnectedness and the too-big-to-fail issue also transmitted shocks across the financial system and economy. Work on this topic is ongoing. The Committee and the Financial Stability Board are developing a well integrated approach to systemically important financial institutions. This could include combinations of a capital surcharge, bail-in debt and contingent capital. Many of the Committee’s reform measures also help address risks that originate or concentrate outside of the banking sector. For example, the Committee’s July 2009 Basel II enhancements specifically addressed risks related to securitisations, resecuritisations and off-balance-sheet exposures (eg structured investment vehicles). In addition, the limitation established by the leverage ratio, which takes account of off-balance-sheet exposures, and the measures to improve both the risk management and capitalisation of counterparty credit risk, will also play important roles. Moreover, a heightened sensitivity to financial innovation and the regulatory perimeter, a renewed focus on consistent and timely implementation, as well as more rigorous supervision will help safeguard against risks arising from or concentrating in a non-banking sector. Conclusion and the road ahead In all, the Committee has taken major steps to move the banking system to a much higher level of resilience. If, prior to the crisis, banks had the levels of capital we are asking for, we likely would not have experienced such a deep crisis. Let me be clear, the current standards are extremely demanding. Before we even raise the level of capital, we have introduced a much stricter definition of capital. This is equivalent to a substantial increase in the minimum requirement by itself. In addition, we have raised the capital requirement for trading, derivatives, and interbank exposures by a substantial amount. Finally, we have increased the amount of common equity that banks need to hold from 2% to 7%. To help illustrate this point, for many global banks, a 7% requirement is substantially higher than the same number under the old standard, as one must factor in both the effect of regulatory adjustments to common equity and the higher risk-weighted asset requirements for trading and counterparty exposures. This is a fundamental improvement in addition to the other improvements I have mentioned and the Committee has taken full account of the potential impact. It has conducted a comprehensive quantitative impact study and other analyses to assess the impact of its regulatory reforms. In August, the Committee and the FSB published a report on the macroeconomic implications of the proposed higher regulatory standards during the transition to these new standards. This report concluded that the transition to stronger capital and liquidity standards is likely to have only a modest impact on economic growth. This report was accompanied by an additional study conducted by the Committee on the longterm economic impact of the new standards, which concluded that there are clear economic benefits from increasing the minimum capital and liquidity requirements from their current levels. These benefits accrue from reducing the probability of financial crises and the output losses associated with such crises. Indeed, in recognition of this more stringent regime and to support the ongoing recovery, the Committee is keen to provide for a smooth transition. As of 2013 the standards rise each year to their final level at the end of 2018. Over the same period, the leverage ratio and the liquidity standards will also be phased in. These are minimum requirements. We have said that countries should move faster if their banking systems are profitable and able to do so without having to restrict credit. Banks should not be permitted to increase their distributions if they are still below the ultimate target but feel they can take their time to get there. Banks can meet the new standards through earnings retention, capital raising, or reducing their riskier exposures that are not necessarily associated with the granting of credit to ultimate borrowers. Will our response to the recent financial crisis be adequate? The answer to this is “yes” but a qualified “yes” as there is much more to be done and the crucial second step of the policymaking process has yet to take place. I refer here to implementation and rigorous supervisory follow up. We must remember that memories fade quickly. Regardless of how tough the new standards are and how we expect them to increase the resilience of bank and banking systems, they must be effectively implemented and enforced. Moreover, our standards need to keep pace with financial innovation. We have provided a road to a much safer banking system. When we meet again in two years, it is my hope that the banking sector and broader economy will be well along towards greater resilience. Thank you very much for your attention. | netherlands bank | 2,010 | 11 |
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Colloquium of the Centre for Financial Studies, Frankfurt am Main, 8 December 2010. | Nout Wellink: Rebuilding the financial sector Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Colloquium of the Centre for Financial Studies, Frankfurt am Main, 8 December 2010. * * * Introduction 1. Ladies and gentlemen, the financial crisis that has raged since July 2007 is a manyheaded monster. At its core is a lack of market confidence in financial institutions and in some countries. I will speak about the background to the global financial crisis, its impact, and about the current situation in some European countries. I will elaborate on some challenges we face for the future. In particular, I will focus on strengthening the resilience of the banking sector, including the approach towards too-big-to-fail banks. I will conclude with the initiatives to enhance macro-prudential supervision. Causes of the global crisis Global fire fuelled by interdependencies, … 2. After the first signs of difficulties with subprime mortgages in the United States emerged in the summer of 2007, they were long thought to be a specific US problem that would only indirectly affect other parts of the world. That proved an illusion: the mortgage problem in the US was the spark that set the system on fire worldwide. The flame was kindled by the negligent contracting of mortgage loans, via risky constructions and poor documentation. The popularity of financial innovations generated an opaque pyramid of financial risks that became steadily more unstable. … and insufficient buffers 3. The innovations enlarged the net leverage in the system, because they enabled banks to operate with an ever slimmer capital position; the ratio between assets and capital at large banks before the crisis averaged out at more than 30. The supervision of liquidity risks at banks was inadequate and fragmented, also in Europe. In addition, the innovations deepened the interdependencies between financial institutions, and hence the pace and scope of contagion channels. In other words: the fuel to start a great fire was omnipresent. The crisis eventually erupted with great force after the collapse of the US investment bank Lehman Brothers in September 2008. The losses caused by that collapse and the major uncertainty about who exactly was hit, led to a disappearance of market confidence and a full-blown systemic crisis. Global imbalances contributed to indiscipline 4. Although the relative importance of the various causes is subject to debate, there is now a rather broad consensus about the developments that led to the crisis. The globalisation and integration of some parts of the global economy, like China and Eastern Europe, that had thus far been isolated was coupled with the build-up of global imbalances. Excessive debt build-up in Western, notably Anglo-Saxon, countries went in tandem with huge surpluses in oil-exporting countries and Asian countries. Asian countries stuck to a stable currency, causing the imbalances to continue and their currency reserves to accumulate. The investment of these reserves in the US kept US interest rates low, the socalled global savings glut, contributing to financial indiscipline in that country. Loose monetary policy another cause 5. The accommodating monetary policy, particularly in the US, sowed the seeds for the imbalances. In the years before the crisis, money supply growth well outpaced potential GDP growth. This was not reflected in mounting inflation, because the supply of relatively cheap products from Asia kept price rises moderate. Nonetheless, the monetary expansion resulted in an acceleration of asset prices and credit aggregates. Before the crisis, lending in industrial countries grew by around 10% annually. The low interest rates and the abundant availability of credit encouraged a search for yield. Risks were underpriced and bubbles could easily arise, especially in real estate. This was the case in the US but also in some European countries. With hindsight, the interest rates were too low to tame the monetary expansion and other, more macro-prudential, instruments should have been deployed to contain the credit expansion. What has been the impact of the crisis? Serious damage in financial sector, partly at governments’ expense 6. Writedowns on securitisation products and on ordinary loans led to huge losses in the banking sector. Banks worldwide have written down around USD 1,400 billion. This blew big holes in their capital base, and in order to uphold confidence in the sector, governments rigged up extensive support programmes. Some USD 500 billion was pumped into the banks, while bank debts and asset risks were guaranteed and deposit guarantees were extended. Large amounts were required to stabilise institutions, relative to GDP especially in Ireland, Belgium and the UK. Real economy hit hard 7. The current economic downturn is deeper, more prolonged and more widespread than those occurring after 15 previous crisis periods in history, according to a multi-country study by Reinhart and Reinhart (2010). This reflects the radical deleveraging in the financial system. The study shows that deleveraging after a financial crisis is often initially postponed and is a lengthy process of on average seven years. The revival following a financial crisis hence tends to be very slow. A rapid recovery in the global economy set in over a year ago. As of the end of last year, that recovery has gradually flattened out somewhat, but the likelihood of a double dip in the US seems slight. The European debt crisis: imbalances underpin negative momentum 8. Let me mention some words on the debt crisis that is currently plaguing Europe, on the causes and on the policy response. It was clear when establishing EMU that the currency union did not satisfy the ideal conditions. A currency union should preferably be coupled with a political union, and the latter – notwithstanding the continuing European integration – is still not in place. Large balance-of-payments imbalances had been built up, with Germany and the Netherlands running surpluses of around 5% of GDP and the so called peripheral countries reporting deficits of 5% of GDP or more. The current account deficits were a signal of major structural imbalances, such as in public finances. When investors became reluctant to finance the deficits, the debt crisis unfolded. This threatened financial stability Europe-wide because the countries in the euro area are highly interdependent financially. Decisive action by governments required 9. In the market turbulence last May, Greece was the epicentre. With drastic intervention, government leaders and the ECB temporarily managed to turn the tide and market turmoil abated. However, owing to concerns surrounding Ireland, the market turbulence flared up again recent weeks, with market participants fearing potential contagion to other peripheral countries. To maintain market and public confidence, it is essential that countries make every effort to introduce a credible consolidation programme and reforms to bring public finances onto a sustainable path. The primary responsibility for improving public finances lies with the authorities. Moreover, Europe and the IMF have set up an ultimate safety net that could also be resorted to if need be, while the Eurosystem provides enhanced credit support with the aim of safeguarding monetary transmission and preventing tight credit rationing in the private sector. In November, Ireland concluded a program with the European Commission and the IMF, in liaison with the ECB. This program will deliver an important contribution to restoring financial stability in the country. Lessons learned and challenges 10. The worldwide crisis has exposed some fundamentally weak spots in the international economy and the global financial system. In many cases the efforts to address them have only just got under way, while there is still much uncertainty about the effects of the measures. I will focus on two main challenges, first strengthening the banking sector and second enhancing macro-prudential oversight. Strengthening the resilience of banks 11. Banks were at the epicentre of the crisis. After the wave of bank collapses, nationalisations, conversions, break-ups, sales, bailouts – all of which impacted on the real economy – the financial and banking system seems to have stabilised and to be on its way to recovery. However, reforms are essential to make the financial and the banking system truly resilient during periods of stress. The Basel Committee on Banking Supervision has announced a comprehensive package of measures to strengthening the banking sector. The contents of what we now call Basel III were endorsed by the G20 World leaders, in Seoul beginning of November. Basel III contains bankspecific reforms, the goal of which is to make banks more resilient to shocks. It also addresses system wide risks, as a bank-specific approach will not be enough. Bank specific reforms 12. The core of the bank-specific reforms is stronger capital and liquidity regulation. Raising the quality of the capital base has been one of the primary objectives of Basel III. In the future, the emphasis will be on core capital, that is common equity and retained earnings, and banks will have less incentive to attract lower quality capital. In line with these qualitative improvements is the increase in the minimum quantity of regulatory capital. For the first time, a hard minimum requirement has been set for core capital, namely 4.5% of a bank’s total risk-weighted assets. In addition, the Committee has improved risk coverage of the regulatory framework and more improvements are on the way. The goal is to ensure that all material risks are captured. During the crisis, many risks were not reflected in the risk-based regime. Capital requirements for trading book exposures as well as for complex securitisations and exposures to off-balance-sheet vehicles will be increased substantially, about three to four times the old capital requirements. 13. An additional element to the capital framework is a leverage ratio, which will serve as a backstop to the risk-based capital requirement. In the lead-up to the crisis, many banks reported very strong risk-based capital ratios while, at the same time, managed to build up high levels of on- and off-balance sheet leverage. The use of a supplementary leverage ratio will help contain the build-up of excessive leverage. It will also serve as an additional safeguard against attempts to “game” the risk-based requirements and it will help address model risk. A minimum leverage ratio of 3% will be tested during an observation period. 14. The proposed liquidity framework will also have a profound effect since a global liquidity standard does not currently exist. During the crisis, funding remained in short supply for an extended period. In response, the Committee has proposed global minimum liquidity standards to make banks more resilient to potential short-term disruptions in access to funding and to address longer-term structural liquidity mismatches in their balance sheets. The Liquidity Coverage Ratio will require banks to have sufficient high-quality liquid assets to withstand a 30-day stressed funding scenario. This is complemented by the Net Stable Funding Ratio, which is a longer-term structural ratio designed to address liquidity mismatches. Addressing system-wide risks 15. However, this firm-specific approach by itself will not be sufficient. Broader macroprudential measures to strengthen the entire banking system are equally important. An essential element in addressing system wide risk is the build up of buffers in good times that can be drawn down in periods of stress. The Committee has introduced two capital buffers. First a capital conservation buffer, which will increase the minimum capital requirements with 2.5%. As bank’s capital levels move closer to minimum requirements, the conservation buffer will impose a constraint on its discretionary distributions, like dividend payments, share buybacks and bonuses. Secondly, the countercyclical buffer, which would be imposed when excess credit growth is associated with an excessive build-up of system-wide risk. This buffer can vary between 0 and 2.5%. 16. In order to give banks time to adjust to the new requirements and to support the ongoing economic recovery, Basel III will be implemented gradually. From 2013 onwards, the increase of the minimum requirement for core capital will be phased in three years’ time. And only thereafter the capital conservation buffer will be introduced step-by-step in four years’ time. The new liquidity standards will be implemented after an observation period to ensure their effectiveness. Too important to fail 17. But an effective system wide focuses also addresses problems related to interconnectedness and the perception that some banks are too important to fail. Some institutions have grown so vital for financial stability that they have become systemically important and their failure is not a socially acceptable option. During the financial crisis, government authorities had no other choice then to save these institutions. At the same time losses of external capital providers were kept to a minimum. Let me explain the concept of systemically important financial institutions, the so called SIFIs, and discuss the international policy response to address the problems related to “too important to fail”. 18. There are roughly three characteristics that make an institution systemically important: its size, interconnectedness and limited substitutability. Size measures the volume of financial services provided by a financial institution. Interconnectedness increases the extent to which problems at an institution may affect the financial system. This may happen via an institution’s direct links with other institutions as well as indirectly, via its role in the financial infrastructure or financial markets. The third factor, limited substitutability, indicates that if crucial functions or services cannot be quickly and easily taken over by another party, the system can become seriously disrupted. 19. Aside from these structural characteristics of institutions, two other factors may accelerate the spillover to the entire financial system. First of all, the complexity of the organisation structure. Complex and internationally active banks cannot be easily wound up nor can their crucial functions be easily transferred to another party. Secondly, in a crisis situation, confidence effects and herding behaviour of market participants play a reinforcing role. FSB Framework for SIFIs These contagion channels made bailouts of systemic institutions during the crisis inevitable. Such intervention, however, carries a number of problems, like a burden on fiscal position, creating moral hazard by making government guarantees explicit, and undermining the level playing-field between institutions. Therefore, steps have been taken to tackle the tooimportant-to-fail problem. The Financial Stability Board has developed a policy framework to deal with systemically important financial institutions, which the G20 World leaders ratified last month. This framework is designed to reduce the probability and impact of a failure of a SIFI. It rests on more intensive supervision, higher buffers for SIFIs compared to Basel III and an increased resolution capacity of national authorities. The case for macro-prudential oversight 20. On top of these new standards and regulations, enhancing supervision is also vital. Macro-prudential oversight is, to put it simply, the missing link between the different approaches of a central bank and a financial supervisor. A central bank significantly promotes financial stability by aiming at low inflation, sound payment systems and sustainable credit growth. Supervisors exercise their responsibility for the stability of individual financial institutions by ensuring that they have adequate buffers to withstand shocks. The problem is that both responsibilities, although closely interrelated, have been poorly attuned. Let me explain. 21. In the run-up to the crisis, most central banks warned against the risks to the financial system. But these warnings did not prove meaningful, as they were not effectively translated into mitigating action by supervisors. Likewise, most supervisors believed that if individual institutions were sound, the financial system as a whole would be too. However, the financial crisis has shown that supervision of individual institutions is important, but not sufficient to preserve financial stability. 22. The message is clear: the supervision of the financial system as a whole should be strengthened to lower the chance and impact of future crises, and this requires central banks and supervisors to join forces. One important added value of macro-prudential oversight is that it looks at the interactions between financial institutions and their environment. A single bank, say, can exercise only a limited influence on housing prices. But, if many banks eased their credit standards for mortgage loans, housing prices could soar, possibly causing the housing market to overheat. A housing market crash can entail huge losses for the banking sector and the real economy. Thus, by monitoring the interactions within the financial system, including the dynamics behind a build-up of imbalances, macro-prudential oversight can identify threats to financial stability. In light of these lessons, the EU political authorities have decided to establish a new European Systemic Risk Board per 1 January 2011 to strengthen macro-prudential oversight in the EU. Conclusion 23. Ladies and gentlemen, let me come to an end. I have talked about one of the most sweeping crises the financial world has been confronted with since a long time. Governments, supervisors and the financial sector worldwide have replied to this with ambitious measures and reforms. I am sure that many people, maybe even some among you, will question whether all these measures and initiatives will in the end improve the world? It is a simple and fair question, with no easy answer! And though I am no fortune teller, I firmly believe that these reforms will make the financial sector healthier, stabilise economies and so improve the world. 24. And the need for these reforms is evident. A recent IMF study, for instance, estimates the costs of a financial crisis at around 15 percent of GDP, while research that factors in the long-term impact of a crisis might easily arrive at a multiple of this figure. With the measures we discussed, future crises will become less probable. At the same time we should realise that this objective is not presented to us on a silver platter. All the parties involved will have to work hard to meet all the requirements now that implementation is the next challenge. So let us not wait too long, and start making plans instead. Thank you for your attention. | netherlands bank | 2,010 | 12 |
Speech by Ms A J Kellermann, Executive Director of the Netherlands Bank, at the European Central Bank (ECB) Diversity forum, Frankfurt am Main, 28 March 2011. | Joanne Kellermann: The challenge of diversity in central banks Speech by Ms A J Kellermann, Executive Director of the Netherlands Bank, at the European Central Bank (ECB) Diversity forum, Frankfurt am Main, 28 March 2011. * * * Within De Nederlandsche Bank, role models are important for the emancipation of its female staff. As the first and only woman on DNB’s Governing Board, I am glad to act as a role model in that sense. Although DNB may appear to be a male bastion, it’s good to remember that its continuance – shortly after its establishment – depended on a woman: the widow Borski. When King Willem I founded De Nederlandsche Bank in 1814, not all of the 5000 issued shares were sold immediately. However, Madam Borski had confidence in the newly established bank and, in 1815, she decided to buy the remaining 2000 shares. Her purchase was subject to a secret condition that the King would not issue any extra shares for three years. Many years later Madam Borski sold her shares at a tidy profit. Introduction – general Many women are inclined by nature to wait until the organisation notices their management potential. They only apply for a position if they comfortably meet all the job requirements. When interviewing job candidates of their own sex, recruiters tend to more easily recognise gender-specific aspects and to value them more highly. Personal Within our organisation too – despite our successful diversity policy – these gender aspects sometimes play a significant role. As a woman member of DNB’s Governing Board, I see it as my task to speak out in such situations. For example, not a single woman was included in a recent list of potential candidates for the position of Divisional Director. However, I was able to intervene to add the name of a good female candidate to the list. Why do we need a diversity policy? DNB is convinced that diversity among its staff will lead to better results. In view of the tighter labour market, DNB is keen to use female potential. Finally, as a guardian of financial stability, DNB has an important social role. In keeping with our social responsibility, we wish to pursue a diversity policy that ensures that our workforce is a good reflection of our society. This means that diversity within DNB embraces more than just the gender aspect, which I am focusing on today. Cases in point are employees with different cultural backgrounds, an occupational handicap or different sexual preferences. I’m glad to tell you that DNB has its own network for homosexual and lesbian employees and that, for the third time, DNB will participate with its own boat in the Canal Parade as part of the Amsterdam Gay Pride celebration. The Talent to the Top Charter Let me tell you about an interesting Dutch initiative, launched in 2007 by the government, corporate sector and women’s representatives: the Talent to the Top Charter. The idea behind the Charter is to bring more talented women to the top and help keep them there. The Netherlands was lagging behind internationally in respect of the number of women in top BIS central bankers’ speeches management positions. In 2008, the signatories reported that the number of women in top functions at their organisations was 16.7%. Their aim is to bring this figure up to 24.6%. The Talent to the Top Charter has since been signed by almost 170 organisations, including DNB in 2008. Commitment by DNB By signing the Charter, we committed ourselves to realising and preserving a continuous smooth flow of women into top positions. Here is an overview of the exact percentages at DNB over the past few years. A commission will monitor whether we actually honour our commitment as a signatory. Starting from the year 2009, when women were underrepresented at 28%, DNB has set itself a target that women will fill 32% of its management positions in 2012. It’s important to note that at that moment – in 2009 – there were not many women whose potential talent had been recognised and who were being groomed for a managerial position. So what is DNB’s vision and policy to meet the challenge of increasing gender diversity. What measures have been taken to realise this vision? I’d like to share our experiences and the lessons we have learnt in the process. DNB’s vision and objectives In the context of our commitment to the Talent to the Top Charter, we have set some target figures for 2012. These clear and measurable targets show where we are heading, but are not an end in themselves. The slide shows the situation in 2004, where we are now, and our target for 2012. The target for divisional directors is set at 25%, for department heads at 30% and for section heads at 40%. DNB’s Governing Board has expressly committed itself to these targets and the Supervisory Board is given an annual update on progress towards them. DNB has translated this vision into several diversity targets. Within DNB, we promote that: more women enter the organisation as professionals and later move on to management positions, more women participate in training and mentoring programmes, more women are nominated for management vacancies and are appointed and more women with valuable capacities are seen and stimulated to put themselves forward and to present themselves as management candidates. We deploy a range of instruments to realise these diversity targets. Let’s take a look at some specific instruments. Instruments 1) Entrants We made our recruitment and selection process diversity-proof by enhancing the awareness of gender aspects among our recruitment and selection staff. In addition, the HR advisors who interview candidates are trained to operate from a broader gender perspective. Moreover, we try to always include a woman in the selection commission, which generally consists of an HR advisor, line manager and sometimes a team member. BIS central bankers’ speeches 2) Development – VLOT and questions DNB has its own year-long training programme to develop management potential. Within DNB, this management development programme is important for employees’ chances of securing a management position. Formerly, candidates applied to join the programme themselves. Now, the divisional directors have been asked to nominate candidates and to ensure that at least half of the nominees are female. If the ratio falls short, our management commission will discuss the nominations with the divisional director. Women should make up at least 40 percent of the group that is eventually admitted to the management development programme. To create a sufficient pool of high-potential women, DNB launched a personal development course for young promising staff a few years ago. At least 40 percent of the entrants to this group, too, should be women. 3) Appointments to management positions DNB uses an open application procedure for management vacancies. Management development staff regularly discuss gender diversity with the persons involved in selecting and interviewing candidates. The name of the preferred candidate is passed on to a management commission, consisting of four divisional directors, which then puts the proposed nomination before the DNB Governing Board. An important success factor in recognising female management potential is that women make up 50 percent of this management commission. After all, people are more inclined to appreciate gender-specific aspects in a candidate of their own sex. Another important success factor is that Management Development staff actively encourage female colleagues to apply for a management position. Women still appear to need such encouragement. Finally, I notice that divisional directors are becoming more keen to appoint a female candidate to enhance diversity in their team. 4) Discovering female talent Within DNB, too, women tend to wait until the organisation notices their management potential. The Human Resources department hence engages in active dialogue with DNB’s female staff. In this way HR officers detect management potential and gain an overall impression of women’s professional desires and ambitions and the obstacles facing them in their career. Our terms of employment are already conducive to female participation thanks to the opportunity for a 36-hour working week over four days and partially paid parental leave. Moreover, working times at DNB are flexible. We aim to support talented women with the ambition to become managers. Through our “Empower yourself” workshops and mentoring, women with valuable capacities can be identified and encouraged to profile themselves as management candidates. As our mentoring system had proved itself in practice as an effective development tool, we decided to radically expand it in 2009. Part of the success of mentoring is that it is an easy and quick way for adults to learn. 5) Management targets The success of these diversity measures hinges on management commitment. When we introduced this diversity policy we made managers aware of the prejudices against women, but also of the benefits they bring to the workplace. Diversity, in a broader sense too, was highlighted through workshops and seminars. BIS central bankers’ speeches All managers at DNB are required to set personal performance targets for promoting diversity. The point is not to meet a specific target figure but to give an undertaking to actively support more diversity. Role models are also important within DNB. Role models make employees aware of the effect of their own behaviour and create support for the envisaged changes. A women’s network at DNB organises a wide range of activities for all DNB staff. As of 2007, a man or women who acts as a role model for others is chosen from a shortlist. A person who makes an significant contribution to shifting the boundaries within DNB is awarded an annual trophy. I am honoured to say that the trophy bears my name because, thanks to my position, I can act as a role model for many female colleagues. I’m sure you are wondering whether our measures have worked. Fortunately, the answer is unmistakably yes. We are on track, and it now looks as if women will fill 32% of management positions at DNB in 2012. Finally, I’d like to share a key insight: recruiting talented women takes a woman’s touch. BIS central bankers’ speeches BIS central bankers’ speeches | netherlands bank | 2,011 | 3 |
Speech by Mr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the ING Basel III Financing Conference, Amsterdam, 14 April 2011. | Nout Wellink: Basel III and the impact on financial markets Speech by Mr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the ING Basel III Financing Conference, Amsterdam, 14 April 2011. * * * It is has been three and a half years since the global financial crisis began. The banking sector and financial system now seem to have stabilised. But this required unprecedented public sector interventions, and significant risks remain. Despite the severity of the crisis, we are already seeing signs that its lessons are beginning to fade. At the same time, there are still significant risks on the horizons, while key reforms still need to be carried through if we are to achieve a truly stable banking and financial system. The Basel III framework is the cornerstone of the G20 regulatory reform agenda and the Basel Committee rules were issued at the end of last year. This development is the result of an unprecedented process of coordination across 27 countries. Compared to Basel II, it was also achieved in record time, less than two years. The next step, which is just as critical as the policy development, is implementation. Consistent and timely global implementation of the minimum standards of Basel III is critical to ensure longer-term banking sector and economic stability. Some countries may choose to implement higher standards to address risks particular to their national contexts, examples of which so far are Switzerland and Sweden. This has always been an option under Basel I and II, and it will remain the case under Basel III. To minimise the transition costs, the Basel III requirements will be phased in gradually from 1 January 2013. This morning I would like to discuss with you the impact of Basel III on financial markets. In addition, I would like to focus on a key remaining area of policy development work, which is dealing with the risks of systemically important banks. The liquidity framework I am aware that the impact of Basel III on financial markets is especially interlinked with the new funding and liquidity ratios. Let me therefore first say a few words about new the liquidity standards. Weak liquidity profiles of banks were one of the core elements of the crisis, and they therefore represent a critical part of the regulatory framework going forward. Overall there is broad support for the liquidity framework introduced by the Basel Committee. Banks and other market participants already use methods similar to the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). Many of the issues that have been raised pertaining to these requirements revolve around the calibration of the ratios, rather than the conceptual basis of the framework. It is important to emphasise the goal in establishing the liquidity framework: to require banks to withstand more severe shocks than they had been able to in the past, thus reducing the need for such massive public sector liquidity support in future episodes of stress. The success of the framework should not be measured in terms of whether it will have zero cost. Instead, the better measure of success is whether the framework corrects pre-crisis extremes at acceptable costs. Banks that take on excessive liquidity risk should be penalised under the new framework, while sound business models should continue to thrive. With these objectives in mind, the Committee will use the observation period to review the implications of the standards – all the more as they are brand new – for individual banks, the banking sector, and financial markets, addressing any unintended consequences as necessary. BIS central bankers’ speeches In this regard, the Basel Committee’s focus is now on ensuring that the calibration of the framework is appropriate. Certain aspects of the calibration will be examined and this will involve regular data collection from banks. Any adjustments should be based on additional information and rigorous analyses. However, banks’ data on the crisis are distorted because of the government support schemes. Hence, the analysis will need to include both quantitative bank experience and additional qualitative judgement. It is worth emphasising that a number of effects of the framework are indeed intended. For example, with regard to the pool of liquid assets, the rules are meant to promote changes in behaviour and to create incentives to reduce risky liquidity profiles. This can be done, for example, by pushing out the average term of funding or increasing the share of stable funds. In other cases, banks did not price liquidity appropriately throughout the firm, and correcting risk management deficiencies will in turn improve liquidity profiles. In fact, the initial response we have observed in some countries that have already implemented comparable liquidity ratios suggest that these are the types of strategies that are being pursued. Effects of Basel III on financial markets Since the new regulation will change the behaviour of banks, it will also have wider effects on financial markets. The effects in the transitional phase will be different from the effects in the new steady state. In the transitional phase, adjustments of banks’ balance sheets to meet the new capital and liquidity standards will affect supply and demand in capital markets and could lead to relative price changes. Equity markets: impact of the new buffer regime On equity markets, additional demand from banks is expected. The quantitative impact study by the BCBS shows that banks worldwide need additional capital of EUR 175 billion to reach a core capital ratio of 4.5% and around EUR 600 billion for the 7% requirement. For comparison, euro area bank equity issuance has been USD 20 to 50 billion annually since 2005. Mind that this includes the crisis period. The worldwide figure ranged from USD 50 to USD 150 billion. This suggests that, given enough time, markets should be able to absorb the new capital that needs to be raised. Especially if banks are able to use this time to accumulate capital through retained earnings and lower costs. This would reduce their need to go to the equity market. Bonds markets: impact of Liquidity coverage Ratio (LCR) The new liquidity requirements could influence fixed-income markets. The quantitative impact study by the BCBS shows that the shortfall of liquid assets to meet the LCR is around EUR 1.7 trillion for the worldwide banking sector [this figure does not include the surplus of banks that meet the LCR]. This seems high, but is less than 10% of the total market size of domestic liquid assets. Nevertheless, there may be some currency areas where the supply of liquid assets is smaller than in other areas. The new liquidity regulation provides for tailor made solutions in those cases. For instance, the Reserve Bank of Australia has established a liquidity facility to help local banks meet the LCR requirement, while Denmark intends to give special treatment to covered bonds; the possibilities to do so will be fleshed out over the observation period. The LCR will change the relative preferences for banks to hold certain asset classes. It will make assets that are considered as liquid under the new regulation more popular, and assets that are not considered as liquid assets less so. This can shift demand to sovereign bonds, covered bonds and high quality corporate bonds and away from less liquid assets, such as other bank bonds, securitised assets and lower quality corporate bonds. All this can have implications for credit spreads and investors’ returns on particular market segments. BIS central bankers’ speeches The asset purchasing programmes of the US Federal Reserve give an indication of the effects of large-scale bond purchases on interest rates. The effects on the 10-year Treasury yield per USD 100 billion of asset purchases have been estimated to range between 2 and 7 basis points, which suggests a high degree of uncertainty. Moreover, these effects can not be translated one by one to the impact of the new liquidity regulation. The expected investments by banks will stretch over a much longer horizon than the asset purchases by the Fed. In any event, banks’ reactions to the introduction of the new liquidity standards are uncertain. In addition to accumulating liquid assets, banks could also scale back business activities that are vulnerable to liquidity risk, or lengthen the maturity of their funding. Bonds markets: impact of Net Stable Funding Ratio (NSFR) The requirement to reduce the maturity mismatch via the NSFR will urge banks to look for more stable sources of funding. Since they will have to compete with other borrowers in the term funding markets, the additional demand by banks could drive up the yields on bank bonds. To limit funding costs, banks will pursue different strategies in their liquidity management. They will try to raise more retail deposits. However, the supply of retail savings is limited, in particular in the Netherlands where banks have to compete with insurance companies and pension funds. Alternatively, banks could issue more secured funding, for instance covered bonds, or issue more long-term unsecured bonds. To raise more unsecured long-term bonds, banks may have to rebuild their investor base, for instance through increased transparency. Stress-tests could contribute to that; they are a useful tool to disclose exposures to particular risks. Reducing maturity mismatches to meet the NSFR is a big challenge for banks in the coming years. The study of the BCBS shows that the shortfall of liquid assets to meet the NSFR is around EUR 2.9 trillion for the worldwide banking sector [this figure does not include the surplus of banks that meet the NSFR]. This headline figure can not be simply totalled with the shortfall of the LCR that I mentioned before. A bank that meets the NSFR probably also meets the LCR. Another issue is that the shortfall in terms of the size of the long-term funding market differs widely across countries. In currency areas where banks have a large shortfall relative to the available supply, the long term debt markets might need to expand significantly to meet the additional demand by banks. Outlook for bond markets and regulatory issues Term funding markets may expand in response to increased supply by investors and the presumably higher yields. It could make short-term investors willing to make longer term investments, particularly if the market liquidity of long-term paper improves relative to shorter-term paper. This could be stimulated by transparent, collateralised and straightforward asset structures. For these reasons covered bonds have become popular recently, although we are not sure on the precise impact on unsecured investors. In the first quarter EUR 100 billion of covered bonds was issued in Europe and observers expect this asset class to grow further. The recognition as liquid assets in the LCR supports the issuance of covered bonds. As you probably know, MBS securities are not recognised in the LCR buffer. Increased transparency and market liquidity, for instance through market quotation, would increase the likelihood that MBS securities would be recognised as liquid assets. Bonds yield might also be influenced by new resolution regulation that gives authorities more options to deal with ailing institutions. Market participants fear that this might raise the probability of burden sharing by bond holders. I guess this primarily concerns Tier 2 debt. Since that is a limited portion of total funding – at least for Dutch banks – there is little reason to worry. More in general, a rise in the yield on such bonds could be welcome if it implies a more adequate pricing of the risks that holders of bank bonds face. BIS central bankers’ speeches Steady state Assessing the long term market impact of Basel III is difficult, since banks may change their business models. It is likely that banks will look for more capital and liquidity efficient models, for instance by offering products with a more stable or fee-based income stream. This will change their capital and liquidity needs and thereby their reliance on financial markets. It is clear that in the new steady state we will end up with a stronger banking system. The Basel Committee has estimated that if bank capital increases from 6 percent to 8 percent of the risk-weighted assets, the risk of a crisis is more than halved. If liquidity risk is also reduced, the probability of a crisis declines even more. The reduced default risk of banks will lower credit risk premia they have to pay in capital markets. Moreover, a stronger banking system is expected to have a positive impact on market confidence, reducing thus the volatility in financial markets. Addressing the SIFI problem I would also like to mention some developments that are not included in Basel III but that are high on the international agenda of financial policy makers. The crisis has taught that a targeted approach to systemically important institutions, so-called SIFIs, is crucial to safeguard financial stability and mitigate moral hazard. For a country like the Netherlands – a small open economy with a number of very large and interconnected financial institutions – addressing this problem is even more important. These institutions play a vital role in the Dutch financial system and real economy. In order to tackle the SIFI problem the Basel Committee together with the Financial Stability Board are working on additional measures for systemic banks. These measures first involve more intensive supervision and a higher loss absorbing capacity, primarily to reduce the probability of a default of a systemic bank. This will mean that possibly systemic banks will be required to hold larger capital buffers. Secondly, the measures involve improving the resolution capacity of national authorities and the requirement for systemic banks to develop recovery and resolution plans. This should help to make it easier to wind down any type of institution in an orderly fashion which will reduce the impact of a failure of a systemic bank. Moreover, the Basel Committee is working on a proposal for a methodology to identify systemic banks. A distinction will be made between domestic and global SIFIs, and stricter rules will apply to the latter group of institutions. Let me be clear, we are not talking about hundreds of banks, but rather a few dozens, which because of their size, interconnectedness, or limited substitutability could pose a risk to the international financial sector. This will help secure that at least the externalities associated with those institutions that are most interconnected on a global scale will be addressed. The temporary changed role of central banks Besides Basel III, the financial markets have been influenced significantly by the activities of central banks. Their role has dramatically changed in the crisis, owing to the unconventional policy measures, which are meant to be temporary. In autumn 2008, enhanced credit support to the interbank market was introduced in the euro area, by way of unlimited liquidity supply to banks against adequate collateral. This has supported monetary transmission and prevented a credit rationing of the private sector. For the same purpose, the Eurosystem purchased covered bonds issued by banks on a limited scale. This program has already been completed last year. In May 2010, when the sovereign debt crisis erupted, the phasing out of the extended refinancing operations was temporary delayed and the Securities Markets Programme started. This bond purchasing program aims at non-functioning Eurozone bonds markets. BIS central bankers’ speeches The Eurosystem buys bonds from monetary counterparties, while the liquidity creation is sterilised by the issuance of term deposits. The program has prevented that bond markets collapsed due to a drying up of market liquidity. It has supported the transmission of the policy rate to longer term interest rates in bond markets. The Eurosystem has purchased EUR 77 billion government bonds of EMU countries so far, which is a substantial share of the government bond markets in the most affected countries. This is an unhealthy situation, since it creates an undesired dependence of governments on the central bank. Moreover, an extended government bond portfolio of the Eurosystem is not desirable from a risk management perspective. The European debt crisis Given the fact that monetary policy has been fully stretched, it is crucial that governments take their responsibilities to tackle the root causes of the sovereign debt crisis. To this end, Europe and the IMF established the European Financial Stability Facility (EFSF), an ultimate safety net that could be resorted to if needed, as Ireland did in November. It is important that governments keep improving the EFSF in terms of both quantity and quality, meaning maximum flexibility in the intervention of the EFSF. To be effective in supporting market confidence and prevent a further escalation of the crisis, a convincing increase of the level of available capital in the EFSF is desired. The European Stability Mechanism (ESM) will replace the EFSF in 2013. Last month the European Council agreed that the ESM will have an effective lending capacity of EUR 500 billion. By exception, the fund will be able to buy sovereign bonds in the primary market. Debt purchases in the secondary market remain impossible, which I regret, since it complicates a transition of responsibilities from central banks to governments. Any financial assistance to be granted under the ESM will be subject to strict conditionality and provides for involvement of private creditors in the unexpected event of insolvency, in line with IMF policies. To facilitate this process, from June 2013 onward, standardised collective action clauses (CACs) will be included in newly issued bonds with a maturity longer than one year. Moreover, the ESM gets a preferred creditor status, junior only to the IMF. These elements have made investors nervous, but probably markets will get used to them. They could enhance the disciplining market influence on sovereign debtors, although conditions to involve the private sector should be flexible, to prevent a disruption of market access by sovereigns and to prevent that credit spreads correct too abruptly. Finally, I would like to stress that the European authorities, including the Eurosystem, do everything to stem the sovereign debt crisis. Countries conduct rigorous economic reform programs: to regain the trust of financial markets, improve economic growth, restructure banking sectors and strengthen public finances. These measures contribute to a more sustainable debt situation, although the challenges are huge in certain countries. The ESM will only reinforce the need for fiscal and macro economic discipline and stronger governance with more automatic mechanisms. The alternative of default would have much graver consequences, with unforeseen, but probably serious first and second round effects on the financial system across the euro area. This is precisely what policymakers are preventing with unprecedented measures. BIS central bankers’ speeches | netherlands bank | 2,011 | 4 |
Speech by Mr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Amsterdam Financial Forum, Amsterdam, 17 June 2011. | Nout Wellink: Looking beyond the current reforms Speech by Mr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, at the Amsterdam Financial Forum, Amsterdam, 17 June 2011. * * * The history of The Grand dates back to 1578, even before the establishment of the Amsterdam Stock Exchange, which is the oldest in the world. In the course of the centuries, the buildings of The Grand underwent quite a few architectural changes and additions. As a consequence, they have not become outdated, and today they provide a great location for the Amsterdam Financial Forum. It is easy to see a parallel between the architecture of this site and the future global financial architecture, the topic of this session. We need to keep financial system regulation up to date as well and make quite a few changes and additions to it in the course of time. My term as governor is coming to an end. In about two weeks time, I will hand over the presidency of the Dutch Central Bank to my successor, Klaas Knot. In these last days, I am not going to look back on the past 14 years. Neither will I focus on what is going on in the financial system today. Instead, I will share some thoughts with you about the future of the financial system. That future is being shaped by a broad set of new regulations addressing weaknesses exposed by the financial crisis. In this speech, I will briefly highlight the main elements of these reforms. After that, I will focus on the consequences for the financial system – both the intended and the unintended ones. Looking beyond the current reforms, I also have a few messages for regulators and for the financial sector. Key elements of the current reforms The financial system is currently being reformed. Some new rules are already fully in effect, others are being phased in or are still being fleshed out. For some issues, the approach differs per country. Nonetheless, several key common elements can be identified. I will discuss the following four: capital requirements, liquidity requirements, measures to reduce excessive risk taking, and resolution measures. Capital requirements are a first key element. During the crisis, it turned out that banks had insufficient buffers to withstand large losses. The Basel III framework therefore sets tighter capital standards. Most importantly, it requires that the quality of bank capital be improved. A larger part of capital must consist of common equity, the most loss absorbing type. Furthermore, banks will have to increase the size of their capital buffer. The new regulations involve a higher minimum capital ratio as well as heavier risk weights for specific activities. For proprietary trading, which caused large losses during the crisis, and investments in resecuritisations, a complex and relatively high-risk financial instrument, banks will have to hold much larger capital buffers. Still, in good times, risks may again be underestimated. Therefore the new regulations also set a limit for leverage regardless of risk weights. To further ensure the build-up of additional buffers in good times and enhance the capacity of banks to absorb losses in bad times, the Basel III framework introduces dynamic capital requirements. These come on top of the minimum capital requirements that must be met at all times and by all banks. The dynamic buffer consists of two parts. One part, the capital conservation buffer, relates the build-up of buffers to the profits of an individual bank. The other part, the countercyclical buffer, relates it to conditions in the economy at large. This is truly a novelty: for the first time in history, a macroprudential element has been included in international banking regulations. BIS central bankers’ speeches On top of the minimum and dynamic requirements, there will be a capital surcharge for systemically important banks. This will make those banks whose failure would pose the greatest threat to the financial system yet a little bit safer. The second key element of the current reforms concerns liquidity requirements. These are essential to make the financial system more stable. Liquidity and maturity transformation is at the core of the banking business and provides a large benefit to the economy. It enables households and companies to earn interest on savings that they can access at any time, while providing essential long-term financing to the economy. However, when excessive, maturity transformation creates a vulnerability to market shocks and can become a source of instability to the financial system. During the crisis, insufficient management of liquidity risk emerged as a major problem. Even well-capitalised financial institutions experienced liquidity problems and central banks needed to intervene, including with unconventional measures, to provide large scale financing and thereby prevent further escalation. Therefore the new liquidity requirements, introduced as part of the Basel III framework, are of utmost importance. They require banks to hold sufficient high quality liquid assets to cover net cash outflows for a period of 30 days under a stress scenario. In addition, they set minimum requirements for the use of long-term and stable funding sources to finance longterm lending. Together, these measures will help to prevent excessive maturity transformation. Given the importance of these liquidity requirements, it is worrying that the EU has not yet shown a clear commitment to implement them in full, without any reservations. Next to capital and liquidity requirements, there is a variety of other measures aimed at reducing excessive risk taking. These are a third element of the current reforms. For instance, in the US, the Volcker rule may impose direct restrictions on trading by banks for their own account. For banks based in Europe, excessive risk taking will be discouraged by remuneration rules. These rules require that traders with a significant risk-taking role will receive part of their bonus in the form of shares with a delay of several years. Thus, if highrisk trading results in large losses, then traders will share in these losses. The fourth key element of the current reforms consists of resolution measures. The crisis has shown that with the current regulatory tools large banks cannot be allowed to fail, because the costs for society would be too large. However, a bank failure can never be fully prevented – not even with the new rules for capital and liquidity and the other measures. It is therefore essential that any bank failure can be resolved at minimal cost and, if possible, without taxpayer support. Resolution measures include the preparation of recovery and resolution plans, or living wills. These plans provide detailed guidance for emergency measures and, if these were to fail, an orderly restructuring or bankruptcy. In addition, in some countries there is a discussion about precautionary measures such as ring-fencing of retail activities. Regardless of the precise regulatory approach, to make the failure of a large international bank – however unlikely it may be – a manageable event, some banks may need to change their structure. Unfortunately, for the near future, resolution frameworks will remain focussed on the national level, because an international resolution regime is not politically feasible. As a consequence, resolution can be inhibited by the complex structure of large banks, many of which consist of thousands of legal entities all over the world that are interconnected through a variety of financial arrangements. To be able to quickly restructure a bank in times of crisis, these interdependencies must be made transparent and reduced. Consequences for the financial system The current reforms will undoubtedly increase the resilience of financial institutions and enhance the stability of the system as a whole. However, there will also be broader consequences for the financial system. Some of those consequences are intended, others BIS central bankers’ speeches are unintended. Looking beyond the current reforms, which will take years to be fully implemented, I will now say something about the outcomes. What follows refers to the financial system as a whole, not to specific countries or institutions. First, besides reducing risks, the reforms will inevitably lead to unintended risk shifting. The new regulations will increase resilience and discourage excessive risk taking in of most parts of the financial sector, but elsewhere financial risks are likely to grow larger. For instance, risks will shift to households. There is already an ongoing trend of insurers providing less guarantees on new life insurance policies. This is largely driven by the lessons that institutional investors learned from previous crises, but they may well be reinforced by new regulations, such as Solvency 2. As a consequence, households are bearing more and more financial market risks, even though they may not be very well equipped to deal with those risks. That is an unintended consequence. Like before the crisis, risks may also shift to unregulated entities that form a shadow banking system. Maturity and liquidity transformation do not only take place within the official banking system, but also outside it. To some extent, this is being addressed in the current reforms. However, some part of financial innovation will always be aimed at circumventing existing regulations. An unintended but likely outcome is therefore that over time, risks will again shift to yet unregulated areas. The response should not be to control innovation, but to closely monitor the main vulnerabilities in the financial system and adapt the regulatory framework when necessary. A second consequence for the financial system is that the reforms will induce changes to business models. For banks and insurers, some activities and investments will become less attractive due to the current reforms. Banks may move out of certain trades for their own account, for instance, because the required capital buffers will reduce the return on equity. Under Solvency 2, insurers may find it unattractive to continue investing in complex structured products, because of the high risk weight and the detailed analysis that is required of the underlying assets. Furthermore, retail deposits will become a favoured source of bank funding, as a consequence of the new liquidity requirements. These are just some examples. Such changes in business models are not merely side effects; they are a necessary outcome of the current reforms. Changes in business models are a fully intended consequence. If there would be no significant changes to business models, and if that would mean that risk profiles remained too high and potential threats to the stability of the financial system were insufficiently addressed, then we will need to see a further tightening of the rules. The most profound changes to business models will probably not result from capital or liquidity requirements or from other measures to reduce excessive risk taking. Instead, the most profound impact will come from resolution measures. That is because effective resolution measures will put an end to the “too big to fail” or “too big to save” status of systemically important financial institutions. When they loose this status, large financial institutions will also loose important competitive advantages over smaller and less interconnected institutions. At present, systemically important banks enjoy an implicit subsidy on their funding costs. This is apparent in credit ratings, for instance. Credit rating agencies assign higher ratings to large banks than their intrinsic financial strength would justify. The rating enhancement reflects the probability of government support and can be as large as five notches. For smaller banks, the enhancement is lower or even zero, because it is perceived that smaller banks are less likely to receive government support when they get in trouble. Effective resolution measures will thus eliminate the support-related rating advantage and lower funding costs of large banks. A capital surcharge for systemically important banks fits with this reasoning and compensates for the unfair benefits of being very large. This is a fully intended consequence and will enhance economic efficiency and market discipline. BIS central bankers’ speeches But there may be unintended consequences too. Ideally, governments would agree an international resolution framework, but that requires international burden sharing in case they would have to support the restructuring of a cross-border bank. At present, this is not a realistic option. The alternative, national resolution regimes, imply that some degree of autonomy for domestic retail operations may be a necessary precondition for effective resolution. This comes at a cost. Financial integration can make financial markets more efficient, especially within a common market like the EU. It enables banks to raise funds where they are readily available and invest those funds where they generate the largest return, even if that is in another country. In addition, banks can diversify their risks by combining retail and investment banking. If the economic benefits from international and universal banking operations cannot be fully realised, that would be an unintended and indeed an undesirable outcome. A third consequence of the current reforms is that they will have an impact on financial markets. We know for sure that there will be an impact and we can almost be sure about the direction of some changes. For instance, banks will need to attract more stable long-term funding. At the same time, European insurers, which are important providers of bank funding, show an increasing preference for investment in covered bonds because of the low capital requirements under Solvency 2. Together with a range of other factors, this will give a boost to European covered bond markets. However, we cannot be sure how large and how permanent the changes will be. That is because there are many different factors at work. Some market participants, such as pension funds and other large investors, are much less affected by the current reforms. They will respond to changes in market prices and this may partly offset the impact of new regulations. This makes the overall impact on financial markets uncertain. It is therefore important that major new regulations are phased in gradually. The new liquidity measures for banks provide an example of this approach. They are phased in over four to seven years to prevent large shocks to financial markets. In addition, they are subject to an observation period to facilitate mitigation of undesirable outcomes. A fourth consequence from the current reforms is that the financial system will continue to suffer from important distortions. In other words, there will be incentives for financial institutions to behave in a way that is not in the public interest. Of course, this will always be the case. The perfect world of economists, without distortions or frictions of any kind, exists only in their models. Still, it is worth pointing out a few important distortions that the current reforms have been unable to tackle. Perhaps the most important distortion is that high leverage will remain attractive for financial corporations because interest payments are tax deductible. This makes it attractive for a company to use more debt financing and less equity capital than would be desirable from a social point of view. Of course, this distortion exists for non-financial corporations as well. Yet in the financial sector it is more troublesome, because tax considerations do not just have an effect on the funding choices, they also stimulate the design of tax-driven financial products. Such products may add little economic value, but create leverage and complexity, increasing vulnerabilities in the financial system and making them more difficult to monitor. Another distortion is that the current reforms are not uniform across countries. For example, countries with a large financial sector, such as Switzerland, will require large banks to hold more capital than the international standard. Furthermore, EU remuneration rules will apply to the global operations of banks headquartered in Europe and the US Volcker rule will apply to the global operations of banks headquartered in the US. The lack of uniformity has the unintended consequence that banks operating abroad in the same market, but headquartered in different countries, will each have to observe different rules. This causes unfair competition, induces arbitrage and creates complexity. However, just as with resolution frameworks, it is a political reality that some reforms, however desirable they may be, can only be passed at the national level. BIS central bankers’ speeches Concluding remarks Looking beyond the current reforms, there will be major changes to the financial system, some intended and others unintended. Regulators will have to monitor the consequences carefully and respond to what they see. Risks will shift away from where they are regulated most tightly. Regulators will also need to evaluate the impact on financial markets and the effects of market distortions. If they detect the emergence of new vulnerabilities, rules will need to be adjusted. Furthermore, business models have to be adapted. If the largest banks do not undergo a substantial transformation, a further tightening of banking regulations will be required to produce the intended outcome. One thing is certain: beyond the current reforms, further reforms will be necessary to safeguard the stability of the financial system. It took ten years to develop the Basel II framework. The current, more profound reforms will have taken shape in about half that period. Future regulators should continue this trend and make sure that regulation of the financial system keeps evolving, especially when public concerns about global financial crises fade away. And ideally, the next round of reforms should be even more harmonised at the international level, to reduce unfair competition and unproductive barriers to financial integration. I also have two messages for the financial sector. First, within the new regulatory framework, it is important that financial institutions continue to strengthen their own risk assessments. To all executives that are present here, I would say: you have a responsibility of your own as well. Second, risk shifting and financial innovation imply that the regulatory framework will continue to evolve and will never be completed. Therefore your business models should be sufficiently flexible and not fine-tuned to a current set of regulations. You have seen that most of today’s regulators are quick and determined to pass the necessary reforms. I am confident that this will also apply to tomorrow’s regulators, who will continue to make changes and additions to the future global financial architecture. BIS central bankers’ speeches | netherlands bank | 2,011 | 6 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Third Annual Nyenrode Finance Day, Breukelen, 28 October 2011. | Klaas Knot: Monetary policy and the Great Financial Crisis Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Third Annual Nyenrode Finance Day, Breukelen, 28 October 2011. * * * The past four years have been tumultuous for the global financial system and the global economy in an unprecedented way for all of us. The eruption of a systemic financial crisis of quite unusual intensity and international reach has been compared to the widespread shutdown of international capital markets on the eve of the First World War. The violent unraveling of events has shaken many beliefs in the economics profession. And the threat of a collapse of the world economy similar to the Great Depression has prompted unprecedented policy responses. Monetary policy makers reacted to the crisis by deploying both conventional and unconventional tools. In this speech, I want to discuss how the conduct of monetary policy in the euro area has evolved during the different stages of the crisis and the challenges it is currently facing. To put this discussion in perspective, let me start by recalling the ECB’s mandate to deliver price stability, as is anchored in the Maastricht Treaty. Pursuing this mandate requires that a number of elements are in place. First, there has to be a credible commitment to price stability as a primary goal of monetary policy. A credible commitment implies that the public’s long-run expectations about inflation are anchored by the ECB’s definition of price stability – HICP inflation below but close to 2%. Second, monetary policy has to be transparent and monetary authorities must be accountable for their decisions. This implies a need for clear and effective communication. Third, monetary policy decisions have to be taken in full independence from political influence. This principle is laid down in the Maastricht Treaty. It implies the strict prohibition of monetary financing. Fourth, monetary policy has a medium-term orientation, given the long and variable lags of the monetary transmission mechanism. Fifth, monetary policy is underpinned by a comprehensive analytical framework, which rests on two pillars: the economic analysis and the monetary analysis. I should note that the crisis has shown how the monetary analysis can play an important role in signalling financial imbalances and vulnerabilities. It is an important input in a strategy of “leaning against the wind”. Finally, monetary policy follows a so-called “Separation principle”, which distinguishes decisions about the monetary stance aimed at achieving price stability from tools directed at implementing monetary policy decisions through liquidity management. With these principles in mind, let me turn to the monetary policy responses to the crisis. At a very general level, the ECB used conventional tools – an aggressive easing of the policy rate – to counter deflationary pressures and unconventional tools, which aimed at restoring a well-functioning transmission mechanism. These policies were pursued in four phases. 1. Between July 2007 and the fall of 2008, the ECB responded to disruption in interbank markets by expanding its liquidity provision to commercial banks. 2. Between the fall of 2008 and end-2009, as the financial crisis escalated and turned from a liquidity crisis into a solvency crisis, the ECB lowered its policy rate in quick steps to an unprecedentedly low level. In addition, it also employed a range of unconventional tools – such as fixed-rate full-allotment at the weekly tenders, longer-term refinancing operations. BIS central bankers’ speeches 3. The third phase extends from end-2009 to mid-2011. As the macroeconomy rebounded and financial market conditions improved in late 2009, the ECB started a gradual exit from its unconventional measures. When the sovereign crisis hit euro area bond markets in the early months of 2010, the Eurosystem responded to an increasingly dysfunctional monetary transmission mechanism, by activating a Special Markets Program (SMP). 4. When the sovereign crisis intensified in August 2011, the gradual exit from unconventional was stalled. Also, additional unconventional measures were taken to support the monetary transmission mechanism. These policy responses went a long way in supporting the ECB’s goal of price stability, and to address problems in the monetary transmission mechanism. At the same time, these measures – and the SMP in particular – entailed a number of risks. As I mentioned in earlier speeches and interviews, I see four main risks. First, these measures tended to reduce pressure that markets exerted on governments to pursue fiscal discipline. Second, treading further along the path of interventions in government bond markets implies increasing risks of monetary financing of fiscal debt. Third, purchases of assets in markets under stress implies a financial risk for the Eurosystem’s balance sheet, which may eventually lead to fiscal transfers. Fourth, there is a risk that the Eurosystem will enter political waters, which will make the conduct of monetary policy more difficult. With our experience during the crisis and the connected risks in mind, we need to rethink the role and set-up of monetary policy after the crisis. Where are we headed? And how do we get there? I see three main elements of monetary policy after the crisis. For the monetary policy framework, the crisis has shown that the monetary analysis can play an important role in signaling financial imbalances and vulnerabilities. It is an important input in a strategy of “leaning against the wind”. For the operational framework for monetary policy, it is crucial that after the crisis we will return to the principles that guided the framework before the crisis. In particular, we need to return to a clear and transparent separation principle between monetary policy stance, on the one hand, and liquidity management, on the other hand. Finally, there is a clear need for a sustainable institutional framework for the euro area. This framework will need to center on budgetary discipline and sound economic governance. In the long-run, as a closing piece, I see joint financing through euro bonds as the only sustainable solution to self-fulfilling liquidity/solvency problems in individual member states and domino-effects/contagion between euro area member states. How do we get there? In a transition to a post-crisis monetary policy, it is important to exit gradually from unconventional and conventional instruments that are being used during the crisis. In this phase, communication will play a very important role. And fiscal and prudential policies need to play a primary role in addressing problems that originate in the fiscal and financial spheres. Let me conclude. As Stan Fischer said in a recent Tinbergen Lecture in Utrecht, the big question monetary authorities face in these times is – what do you do if policymakers that should tackle problems do not act sufficiently? My answer is that monetary policy cannot solve the crisis, since it is rooted in fiscal policy and the vulnerability of the banking system. All monetary policy can do is to buy time, at the cost of stretching its mandate to the limit, if not beyond. BIS central bankers’ speeches | netherlands bank | 2,011 | 11 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, before the OMFIF (Official Monetary and Financial Institutions Forum), London, 17 February 2012. | Klaas Knot: The future of EMU and the Netherlands’ place in Europe Speech by Mr Klaas Knot, President of the Netherlands Bank, before the OMFIF (Official Monetary and Financial Institutions Forum), London, 17 February 2012. * * * Thank you for this opportunity to exchange views with you on this topical issue. Thank you also for arranging for me to do so amid the splendour of this magnificent hall. I feel quite safe standing here, for I understand the Armourers’ Hall was among the few buildings that escaped destruction in the Great Fire of 1666, and, in 1940, also survived a major blitz on London, while the surrounding area was devastated. So one might say that this venue symbolically suits my subject of today, for I am confident that in the distant future we will be able to say that EMU still survives. Speaking of which, I couldn’t help but notice that the title of my talk as announced in the flyer is “The Future of European Monetary Union”, instead of “Economic and Monetary Union” which the term “EMU” stands for. Don’t worry, you find yourselves in good company; many European governments are only now starting to realize that they haven’t paid enough attention to the “E” in EMU. My talk today consists of two parts. In the first part, I’ll focus on why it is that, for the Netherlands in particular, it is so important that the European project will be successful. In the second part, I’ll discuss the implications of the European sovereign debt crisis for the future design of EMU. I will argue that at the root of the crisis we find some individual euro area countries pursuing wrong policies and a failing system of mutual surveillance in the euro area. These deficiencies pose a number of challenges for the future of EMU. While the introduction of the euro has increased macroeconomic stability and furthered trade and financial integration, the sovereign debt crisis clearly demonstrates that the job is not done yet. The alliance of the Netherlands with Europe has always been strong and will remain so in the future, if only because of its small size and geographical location. The same holds true for the other “low country”, Belgium. By nature, Dutch people have always had a strong focus on Europe. Just to illustrate this point, every pupil in high school has to learn at least two foreign European languages. Foreign residents in the Netherlands even complain that it is hard to learn Dutch in Holland, because everybody they speak to in Dutch replies in English, French or German. Another way to illustrate the Netherlands’ focus on the outside world is to look at the openness of its economy. If you take a look at Chart 2, you find openness defined as exports plus imports as a percentage of GDP. As you can see, in the US, exports plus imports are less than 30% of GDP. In France, Italy, Spain and the UK, this indicator is between 53 and 63%. In the Netherlands, exports plus imports are nearly 150% of GDP, and in Belgium and Ireland even more. As a consequence of this openness, the realization of the single market and the introduction of the euro later on did have a substantial positive impact on the Dutch economy. After all, one of the most significant yields was the boost that EMU provided to trade. Driven by lower transaction cost, lower exchange rate risks and more market transparency, trade within the euro area developed more strongly than outside the euro area. Being a country of trade and distribution by tradition, the Netherlands has taken advantage of these circumstances. For BIS central bankers’ speeches sure, it is one of the reasons why the Dutch economy outperformed the euro area in terms of GDP growth in 14 out of the last 20 years. The strong alliance of the Dutch economy with Europe in general and the euro area in particular also shows up if we look at its exports orientation. In Chart 3 you see this defined as exports to the euro area expressed as a percentage of total exports. It follows that the orientation on the euro area is the largest in the Netherlands. More than 60% of our exports goes to euro area countries. Given its close ties with the euro area, it is obvious that for the Dutch economy a solution of the European sovereign debt crisis is of vital importance. If EMU were to fall apart, the consequences for the open Dutch trading nation would be severe. Therefore, Dutch policymakers and central bankers should do their utmost to solve this crisis. In what follows, I will first focus on the causes of the sovereign debt crisis. Finally, I will present my views on the implications for a stable design of EMU. Over the last couple of months, European policy makers have done a lot to restore confidence. As a consequence, most stressed sovereign debt markets have calmed down substantially (left-hand side of the graph). The most important development was the announcement and finalisation of the Fiscal Compact, in which the political leaders of the euro area countries (and most other EU countries) further strengthened the rules governing budgetary discipline in Europe. Furthermore, in March the capacity of the EFSF/ESM will be evaluated. We have to conclude that the EFSF in its current form (based on guarantees) and size unfortunately has failed to convince markets that all countries will get through this crisis unharmed. This is why we as central bankers call upon the European governments to increase the emergency facility as soon as possible. The ECB also took further measures to avoid the sovereign debt crisis from severely dragging down the real economy. It did so by introducing a refinancing operation with a maturity of three years. As Chart 4 shows, this operation attracted a lot of interest, with a total volume of EUR 490 billion (right-hand side of the graph). This is not all “new” liquidity by the way, since banks also rolled over operations with shorter maturities into this new facility. This provides them with the liquidity security they need in light of the market tensions and, thus, helps prevent a sharp reduction in credit supply to the economy. At the end of this month, a second three-year operation will be carried out. In analysing and solving the sovereign debt crisis, the focus was on fiscal and monetary factors rather than on the macroeconomic causes of the crisis. However, as I’ll briefly demonstrate by means of Charts 5, 6 and 7, these causes are at least as important as the fiscal slippages some countries allowed themselves. At the start of EMU, per capita income levels between countries differed significantly. It was assumed that catching-up countries would experience faster economic growth. This is what did happen, but not quite to the extent expected. Prior to the crisis, mainly Ireland, and to a lesser extent also Greece and Spain, showed signs of real convergence. Their cumulative growth differentials compared to Germany reached 20 to 45% in 2007. Note that Italy and Portugal hardly experienced any real convergence towards the German welfare level, even before to the crisis. Even the Netherlands “converged” more than these countries. BIS central bankers’ speeches Unfortunately, the catching-up process largely took place through debt, either public or private. As Chart 6 shows, in some countries credit to the private sector grew by more than 10% a year for over a decade. As a result, their debt with the rest of the world ran up tremendously. This was most dramatically the case in Ireland, which moved from a net creditor position of 52% of GDP in 1999 to a net debtor position of 71% of GDP in 2008. Note that the Netherlands is not doing particularly well with regard to this measure either. This is mainly the result of the growth in mortgage loans. In my view the high stock of mortgage debt is among today’s biggest vulnerabilities of the Dutch economy. Besides being largely based on credit, real convergence was accompanied by high inflation, as you find visualised on Chart 7. Whereas Germany experienced lower inflation compared to the euro area average, the inflation rates in Greece, Ireland, Spain and Portugal were much higher than the EMU average. This substantial deterioration of competitiveness mainly reflects the development of unit labour costs. The economic developments in Germany in the last decade have been phenomenal. The time that Germany was called the sick man of Europe is not so far way. Partly due to the supply of many low-paid workers from East Germany, the labour market institutions in Germany were no longer sustainable. This has led to the so-called Harz reforms, which made the German labour market more flexible and tempered unit labour costs and inflation. Before EMU, the current euro area countries followed different economic strategies. Between 1970 and 1999, unit labour costs in Germany, the Netherlands en Austria grew by a factor of 2.5 to 3. During these 28 years prior to EMU, unit labour costs grew by a factor of 12 in Italy, 14 in Spain, 35 in Portugal and 55 in Greece. By regularly devaluing their currencies, these countries were able to restore competitiveness. But after the launch of EMU, this policy option was no longer available, of course. The hope was that these countries would adapt to this new reality and unit labour costs growth would slow down. But has this happened? Chart 8 shows the cumulative growth of unit labour costs relative to the euro area average from the start of EMU. While countries like Germany, Austria and Finland continued their modest wage policies, unit labour costs in Southern European countries went up at a much higher pace, undermining their competitiveness. This proved unsustainable. The countries that found themselves in the top of the chart when the sovereign debt tensions started in 2009 – that is Greece, Spain, Ireland, Portugal and Italy – all ran into trouble one after the other. This is no coincidence. Currently, adjustments are hard-handedly being enforced by the markets. In the said countries, Ireland excepted, product and labour markets didn’t function properly and they still don’t. Markets are overregulated and labour markets are highly inflexible. By addressing these problems, labour productivity can increase, thereby lowering unit labour costs. I am not saying this will be easy, but I’m convinced that such steps are absolutely necessary for EMU to function properly. As the chart also shows, in the Netherlands unit labour cost growth was also relatively high during the first years of EMU. This, however, wasn’t caused by the high inflation rates and low flexibility of the labour market, but reflected the low unemployment rate in the Netherlands in that period. BIS central bankers’ speeches For many years, the unemployment rate in the Netherlands was the lowest in the euro area. The divergences in unit labour cost developments and price competitiveness within the euro area are reflected in the current account balances of the individual countries. As you can tell from Chart 9, before the crisis, most southern European countries and, to a lesser extent, Ireland experienced high and steadily increasing current account deficits, while the current account surpluses of Germany and the Netherlands improved further. For many years it was thought that in a monetary union, the current account balances of individual countries were no longer relevant. It was only the balance of payment of the euro area as a whole that mattered. We know better now. Of course, besides competitiveness problems, the crisis also had fiscal causes. As can be told from Chart 10, the stability and growth pact didn’t prevent some governments from taking up old habits once they had fulfilled the convergence criteria that enabled them to join EMU. We shouldn’t forget, however, that this was facilitated by some of the core countries of EMU. When it became clear that fiscal policies in these countries wouldn’t be able to meet the rules of the Stability and Growth Pact, it was not the policies that were changed but the Pact. This was clearly a mistake. Besides, the gradual worsening of the budget balance in countries like Italy and Portugal was partly due to their competitiveness problems. Since devaluing out of these problems was no longer an option, the declined competitiveness slowed down economic and employment growth. This dampened tax revenues while stimulating social security expenditures. Looking at it this way, the lack of fiscal discipline partly reflected the lack of macroeconomic discipline. More in general, budgetary policy was supposed to absorb temporary cyclical differences, by allowing the automatic stabilisers to do their work. For example, during a downturn, public spending automatically goes up as more people receive unemployment benefits, while tax revenues decrease. Such “automatic” response to cyclical developments stabilises the economy. But in most member states, the automatic stabilisers have failed to operate properly since 1999. Instead, a number of governments followed pro-cyclical budgetary policies, by loosening the budgetary reins during the economic booms, and tightening them during the busts. In other words, budgetary policies have hampered the functioning of EMU. Budgetary discipline in EMU was supposed to be exacted not only by the stability and growth pact, but also by market discipline. Markets were expected to restrain profligate governments by charging them higher interest rates and, thus, forcing them to change their ways. As is evident from Chart 11, market discipline was largely absent during the first ten years of EMU, allowing governments to pursue unsustainable policies. And when markets finally started to differentiate between governments, they did so with a vengeance. Although market discipline is now imposing necessary corrections, a stable monetary union cannot be based on this mechanism. So what would a stable monetary union look like in my view? BIS central bankers’ speeches As I argued earlier, some euro area countries have not fully adapted to the fact that they lost the option of devaluation in order to restore competitiveness. If they had, they would have increased their flexibility and growth potential by reforming their labour and product markets. Given the spillover effects of postponed structural reforms on the functioning of EMU, these reforms cannot be the sole responsibility of the governments concerned, but should also have a “European” dimension. This can take different forms. One way could be to strengthen the macroeconomic imbalances procedure, by increasing its focus and enforceability. This could be done, for instance, by introducing more reversed Qualitative Majority Voting in these areas. Another way would be to introduce minimum standards or best practices in policy areas where spillovers have turned out to be especially high, such as labour market policies. Importantly, what should be avoided is harmonisation towards some kind of EMU average, as this would force strong countries to reduce their competitiveness. Secondly, debt ratios should gradually be brought well below the ceiling of 60%. This lower debt ratio can only be realised and maintained through independent enforcement of the European fiscal rules and by anchoring these rules in national legislation. A politically independent European authority that can increasingly intervene in the fiscal policy of countries breaking the agreements is essential here. If – and only if – these conditions have been met, eurobonds could be a serious option. Eurobonds could enhance the stability of EMU in several ways. They would prevent a liquidity problem in one euro area country from needlessly transforming into a solvency problem. Moreover, they could provide a fire wall against the danger of contagion. Although eurobonds are not suitable as a crisis instrument, they could be the light at the end of the tunnel for the people of vulnerable euro area countries. For the people in those countries need to feel that their sacrifices will contribute to a permanent solution; one that will safeguard them from the short-sightedness of both politicians and markets. As I said at the beginning of my presentation, it is obvious that for the Dutch economy a solution of the sovereign debt crisis is very important, given its strong connections to the euro area. And therefore, Dutch politicians and central bankers should do their utmost to solve this crisis. But what is it we can offer? In my opinion a lot. Pragmatism, common sense and a focus on problem-solving are crucial now and the Dutch happen to be famous – not to say notorious – for these characteristics. Although we can be very principled on some issues and in many cases see eye to eye with the Germans, these typically Dutch characteristics could help divided euro area countries to stick together and solve this crisis. Pointing at the long-term perspective of eurobonds once the necessary conditions have been met, is an example of this pragmatism and focus on problem solving. Let me finish this presentation by saying that finding a structural way out of the crisis will not only be beneficial for the Netherlands, but also for the euro area, the rest of Europe, and, yes, even for the world economy. Thank you for your attention. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches | netherlands bank | 2,012 | 3 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the symposium "The future of the Netherlands in the Asian era", Center for Japanese Studies, University of Groningen, 31 August 2012. | Klaas Knot: Dutch financial stability in the Asian era Speech by Mr Klaas Knot, President of the Netherlands Bank, at the symposium “The future of the Netherlands in the Asian era”, Center for Japanese Studies, University of Groningen, 31 August 2012. * * * With thanks to Jeroen Hessel. INTRODUCTION Ladies and gentlemen, it is always a pleasure to be back here in Groningen. I find the two buildings on the conference invitation very well chosen. They symbolise the common fears about the rise of Asia. The Dutch Euromast was modern and imposing when it was built in1960, but now looks small and outdated compared to the brand new Sky Tree in Tokyo, the second-tallest building in the world at a height of 634 meters.1 The Euromast would also be dwarfed by the 492 meter Shanghai world financial center or the 509 meter Taipei 101. Does this indeed show that advanced economies like the Netherlands are not able to compete with the larger and more efficient Asian countries? I tend to be optimistic. I will discuss the rise of Asia with a focus on financial stability. Indeed, the rise of Asia implies profound changes for advanced countries. But as long as countries face the challenge and adjust their economies, this need not be problematic. On the contrary, Asia also provides many opportunities. This applies especially to the Netherlands, with our centuries of experience in international trade and finance. After all, our Verenigde Oostindische Compagnie had the only western trading post with Japan for over 200 years. Until 1859, a number of Dutch settlers lived on Deshima, a tiny island just off the coast of Nagasaki. And already in the 1920s, banks like the Nederlandsch-Indische Handelsbank and the Nederlandsche Handelsmaatschappij had offices in Singapore, Shanghai and Bombay. INFLUENCE OF ASIA ON THE REAL SIDE The rise of Asia is not new. In fact, Asia accounted for over half of world GDP for centuries, and only started to lag behind in the 20th century. In a way, Asia is now restoring the old balance of power. We saw the rise of Japan in the 1960s and 70s, and the rise of Korea, Singapore, Hong Kong and Taiwan in the 1980s and 90s. But the recent ascent of large countries like China and India dramatically increases the scale and speed of the shift. The share of emerging Asia in the world economy increased from 8% in 1980 to 26% in 2012. The rise of Asia primarily affects advanced economies on the real side of the economy. Trade and international competition have intensified. Trade with low wage countries has quadrupled the effective global labour supply since 1980.2 Companies more easily offshore stages of their production to these countries. Our iPhones were designed in the US but are assembled in China. So comparative advantages have not disappeared, but they are changing more quickly than before. The Dutch trade monopoly with Japan lasted for two centuries. By contrast, the top position in the mobile phone market has already changed several times in the last decades. It switched from After the Burj Khalifa in Dubai, which is almost 830 meters high. This measure of the effective global labour supply comes from the IMF (WEO April 2007) and is measured as the size of national labour forces scaled by trade openness (export-to-GDP ratio’s). More trade openness means a larger effective labour supply as more people work in the tradable sector worldwide. BIS central bankers’ speeches Nokia in Finland via Blackberry in Canada to Samsung in Korea. It is vital that Western countries become flexible enough to accommodate such more frequent changes, and to prevent structural problems like long term unemployment. This would also help them benefit from Asia’s fast- growing domestic markets. Germany’s strong exports to China show that Chinese people enjoy driving an Audi or BMW as much as we do. The rise of Asia also affects inflation in advanced economies – an important theme for a central banker. Inflation is lower because consumers directly profit from cheap imports like camera’s, computers and clothing. More indirectly, domestic producers also keep prices low because they are afraid of losing market share to Asian competitors. The rise of Asia has therefore contributed to the decline of inflation over the last decades, alongside other factors like better monetary policy. In recent years however, this was partly offset by the strong increase in food and commodity prices, which is driven by demand from emerging markets. China for instance accounted for 30% of the growth in oil demand between 2002 and 2005. INFLUENCE OF ASIA ON THE FINANCIAL SIDE While the rise of Asia has clear effects on the real side, the effects on the financial side are more controversial. Some people claim that Asia had a large influence on the exceptionally loose financial conditions that led to the financial crisis. In their view, the strong increase in global liquidity was largely driven by the savings glut in Asia, particularly in China. Asian countries had increased their current account surpluses after the Asian crisis in 1998. This was partly to reduce their vulnerability and partly due to export-led growth strategies. These savings were mostly held in official reserves, which increased six fold to around five trillion dollars in only a decade. Because financial markets within Asia are underdeveloped, the reserves were invested in advanced economies, for instance in US treasuries. This may have reduced long-term interest rates and fuelled the credit boom. While the savings glut did contribute to global liquidity, it is not the only explanation. After all, Asia still plays a relatively modest role in financial globalisation. Asia, like many other emerging markets, is not so financially integrated. The average size of foreign assets and liabilities is only around 70% of GDP in emerging markets, against a much larger 220% in advanced economies. Emerging markets usually have smaller financial sectors, less developed financial markets, and often a more domestic orientation. China has some of the largest banks in the world, but this is because of China’s enormous domestic market. Their international activities are relatively limited, if only because China still has a closed capital account. Capital flows from emerging markets therefore mainly consist of foreign direct investment, which is relatively stable and not so harmful for financial stability. By contrast, the volatile international portfolio and banking flows are dominated by advanced economies. The recent literature therefore suggests that the loose liquidity conditions before the crisis largely came from financial sectors in advanced countries themselves. The great moderation fed the perception that large fluctuations were a thing of the past, and this has reduced risk premia and increased leverage. This was reinforced by low policy interest rates, which were possible thanks to more credibility in monetary policy and because globalisation contained consumer price inflation. Credit growth was fuelled further by financial innovations like securitization, and by the internationalization of banks. Banks increasingly relied on foreign wholesale funding, which enabled them to expand credit much further than if they had only relied on domestic deposits. The US housing bubble, for example, was partly financed by European banks that bought mortgage- backed securities. The banking glut in advanced economies seems at least as important as the savings glut from Asia. CRISIS ACCELERATES THE SHIFT IN BALANCE OF POWER In retrospect, we should have been aware of the risks. The world became more financialised than ever, as the size of financial sectors and capital flows grew strongly. History shows that these financial factors may lead to recurrent patterns of booms and crises, as the famous BIS central bankers’ speeches book by Kindleberger reminds us. Recent examples are the Japanese crisis in 1991 and the Asian crisis in 1998. Still, most policymakers failed to notice the development of an almost global credit boom since the mid-1990s. Many advanced countries witnessed a strong increase in credit and house prices. Housing bubbles developed in countries such as the US, the UK, Spain and Ireland. In the euro area, the boom interacted with inflexible product- and labour markets, leading to strong wage growth and a severe loss in competitiveness. Especially southern European countries had not adjusted their economies to the loss of exchange rates in the monetary union. Yet all these imbalances largely went unnoticed. Major changes in the economic landscape, such as globalisation, often make it difficult to spot vulnerabilities. We are lead to believe that we are in a new era, while in fact we are close to a new crisis. The consequences are familiar. Almost four years after the collapse of Lehman Brothers, most advanced economies are still struggling. We are reminded that financial crises may lead to a longer period of relatively low growth, with Japan’s lost decade as the most pronounced example. Growth is reduced because banks remain fragile and hesitant to lend, households are saving to reduce debt, and governments are consolidating in order to counter the surge in public after the crisis. In the euro area, the situation is complicated further by the sovereign debt crisis. Sovereign bonds in southern Europe are under severe financial market pressure, while some countries are also experiencing capital outflow from the banking sector. Meanwhile, emerging Asia has remained surprisingly resilient. Many Asian countries had improved their economic fundamentals after the Asian crisis. Their exposures to the current crisis were also limited, because of lower financial integration and because their reserves were invested in safe assets. While the business cycle in these export-oriented economies is affected by demand from the West, their trend growth has clearly decoupled. Emerging Asia recorded an average annual growth of 8.5% per year over the last decade, against only 1.7% for advanced economies. The financial crisis has only accelerated the shift in the economic balance of power in the world, which has important consequences. It for instance changes the composition of international organisations like the IMF and the BIS. Asia is seeking a greater say at the expense of advanced economies, especially in Europe. The recent decision to merge the Dutch and the Belgian constituencies at the IMF is a direct consequence of this. CHALLENGES FOR EUROPE AND THE NETHERLANDS The rise of Asia therefore poses important challenges for advanced economies, and especially for Europe. Industrial countries must restore financial stability, prevent new instability in the future, and implement structural reforms to compete against low wage countries. The required adjustment is not easy, but is necessary to fully reap the benefits of real and financial globalisation in the Asian era. I see four policy priorities. The first is a further reduction of public debt, which this year stands at a staggering 108% of GDP on average in advanced economies. Lower debt reduces refinancing risks and the vulnerability to shocks. It also helps to calm financial markets in the euro area. Further debt reduction is absolutely necessary, even if it will probably reduce growth in the short run. After all, delays only require an even larger adjustment further down the road. Moreover, there is increasing evidence that high public debt levels reduce growth themselves. High debt may for instance crowd out domestic private investment or deter foreign direct investment. A second priority is therefore to increase the growth potential in advanced economies via reforms. Structural reforms of product- and labor markets are especially urgent. The southern European product and labour markets belong to the most rigid in the world. A higher growth potential makes it easier to reduce debt. Wage and price flexibility helps to restore competitiveness and reduce current account imbalances within the euro area. Finally, flexibility also facilitates adjustment to the more frequent shifts in comparative advantages due to trade globalization that I described before. BIS central bankers’ speeches The third priority, related to the first two, is a lasting solution for the European debt crisis. In the short run, a credible financial backstop should give countries under pressure sufficient time to achieve a lasting adjustment. In the longer run, it is also vital that Europe repairs some of the design flaws in the monetary union that the crisis has revealed. The report by EU president Van Rompuy provides a good starting point, although much will depend on the exact design of the various elements. European countries should also realize that further integration is the only way to preserve our position in a world where Asia is gaining importance. This requires a strong and credible commitment from European politicians. A final priority is to prevent financial instability in the future. This requires a large number of different measures, such as the strengthening of banking sectors via the Basel III framework, and the development of macro prudential policy frameworks. As the challenges of financial globalization only became apparent recently, these policies still require time and analysis. Moreover, booms have been missed many times in the past. This should remind us that even new solutions may not always be bulletproof. CONCLUSION Allow me to conclude. Despite these challenges, the fears about the rise of Asia should not be exaggerated. Rotterdam’s Euromast may not be able to compete with Asian buildings, but its harbor is thriving thanks to trade with China. And meanwhile, Amsterdam’s buildings from the time of the Verenigde Oostindische Compagnie increasingly attract Asian tourists. BIS central bankers’ speeches | netherlands bank | 2,012 | 9 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, to the Asia Society, Hong Kong, 15 October 2012. | Klaas Knot: The eurozone crisis – causes and solutions Speech by Mr Klaas Knot, President of the Netherlands Bank, to the Asia Society, Hong Kong, 15 October 2012. * * * Thank you for this opportunity to exchange views with you on this topical issue. I’ve accepted this invitation with pleasure. For you should know that Hong Kong has always held a fascination for me, if only because of its breathtaking dynamics. But, much as I would like to dwell on that, I’ve been invited here to discuss the crisis in the euro area. And I gladly do so, for I feel this crisis needs some explaining. I will first briefly touch upon the role of the Eurozone in the global economy, to clarify why it is so important for everyone that the European project will be successful. After that, I’ll discuss the implications of the European sovereign debt crisis for the future design of EMU. I will argue that at the root of the crisis we find some individual euro area countries pursuing wrong policies, as well as a failing system of mutual surveillance in the euro area. These deficiencies pose a number of challenges for the future of EMU. While the introduction of the euro has increased macroeconomic stability and furthered trade and financial integration, the sovereign debt crisis clearly demonstrates that the job is not done yet. The importance of the Eurozone for the global economy does not directly follow from the size of its population. But the other indicators on the chart show that major economic problems in the Eurozone without a doubt have repercussions on the rest of the world. The Eurozone accounts for almost 20% of world GDP, and almost 15% of world trade. BIS central bankers’ speeches The latter figure is corrected for intra-EMU trade, so it only shows the share in world trade of the Eurozone as if it were a single country. Including intra-EMU trade, the share of the Eurozone in world trade is over 25%. Finally, the share of the Eurozone in global outstanding bonds, equity and bank assets is almost 25%. This indicates that the euro area is an important player for financial markets. Given its role in the global economy, it is obvious that a solution of the European sovereign debt crisis is of vital importance for everyone. If EMU were to fall apart, the consequences for Europe, but also for the global economy would be severe. Therefore, European policymakers and central bankers do their utmost to solve this crisis. In what follows, I will first focus on the causes of the sovereign debt crisis. I will conclude by presenting my views on the implications for a stable design of EMU. Since the Eurozone crisis erupted, European policy makers have done a lot to restore confidence. Important developments include the creation of the emergency facility EFSF/ESM, i.e. the European Financial Stability Facility and European Stability Mechanism, to assist vulnerable euro countries during their reform efforts. Another significant step is the signing of the Fiscal Compact, a treaty in which the political leaders of the euro area countries (and most other EU countries) further strengthened the rules governing budgetary discipline in Europe. The ECB also took unconventional measures to prevent the sovereign debt crisis from severely dragging down the real economy and from frustrating monetary transmission and its efforts to maintain price stability. We first introduced the Securities Markets Programme, or SMP, for interventions in the secondary government bond markets of vulnerable countries in order to restore their proper functioning. We also introduced a refinancing operation with a maturity of three years, which injected around EUR 500 billion of “new” liquidity into the European banking system. BIS central bankers’ speeches This provided the banking system with the liquidity security they needed in light of the market tensions and, thus, helped to avoid a sharp reduction in credit supply to the economy. While these measures calmed markets for a certain period, as the chart indicates, tensions kept returning every time. In my view, this is because the actions of governments and the actions of the ECB were not aligned. In particular, European politicians tended to slow down their efforts after ECB measures had temporarily reduced market pressure. This was especially visible for the SMP. Instead of stimulating politicians to solve the underlying causes of this crisis, the SMP discouraged them to do so. To remedy this situation, the ECB recently replaced the SMP with a new instrument for secondary market interventions: Outright Monetary Transactions or OMTs. The great advantage of OMTs is that they come with strict conditionality for the countries involved. This is meant to ensure that these countries cannot slow down their efforts after ECB interventions have eased market pressure. The ECB will only intervene in euro countries committed to and complying with the structural economic adjustment programme attached to support from either EFS or ESM, and the IMF. This way, the actions of the ECB and the actions of governments do not undermine, but reinforce each other. In response to the announcement of OMTs, most stressed sovereign debt markets have recently calmed down substantially. I will now switch to the macroeconomic causes, but would be happy to answer any queries you may have on OMT and other ECB actions after I finish. As my talk so far indicates, in analysing and solving the sovereign debt crisis, the focus was mainly on fiscal and monetary factors rather than on the macroeconomic causes of the crisis. However, these causes are at least as important as the fiscal slippages some countries allowed themselves. At the start of EMU, per capita income levels between countries differed significantly. It was assumed that catching-up countries would experience faster economic growth. This is what did happen, but not quite to the extent expected. BIS central bankers’ speeches Prior to the crisis, mainly Ireland, and to a lesser extent also Greece and Spain, showed signs of real convergence. Their cumulative growth differentials compared to Germany reached 20 to 45% in 2007. Note that Italy and Portugal hardly experienced any real convergence towards the German welfare level, even before the crisis. Even the Netherlands “converged” more than these countries. Unfortunately, the catching-up process largely took place through debt, either public or private. As the chart shows, in some countries credit to the private sector grew by more than 10% a year for over a decade. As a result, their debt with the rest of the world ran up tremendously. This was most dramatically the case in Ireland, which moved from a net creditor position of 52% of GDP in 1999 to a net debtor position of 71% of GDP in 2008. Note that the Netherlands is not doing particularly well with regard to this measure either. This is mainly the result of the growth in mortgage loans. In my view the high stock of mortgage debt is among today’s biggest vulnerabilities of the Dutch economy, but fortunately some initial measures have been taken to reverse the trend here. BIS central bankers’ speeches Besides being largely based on credit, real convergence was accompanied by high inflation, as you find visualised on this chart. Whereas Germany experienced lower inflation compared to the euro area average, the inflation rates in Greece, Ireland, Spain and Portugal were much higher than the EMU average. This substantial deterioration of competitiveness mainly reflects the development of unit labour costs. Let me pause for a moment here, and note that economic developments in Germany in the last decade have been phenomenal. It isn’t that long ago that Germany was called the sick man of Europe. Partly due to the ample supply of low-paid workers from East Germany, the labour market institutions in Germany were no longer sustainable. This led to the so-called Harz reforms, which made the German labour market more flexible and tempered unit labour costs and inflation. Turning back to the euro area, before EMU came into being, its current member countries followed different economic strategies. Between 1970 and 1999, unit labour costs in Germany, the Netherlands and Austria grew by a factor of 2.5 to 3. During these 28 years prior to EMU, unit labour costs grew by a factor of 12 in Italy, 14 in Spain, 35 in Portugal and 55 in Greece. By regularly devaluing their currencies, these countries were able to restore competitiveness. But after the launch of EMU, this policy option was no longer available, of course. The hope was that these countries would adapt to this new reality and unit labour costs growth would slow down. But is this what happened? BIS central bankers’ speeches This chart shows the cumulative growth of unit labour costs relative to the euro area average from the start of EMU. While countries like Germany, Austria and Finland continued their modest wage policies, unit labour costs in Southern European countries went up at a much higher pace, undermining their competitiveness. This proved unsustainable. The countries that found themselves in the top of the chart when the sovereign debt tensions started in 2009 – that is Greece, Spain, Ireland, Portugal and Italy – all ran into trouble one after the other. This is no coincidence. Currently, adjustments are hard-handedly being enforced by the markets. In the said countries, probably with the exception of Ireland, product and labour markets didn’t function properly and they still don’t. Markets are overregulated and labour markets are highly inflexible. By addressing these problems, labour productivity can increase, thereby lowering unit labour costs. I am not saying this will be easy, but I’m convinced that such steps are absolutely necessary for EMU to function properly. As the chart also shows, in the Netherlands unit labour cost growth was also relatively high during the first years of EMU. This, however, wasn’t caused by the high inflation rates and low flexibility of the labour market, but reflected the low unemployment rate in the Netherlands in that period. For many years, the unemployment rate in the Netherlands was the lowest in the euro area. BIS central bankers’ speeches The divergences in unit labour cost developments and price competitiveness within the euro area are reflected in the current account balances of the individual countries. As you can tell from this chart, before the crisis, most southern European countries and, to a lesser extent, Ireland experienced high and steadily increasing current account deficits, while the current account surpluses of Germany and the Netherlands improved further. For many years it was thought that in a monetary union, the current account balances of individual countries were no longer relevant. It was only the balance of payment of the euro area as a whole that mattered. We know better now. Of course, besides competitiveness problems, the crisis also had fiscal causes. BIS central bankers’ speeches As can be told from the chart, the stability and growth pact didn’t prevent some governments from taking up old habits once they had fulfilled the convergence criteria that enabled them to join EMU. We shouldn’t forget, however, that this was facilitated by some of the core countries of EMU. When it became clear that fiscal policies in these core countries wouldn’t be able to meet the rules of the Stability and Growth Pact, it was not the policies that were changed but the Pact. This was clearly a mistake. Besides, the gradual deterioration of the budget balance in countries like Italy and Portugal was partly due to their competitiveness problems. Since devaluing out of these problems was no longer an option, the decline in competitiveness slowed down economic and employment growth. This dampened tax revenues while stimulating social security expenditures. Looking at it this way, the lack of fiscal discipline partly reflected the lack of macroeconomic discipline. More in general, budgetary policy was supposed to absorb temporary cyclical differences, by allowing the automatic stabilisers to do their work. For example, during a downturn, public spending automatically goes up as more people receive unemployment benefits, while tax revenues decrease. Such ‘automatic’ response to cyclical developments stabilises the economy. But in most member states, the automatic stabilisers have failed to operate properly since 1999. Instead, a number of governments followed pro-cyclical budgetary policies, by loosening the budgetary reins during the economic booms, and tightening them during the busts. In other words, budgetary policies have hampered the functioning of EMU. Budgetary discipline in EMU was supposed to be exacted not only by the stability and growth pact, but also by market discipline. BIS central bankers’ speeches Markets were expected to restrain profligate governments by charging them higher interest rates and, thus, forcing them to change their ways. As is evident from the chart, market discipline was largely absent during the first ten years of EMU, allowing governments to pursue unsustainable policies. And when markets finally started to differentiate between governments, they did so with a vengeance. Although market discipline is now imposing necessary corrections, a stable monetary union cannot be based on this mechanism. So what would a stable monetary union look like in my view? As I argued earlier, some euro area countries have not fully adapted to the fact that they lost the option of devaluation in order to restore competitiveness. If they had, they would have increased their flexibility and growth potential by reforming their labour and product markets. Given the spillover effects of postponed structural reforms on the functioning of EMU, these reforms cannot be the sole responsibility of the governments concerned, but should also have a “European” dimension. This may take different forms. Political leaders already took an important step with the creation of the Macroeconomic Imbalances Procedure. They did so as they acknowledged that diverging competitiveness within a monetary union ultimately creates severe spillovers for all members. However, the Macroeconomic Imbalances Procedure could be strengthened by increasing its focus and enforceability. This could be done, for instance, by introducing more reversed Qualified Majority Voting in these areas. Furthermore, minimum standards or best practices could be introduced in policy areas where spillovers have turned out to be especially high, such as labour market policies. Importantly, what should be avoided is harmonisation of practices towards some kind of EMU average, as this would compel strong countries to embark on mediocre policies. BIS central bankers’ speeches Secondly, debt ratios should gradually be brought well below the ceiling of 60%. This lower debt ratio can only be realised and maintained through independent enforcement of the European fiscal rules, and by anchoring these rules in national legislation. A politically independent European authority that can increasingly intervene in the fiscal policy of countries breaking the agreements is essential here. Thirdly, the diabolic loop between banks and sovereigns in the Eurozone must be dealt with. This calls for European banking supervision, in combination with common mechanisms to resolve banks and guarantee customer deposits. This set-up should apply to all banks in the Eurozone (and preferably the EU) and not only to the cross-border banks. After all, as the experience in Spain and Ireland has shown, a financial crisis involving small, domestically orientated banks can still jeopardize national debt sustainability and European financial stability. If – and only if – these conditions are met, Eurobonds could be a serious option. Given how remote we still are from the 60% debt target, this will likely be a matter of decades rather than years. But once we would be there, Eurobonds could enhance the stability of EMU in several ways. They would prevent a liquidity problem in one euro area country from needlessly transforming into a solvency problem. Moreover, they could provide a fire wall against the danger of contagion. Although Eurobonds are not suitable as a crisis instrument, they could be the light at the end of the tunnel for the people of vulnerable euro area countries. For the people in those countries need to feel that their sacrifices will contribute to a permanent solution; one that will safeguard them from the short-sightedness of both politicians and markets. Let me finish my address today by saying that finding a structural way out of the crisis will not only be beneficial for the Netherlands and the rest of Europe, but also for the world economy. Thank you for your attention. BIS central bankers’ speeches | netherlands bank | 2,012 | 10 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Conference on "The future of banking", organized by the Financierings-Maatschappij voor Ontwikkelingslanden N.V. (FMO), Amsterdam, 12 November 2012. | Klaas Knot: Can intensive regulation and MSME financing coincide? Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Conference on “The future of banking”, organized by the Financierings-Maatschappij voor Ontwikkelingslanden N.V. (FMO), Amsterdam, 12 November 2012. * * * Your Royal Highness, Ladies and Gentlemen, I’m very pleased to be here today to speak on this important topic: the future of banking. Today, we will exchange views on the changing banking sector and the role of regulation in that sector. And I will share some thoughts on how we can make the banking sector in this part of the world healthy again. The key question I will seek to answer is: “Can intensive regulation and Micro-, Small-, and Medium-sized Enterprise (MSME) financing coincide?” But before answering that question, let me first sketch how this intensive regulation came about. Over the past few decades, banking in most developed economies has become increasingly complex, interwoven, innovative and international. Furthermore, the focus of many Western banks has gradually shifted away from what their core task should have been: Namely, to service the real economy and its customers. Instead, these banks increasingly engaged in the lucrative business of making money with money. This change of policy created unnecessary risks for their entire portfolio. Risks that couldn’t be mitigated by the existing regulations. And we all know what problems arose as a result. One of the answers to those problems was more and intensified regulation. Higher capital requirements, minimum liquidity requirements, extra buffers are but a few examples of the measures standard-setting bodies developed. Most of these measures are currently being drafted in national legislation in many countries around the world. Will intensifying regulation help solve some of the problems in the developed banking sector? Yes, I believe so. For, indeed, there was a shortage of capital and liquidity in the banking sector. And the leverage was generally way too high, not just for large, international banks. Increasing capital buffers; establishing resolution regimes; reducing systemic relevance of banks, are some of the important recent initiatives designed to make banks healthier. Thanks to these measures, banks will be better positioned to absorb losses and become less dependent on government support. And thanks to these measures, trust in the financial sector will eventually be restored. I therefore wholeheartedly support these initiatives. Of course intensified regulation will come at a cost. For banks, profits will go down. Generating double digit profits will become an unrealistic target if the underlying real economy the bank is servicing does not generate such high profits either. For customers, it means that financial products and services will become more expensive. And investors will come to realize that investing in a bank is a long-term undertaking, rather than a quick and easy way to make money. Intensified regulation will also make some business models less appealing. But let us not forget that those are exactly the business models we are worried about. Funding an extremely long-maturity asset portfolio with very short-term paper used to be quite common for a while for many larger banks in developed economies. But this is undesirable. However, understandably, many are worried that this intensified regulation will hurt MSME financing. MSMEs are generally treated either as corporate or as retail clients. If they are treated as corporates, MSME loans may in some cases be considered riskier than loans to BIS central bankers’ speeches large corporates. Such as when the MSME loan is provided in a country with a high sovereign risk. An ECB study published last week1 showed that access to bank loans in the Euro area, including MSME loans, was becoming slightly more difficult. Moreover, the survey pointed to somewhat higher rejection rates for loan applications. Meanwhile, the percentage of respondents reporting access to finance as their main problem remained broadly unchanged. The demand for external financing showed even a slight decline. I think that regulators and supervisors must continuously evaluate how risky banking activities really are. This is a learning process. If by evidence it turns out that some activities are less risky than initially considered, we should consider treating such activities more favorably. For instance, through lowering risk weights. If they turn out to be riskier, we should treat them with more caution, whatever the activity concerned, MSME loans included. To me this is the proper approach to making sure banks are sound and the financial system stable. I think, though, that MSME lending will ultimately not be disproportionately affected. Let me explain this: First of all, all new regulation will be phased in only gradually. For some measures even over a period of up to 10 years. This should give banks, investors and customers, including MSMEs, sufficient time to adapt to the new requirements. In addition, this gradual phasing in will also allow the banking sector to benefit again from an economic upturn. This hadn’t been possible if the new requirements had come into force with immediate effect. Second, although the bar will be raised for all banking activities, the new regulation is primarily targeted at the riskiest activities. Systemically important banks, trading assets, complex securitizations, those are the type of banks and activities that will be experiencing the highest impact. Those are the activities that will become least appealing to banks. Not the traditional, plain vanilla banking business, which includes MSME lending. And third, I believe that all new regulation explicitly allows for a proportionate implementation. This means that emerging market economies are permitted to use a risk-based approach with respect to the tasks of the supervisor and the standards that they impose on banks. Even in the latest EU legislation, proposals have been made to ensure that capital requirements for MSME financing do not grow as rapidly as those for other banking activities. I find it encouraging to learn that the Basel Committee on Banking Supervision, starting even this year, will develop guidance on how to apply such a proportionality principle. For emerging markets this guidance is most welcome. So altogether I think that intensified regulation, provided it is implemented proportionately, can continue to go hand in hand with sufficient MSME financing. In the end, sounder and healthier banks will enhance financial stability. This, in turn, will benefit the entire financial sector, and hence also the MSME business. If you ask me if I think that intensifying regulation will solve all of the problems? No, it definitely won’t, I’m afraid! If only, because intensifying regulation does not necessarily motivate the banking sector to move back towards its core task of servicing the real economy and its customers. Take, for example, proprietary trading. This is when a bank trades financial instruments with its own money instead of its customers’ money, sometimes even following an investment strategy it doesn’t advise to its customers. As a result, the bank makes a profit for itself instead of for the customers. Such a disconnect between the interest of the bank and that of the customer still occurs too often. “Survey on the access to finance of small and medium-sized enterprises (SMEs) in the euro area”, 2 November 2012. BIS central bankers’ speeches Ultimately, going back towards their core task of servicing the real economy and its participants is where the future of banking lies. No bank will survive that does not set its clients’ interests center stage, instead of sales targets or profits. I find it encouraging to learn that in many emerging markets clients are still put first. This most likely explains in part why the banking sectors in many emerging market economies have weathered the financial storm much better than in developed economies. Other factors that have contributed to their stability is that many banks in emerging market economies still engage predominantly in plain vanilla banking activities…. …and that they are strongly funded by wholesale funding. Furthermore, I find it encouraging that banks in emerging market economies have remained stable despite the fact that they have used quite innovative ways of banking. Many emerging markets use ICT solutions that are very advanced. Such as mobile banking, which allows individuals and MSMEs to access and transfer money without needing to travel to a branch. Your own country, governor Velarde, may serve as a fine example here. In your country branchless banking may have been borne out of necessity. But in recent years, this has proved to facilitate access to finance for great many MSMEs. You have also shown that regulation, even if intensified, can be designed to accommodate these innovative ways of banking while still protecting customers and safeguarding financial stability. Customer protection in your country is even set as a top priority. It calls for banks to formally assess the financial situation of the client in order to avoid over-indebtedness. Such initiatives have vastly helped to establish a solid MSME business and sustainable growth in your country. I am therefore quite confident that also in developed countries, we shall manage to combine intensified regulation with sound MSME financing. And that we shall also manage to ultimately motivate our banks to move back towards their core task of servicing the real economy and their customers. Ladies and gentlemen, let me conclude. Today’s conference coincides with the opening of the Dutch National Money Week, later today. During this week, we teach our youngsters how to deal with money in a responsible way. For today’s youngsters create the demand for financial products and services of tomorrow. And many of them will become entrepreneurs, setting up MSMEs themselves. By educating young people in money matters, I hope we can empower them to shape the banking sector to their liking and to their demands, instead of merely enabling them to use what banks have to offer. I thank you all for your attention, and I wish to you all a very interesting and fruitful conference. BIS central bankers’ speeches | netherlands bank | 2,012 | 11 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the "International Financial Reporting Standards" conference, Amsterdam, 27 June 2013. | Klaas Knot: Financial stability through transparent reporting Speech by Mr Klaas Knot, President of the Netherlands Bank, at the “International Financial Reporting Standards” conference, Amsterdam, 27 June 2013. * * * Ladies and gentlemen, I would like to talk to you about the role accounting standards fulfil in micro- and macroprudential supervision of the financial sector. From experience I know that the accounting domain, the prudential domain and financial stability cannot be seen separately. The discussion about this subject has been going on for quite some time. But I’ve always contributed to this debate from a supervisory perspective. And so I will today. The main thread of the debate has always been “unexpected losses versus expected losses”. In other words: losses we cannot see coming versus the net present value of predictable future losses. The question for us is: how to translate the prudential notion of expected and unexpected losses to day-to-day accounting practises? I have two messages: The first: Accounting standards should be designed to reflect expected losses, no more and no less than that. And own funds should be designed to absorb unexpected losses. The second: Financial reporting and financial stability supplement one another. They are like a horse and carriage. I believe a combination of transparent capital requirements and accounting concepts based on expected losses, would boost trust in financial institutions and thus improve financial stability. Now, it’s a known fact that the ancient Egyptians were aware that every good seven-year period would be followed by a bad seven-year period. Seven years of favourable weather conditions would be followed by seven years of either too little or too much rain. It’s why they saved grain during the seven good years. This old wisdom would serve the financial sector well too. Stockpiling the metaphorical granary when harvests are good is sound financial policy. So, how does this translate to financial reporting and capital requirements? Well, in the debate, prudential regulators are often accused of building in unexpected losses in loan loss provisions. I think, though, that the facts tell a different story. Let’s look at the Basel Committee for instance. It distinguishes between expected and unexpected losses. It argues that capital requirements should be robust enough to cover unexpected losses. And the Basel Committee welcomes that the IASB is considering including the expected loss notion in their new financial instruments standard, IFRS 9. With a few hundred accounting experts here in the audience, I won’t need to explain why a bank that maintains adequate loan loss allowances and robust capital buffers, is doing itself a favour. This serves that bank as well as financial stability. As to the capital buffers, I take it that most of you are aware that both Basel III and Solvency II contain stricter requirements for buffers than the former versions of these solvency regimes. BIS central bankers’ speeches For banks, Basel III specifies that the minimum levels be increased and expanded with socalled capital conservation and countercyclical buffers. Capital conservation buffers are to be built specifically in good times, through profit retention. And countercyclical buffers are meant to be created in times of rapid credit growth, when banks extend a lot of new loans. For we know that, more often than not, such periods are followed by a prolonged financial downturn. As far as the supervisory requirements are concerned, it is the explicit aim that the granaries be filled during the good years. Supervisors play a crucial role in ensuring that banks comply with this requirement. But there’s an important role for accounting standard setters here, too. For I would argue in favour of maximum transparency about these buffers. And it wouldn’t surprise me in the least if the IASB chose to include disclosure requirements about own funds in their standards, for instance in IAS 1. Now let me turn to financial stability. Obviously, economies are cyclical: every upward trend is followed by a downward one. And vice-versa. Given the current negative sentiment, trust in banks has turned sour. To illustrate this, we only need to look at the price-to-book ratios of many banks. The figures are telling us things are not well. Among a number of reasons why price-to-book ratios are this low, is that investors are still expecting hidden losses to appear. They believe the banks have not yet put these future losses in the books and are thus sceptical about their financial health. For when part of the capital will be used to absorb expected losses, they know that less will be available for unexpected losses. Whether these investors are right is irrelevant. What is relevant is that this fear stems from knowing that banks apply the incurred loss-model. The impairment requirements in the current standard, IAS 39, are just not sufficiently forward-looking. This is not just their perception; it’s mine too. In terms of the grain metaphor, that’s like having a well-filled granary built on soggy soil and knowing that the grain is leaking away through cracks in the foundation. This makes for a deadlock between investors and banks – one that can have adverse consequences for financial institutions, governments and national economies, as we have witnessed in recent years. In my view, it’s therefore highly advisable that we make the impairment requirements in the new accounting standard forward-looking. High-quality accounting standards should form the foundation on which these capital buffers are based. Sound reporting will increase trust in the institution. There are those that think it unwise to estimate future losses, as these estimates are subjective and imprecise. I would disagree for two reasons: First, expected losses can be described in such concrete words that they can be properly reported by the reporting entity and subsequently verified by the auditor. And, second, I believe that the current incurred loss model is more subjective than people tend to think. To illustrate the subjective character of the current incurred loss model, I can draw from our experience at the Dutch Central Bank. We are currently executing a so-called Asset Quality Review. In this review we’re also evaluating the processes that lead to adequate levels of loan loss provisioning. BIS central bankers’ speeches What we are seeing is that different banks use different interpretations for similar loans. Apparently, there’s already room for a certain degree of subjectivity. I’m not too worried about this subjectivity. Preparing financial statements has always carried some measure of subjectivity and this will remain so. I agree with those who say that too much subjectivity will foster “gaming of the system”. In order to control this subjectivity, I would welcome that the new IASB standard, IFRS 9, clearly defines those relevant forward-looking elements. For me the proof of the pudding would be preparers and auditors saying that the new forward-looking requirements cannot be ignored when calculating the expected loss allowance accounts. So far, I concentrated on the impairment requirements to be included in IFRS 9. But IFRS 9 also contains other elements that are quite relevant to us. These are the classification and measurement sections. Let me also say a few words about these. It’s generally accepted that a bank’s economic value is determined by its cash flows. Accounting standards should reflect this. That’s why I am in favour of introducing the business model criterion. If the bank’s business is trading, then the Fair Value-method would give a good estimate of future cash flows. If the bank specialises in hold-to-collect management of financial instruments, then unrealised gains should not be part of its own funds. Obviously, I’m implicitly referring to the revision of standards for financial instruments: the conversion of IAS 39 to IFRS 9. I’m glad we are converting, as the new standard is a big improvement. For the resulting simplicity will not only help to tell a clear story, but also enhance financial stability. And this is just what the main categories “amortised cost” and “fair value through profit or loss” will do. I know, of course, that the IASB is considering introducing a third category, the so-called Fair Value Through Other Comprehensive Income, or FVOCI. I’ve been told that this new category resembles an old one, the Available-for-Sale category. The very category that caused a lot of uncertainty during the crisis. I would therefore advise the Board to see to it that this third category is made subject to robust conditions, to ensure that this regulation leaves no leeway for arbitraging. Finally, I would say that converting from incurred loss to expected loss would greatly improve things. As I said earlier, accounting principles should take into account expected losses as soon as they are perceptible. This means that the expected loss notion becomes part of the amortised cost principle. And I view this notion as quite similar to fair value notions that include losses in market indices. These also tend to bear a forward-looking element. To some this may come as a surprise, but in my mind both approaches would give us very clear estimates of possible credit risk losses. And, of course, this would serve financial stability. The IASB has been working on the conversion from IAS 39 to IFRS 9 for a while now. I look forward to its swift implementation. In closing, I would like to leave you with three basic principles: One: Transparent reporting of expected and unexpected losses contributes to financial stability. We should make buffers in own funds for unexpected losses and book in the expected losses as part of the new amortised cost valuation method. Two: Prudential regulators and accounting standard setters such as the IASB share an interest. Prudential regulators promote sound risk management practices – and accounting standard setters promote sound financial reporting. Both are prerequisites for a sound banking system and, consequently, for financial stability. BIS central bankers’ speeches I therefore call upon the IASB to continue its cooperation with the regulators, including the Basel Committee. Three: The expected loss model must be included in the IFRS 9 standard for financial instruments – as soon as possible, I would add. Ladies and gentlemen, Let the granaries of the world be filled to the rafters with grain of excellent quality. And let the fields be ready to bear more great harvests. Once everyone sees how well the farmers are prepared for the lean years ahead they will happily go about their business. They will trust the stability of the system that keeps them fed. I thank you for your time and will now happily take some of your questions. BIS central bankers’ speeches | netherlands bank | 2,013 | 8 |
Speech by Mr Frank Elderson, Executive Director of the Netherlands Bank, at the "Future of the Payments System" conference, Amsterdam, 18 June 2013. | Frank Elderson: Payment systems – security, governance and SEPA Speech by Mr Frank Elderson, Executive Director of the Netherlands Bank, at the “Future of the Payments System” conference, Amsterdam, 18 June 2013. * * * Ladies and gentlemen, As you all know, DNB’s objectives include ensuring secure, reliable and efficient payments. That means making sure we can rely on having good and effective payment systems. This is the moment when speakers usually introduce their metaphors. And, in the Netherlands, these are often metaphors involving water. Water that has to flow, and rivers that have to be channelled. And then the dikes that have to be built. But I have decided I am no longer going to do that. Instead, it is now time for conferences on water management to start comparing themselves to payment systems. In other words, to systems that always have to work and that have to be secure, reliable and efficient. Ladies and gentlemen, There are three things I would like to talk to you about today. These are firstly the security of the payment system, and I believe there should be an increasing focus on that. Secondly, what we refer to as “governance”. In other words, how we manage the payment system. And thirdly, which is where I am going to begin today, the near future. In other words, the Single European Payments Area, or SEPA. I think I am right in assuming that everyone here today has been very involved in the introduction of SEPA, and so there is no need for me to explain to you what a complex project it is. And, as always happens with complex projects, that there have been all sorts of problems along the way, and fortunately also some things that have gone well. And that we should really count our blessings. Internet banking systems are switching relatively easily to SEPA. Many businesses have already completed the process, and consumers seem to be accepting IBAN without any major difficulties. The tax authorities, for example, are now generating huge volumes of SEPA payments each month, and believe me when I say that even the Emmer Compascuum volleyball club, which has always been very diligent, has also completed the switch. However I also know from very reliable sources that others, such as the tennis club around the corner here in Amstelveen, are first waiting to see how things develop. On a more serious note, we have seen that introducing the European collections system is proving quite challenging. Although the system is already working well at many businesses, others – particularly some of the larger groups – have had to deal with “bugs”, either in their own systems or in their communications with banks, or sometimes even at the banks themselves. Transactions involving large volumes of collections in particular have not always gone entirely smoothly. I firmly believe, however, that we will be able to resolve all these problems. And my belief has so far been backed up by the facts. What does concern me, however, is that we do not have much time left before 1 February. To be more exact, there are only 161 working days to go. Luckily there are still 228 calendar days to go, and I suspect that, for a few of us, there will not be much difference between a working day and a calendar day over the coming months. Even if a company has calculated that it still has enough time to complete the process, there is always a danger of logjams arising. Many companies and even some banks themselves have experienced delays in their projects, and that means more businesses than expected will need help over the coming period. BIS central bankers’ speeches So what are we going to do? There is no need for me to say that SEPA should be a top priority for you all, and I assume it already is. But just in case you are here today representing a company that has not yet started its preparations, I am afraid to say you will probably have to work through most of your weekends until February next year. There is one other thing I would like to add today. I know that people in some countries are slightly less concerned about the deadline of 1 February. That may be because they are more light-hearted by nature. Personally, however, I think there are two other reasons that may explain the differing attitudes. Firstly, the biggest challenge for SEPA is setting up the European collection system, and many countries use collections far less than in the Netherlands. Secondly, certain other countries are making far more use of conversion services. These services mean businesses can make far more modest adjustments to their systems and then use a conversion service so that the payments they send to their banks are SEPA-compliant. These conversion services have never been able to count on much support in the Netherlands as, ultimately, they mean you are not making genuine SEPA payments. However, they are an interim solution that will certainly help some parties to meet the 1 February deadline. Please do not understand me wrongly. I am certainly not suggesting using conversion services as an alternative to switching over to SEPA. All I am saying is that you should consider whether you need to use these services to meet the deadline. And make sure you do this in time because conversion services also involve more than just pressing a button and suddenly, all at once, you are SEPA-compliant. You also need some preparation time, particularly for collections. I hope, therefore, that conversion services will be included in banks’ discussions with clients who are at risk of missing the deadline. Whether they see these services as a temporary bridging facility, as an emergency sticking plaster or as a solution. That is entirely up to them. There is just one final comment I would like to make on conversion services. What exactly are they? If I enter a payment into my payments engine in the old-style format, is that a conversion service? The answer to that question is “no”. A conversion service is a separate service that is independent of the bank’s payments engine. It is a service you can arrange for separately, either at a bank or from another provider. You might expect to have to pay a fee for the service. Indeed, it was previously said that conversion services would have to be provided by separate legal entities. But there is no need for you to worry. That is not necessary, and this is something I am saying in my capacity as “overseer” of SEPA. And this then brings me to my second topic today: governance of the payment system. I am going to dwell for just a while longer on the subject of SEPA as the Ministry of Finance has given DNB two hats to wear in this respect: that of overseer and that of catalyst. As far as DNB as overseer is concerned, this is when I put my strict hat on as it is the overseer’s task to make sure the banking sector complies with the law. That means staying on top of things, and we will be tightening the reins even more over the coming months. That will sometimes mean difficult discussions with some parties. And sanctions will follow if things are not satisfactory. Even, however, if we do decide to apply sanctions, we cannot do that before 1 February next year. That may sound a bit strange because, by then, it will in any event be too late. That is why we will also be looking at how parties are operating now when we consider whether to apply sanctions next year. BIS central bankers’ speeches I am sometimes asked “Exactly how strict is DNB going to be next year?” My answer to that is quite simple: “Strict”. The next question then is “But are you going to be thorough?” My answer to that question, too, is simple: “Of course we are”. If I then put on my other hat – that of the catalyst – it means looking at the issue from the typical Dutch polder perspective and switching to my role as chairman of the NFS National Forum on SEPA migration. That role means working with everyone to make sure we take account of all the interests at stake and arrive at optimal solutions for us all. Here, too, we regularly have to be strict. The overseer’s hat then comes in handy as there are times when we also have to take decisions. And not every decision is equally welcomed by everyone. The NFS is the SEPA variant of what we are doing on a broader scale in the National Forum on the Payment System (or MOB, as it is known in Dutch). I often have to explain to colleagues from abroad that this Forum works on the basis of equal participation by representatives of providers and users of payment systems. And, if you’ll forgive me this reference to water after what I said earlier: before we start work on, say, a project to build water defences, we first put up a coffee hut at the site. Setting up the coffee hut is not our main task, but we would not want to be without it as that is where we agree who is going to do what during the project. This is also a model that could prove useful in a European context. As you may know, there is a SEPA Council at a European level, and I have attended its meetings on various occasions. But the SEPA Council still has too few powers to make a real impact. However, and despite all the good aspects of the polder model, we also have to admit, in the current climate, that not everything can be done in an atmosphere of cooperation and consultation. Not everything can be voluntary. With the exception of our new SEPA task, DNB’s oversight task is still based on a voluntary agreement, and that is no longer appropriate for the times we live in. The payment system has become far too crucial for society to allow oversight of the relevant players to remain entirely voluntary. We really need legislation in this respect, and indeed some of this legislation is on its way. The Settlement Organisations (Financial Supervision) Act [Wet Financieel Toezicht voor Afwikkelondernemingen] will come into force next year. Although this will certainly provide a legal basis for our oversight activities, it will not plug all the gaps. We are still not allowed to impose measures on organisations such as iDeal, for example, and there is no need for me to tell you how tolerant society is about iDeal disruptions. To ensure secure, reliable and efficient payment systems in a broad sense, DNB needs legislation covering every aspect involved in these systems. That is something we are currently discussing with the Ministry of Finance, and I certainly hope we succeed as the payment system is simply too important for us to be satisfied with the current patchwork of laws. We need a single consistent framework so that we can supervise all the links in the horizontal chain of the payment system. We still do not have that single framework, and that is something that today’s world demands. And now I am coming to my third and final point: the security of the payment system. In April this year various Dutch banks in the Netherlands were hit by a series of DDOS attacks, and this is a matter of great concern to DNB. Fighting cybercrime and dealing with the digital disruption it causes are high priorities for us. Last month I attended discussions at the Dutch House of Representatives to explain my views on these subjects. Society has become less tolerant about disruptions to the payment system as more and more people are using on-line payment products, and consumers increasingly expect BIS central bankers’ speeches payment systems always to work. Those are facts we have to accept. We also have to accept, however, that 100% availability is an illusion. That is just impossible. So what can we do? There are three things we have to work on: 1. Prevention 2. Damage limitation if and when things go wrong, and 3. Communications. In the case of prevention, I believe that we as a sector are going to have to focus more on security and availability. And yes, that may mean we have to accept that systems will sometimes be less efficient than otherwise. By harmonising systems and technologies we can certainly boost efficiency. But this also creates SPOFs, or single points of failure, and these make us vulnerable and, therefore, a more attractive target for cybercriminals. And although I always sleep extremely well at night, cybercrime does sometimes mean I go to bed later. A lot of parties are working extremely hard to avoid becoming victims of cybercrime. But we can never rest on our laurels. It is a race, and the enemy never sleeps. There is one other aspect I would specifically like to draw your attention to, and that is the need for diversity. In other words, the need for alternatives. If we cannot use iDEAL, but another easy-to-use alternative is available, that is fine. But that means that the alternative must not be reliant on the same technology as iDEAL. Diversity in technology is important. Also when you make PIN payments in a shop. If the PIN terminal does not work, you need to be able to pay in another way, and using a method that is not dependent on that PIN technology. We are now thinking about these alternatives, and maybe a more mobile society will help us in this respect. What I mean here is that technology has become more mobile. Mobile internet banking, for example, is becoming increasingly popular, and mobile payments are on the way. In other words, the distinction between point-of-sale and remote payments is becoming blurred, and maybe it will ultimately disappear altogether. If the various technologies become equally fast, it will soon no longer make any difference whether you use your phone to make a mobile payment (a PIN payment, for example) or an internet banking payment (in other words, a transfer). If I put my security hat back on, I would say that is fine, but we do need to make sure we use two different technologies. Otherwise, a single cause could result in both payment options being unavailable at the same time. Some of these changes are still in the future. But the issue also applies to the old tried and trusted alternative of cash. If the PIN system does not work, you need to be sure you can still get cash out of the cash machine. And luckily that is not usually a problem because you withdraw cash from your own bank’s cash machine system, which is separate from the PIN system. So there, too, technological diversity is important. And so, to go back to what I mentioned before, our resilience to cybercrime relies on our having good preventive measures in place and also on our having good mitigating measures, just in case things go wrong. Communications, however, are also important, which is why this topic was discussed at the extra meeting held by the National Forum on the Payment System on 15 April. We reached various useful agreements during this meeting, and these require us to be able to communicate very quickly. And in this case “very quickly” means that communications may often first have to be limited to process-related information. We also reached agreements on the need to communicate better. In other words, on who will communicate what in which circumstances. In the first instance, the bank that has been affected will communicate. If, however, the problem is more widespread, the Netherlands Bankers’ Association (NVB) will communicate on behalf of the sector. BIS central bankers’ speeches DNB will communicate only if the payment system as a whole is at risk. Or, to put it more accurately, the Tripartite Crisis Organisation (TCO) will communicate. DNB chairs the TCO, while the AFM and the Ministry of Finance are the other two members. DNB, or rather the TCO, will act as “communicator of last resort”. That is a role we are suited to. Will it mean we can avoid any form of disruption in the future? No. No-one can give any guarantee of that as there is simply no such thing as a risk-free society. Lastly I would like to look ahead to the future. We should not see SEPA as being finished by 1 February 2014. That date is really just the start. We are going to be seeing other developments, including electronic mandates, and probably more and more mobile payments. Time and experience will refine and change our payment products. And DNB is looking with interest at our neighbours to the east and the shorter transfer times they are achieving on SEPA Direct Debits. SEPA’s arrival will also change the playing field for payment service providers and banks, and innovative parties will grasp their opportunities. One of these innovations will involve parties wanting access to payment accounts so that they can offer new services. The Dutch payment sector has issued a position paper on this subject and has sent this to Europe. There is one issue in that paper, however, where our view may not get accepted, and that is the “dual consent” approach. Just to remind you what that is, it covers situations when a third party wants access to a person’s payment account, either to make a payment or to check the balance. That involves certain risks. In my view, those risks are acceptable only if both the consumer and the bank agree to the role of the third party. One good way of arranging this is for both parties to have to agree to grant access. In other words, dual consent. Our European colleagues are worried that, in practice, banks will not grant access to those third parties, and that this will hold back innovation. That is why there is currently insufficient support for the principle of “dual consent”. The Dutch market, however, is in favour of it, and so that is the challenge I am issuing to any payment service providers and banks here today. Show that it can be done. There is nothing to stop us from operating a “dual consent” approach in the Netherlands. And I for one would welcome it. “Dual control” is also secure, and I am sure no-one will blame me for saying that security is my top priority. And I think that you and the rest of society will probably all agree. Innovation is good, and even very good. But if your bank balance suddenly and innovatively disappears, you would wish that security had been the number one priority. People have to be able to trust that their payments will arrive in the right place and at the right time. The routes that monetary flows take need to be predictable and known. Ladies and gentlemen, It is now time for some rhetoric. If you have read Quintillianus, you will know that this is when I should return to my metaphor. In other words, to the metaphor that I threw overboard at the start of my speech. The metaphor of SEPA as a wonderful new waterway, with neatly finished retaining walls and an efficient system of locks. But I am not going to do that today. Instead I am going to tell you that there is a conference on water management being held tomorrow in Rotterdam and that you might find it interesting. Thank you for listening. BIS central bankers’ speeches | netherlands bank | 2,013 | 8 |
Speech by Mr Jan Sijbrand, Executive Director of the Netherlands Bank, at the University of Groningen, Groningen, 5 September 2013. | Jan Sijbrand: Ethics and the crisis in the financial sector Speech by Mr Jan Sijbrand, Executive Director of the Netherlands Bank, at the University of Groningen, Groningen, 5 September 2013. * * * Dear faculty, students, and staff, let me start by thanking you for the opportunity to speak at this festive opening of the academic year. When I enrolled at university to study mathematics, it had never crossed my mind that this choice might one day lead to a career in the banking sector. I just liked mathematics, is what I remember. Besides, in those days and in the first ten years or so after my graduation, banks weren’t interested in hiring mathematicians. But as in the following decades banking products grew more complex, banks began to turn their eyes to professionals with my academic specialty. So this is how, after working with Shell for a number of years, one day I switched to the financial sector, and came to join, first, Rabobank and, later, ABN Amro. And since 2011, I’ve been an executive director at De Nederlandsche Bank. Of course, it can be argued whether it was a wise decision for banks to hire mathematicians ;) I gave you this brief overview of the jobs I’ve held so far, not just to show the students among you that your professional life may turn out different from what you had in mind when choosing a particular field of study… but also to show how my career enabled me to experience and compare different organizational cultures. Most of you will know that, besides being the central bank of the Netherlands, DNB supervises the financial sector. Within the scope of that latter task, I am responsible for what we call the “prudential” supervision of banks, insurers, and pension funds. This means that we at DNB watch over the solidity of financial institutions and the financial stability of the system. This does not imply that DNB is only interested in “the numbers” – the liquidity and solvency ratios of banks. For “the numbers”, are only part of the story when things go wrong. Obviously, other factors that come into play, as the recent crisis in the financial sector has made clear. I am referring to the cases of unethical behavior of bankers that emerged during and in the wake of the crisis. Where and why did things start to go wrong? What are the possible remedies? And what is the role of DNB as prudential supervisor? These are the topics I would like to focus on today. Let me start by giving an example of unethical behavior of bankers before the crisis. Just some weeks ago, a former Goldman Sachs banker – Fabrice Tourré – was found guilty of fraud by a jury in New York City. Mr Tourré was held responsible for seriously misguiding his clients in the so-called “Abacus deal”. Abacus 2007 was the name of an investment in residential mortgagebacked securities, a product that yields income from mortgage payments by homeowners. The deal was as follows: while Goldman Sachs sold the product, while the intermediary company that arranged the deal, Paulson & Co., went “short” on the deal. That is, they bought other products that would bring in vast amounts of money if these mortgages were to default. To make sure that this setup would work, the mortgages selected for the Abacus investment had a high chance of defaulting. Of course, the clients to whom Goldman Sachs and Paulson & Co sold this product were kept in the dark about this. In other words, what Tourré and Paulson did was seeking to maximize their profits at the expense of their clients. It is therefore hardly surprising that this scheme, once it transpired, led to a significant loss of trust in the financial sector in general. BIS central bankers’ speeches This example illustrates how a bank can engage in unethical behaviour by deliberately misguiding its clients, and betting against them. Let us now take a closer look at the banking business in general: where and why could things go wrong the way they did? A bank is an intermediary between people who have more money than they want to spend, and people who would like to borrow money. Put briefly, a bank’s business is to earn money with money. In some cultures and traditions this is considered inherently immoral. In our society, we find this perfectly acceptable, and even consider it indispensable for our economy to function properly. The past few years have clearly shown, however, how things can go amiss. As the former Chief Economist of the IMF, Raghuram Rajan, put it: “Because [bankers’] business typically offers few pillars to which they can anchor their morality, their primary compass becomes how much money they can make” (Rajan 2010: 126). The question, then, is “in whose interests are banks working?” Before, say, the year 2000, banks used to focus on the interests of their clients, their employees, and their shareholders. In other words, they focused on the interests of all of their stakeholders. But in the early years of the present millennium, their focus came to rest more and more on the interests of shareholders alone. “Managing for value” became the new creed. As I see it, this approach made for an imbalance in bankers’ decision-making. It came to stand in the way of how banks ought to operate, and created problems for all parties involved, bankers themselves included. Let me explain how “managing for value” led to imbalanced decision-making. “Managing for value” fostered both short-term and instrumental thinking. Clients became instruments to extract money from in order to maximize profits and thus increase shareholder value. Employees were hired on the basis of their capacity to make as much money as possible and as fast as possible, rather than for their capacity to make a sustainable contribution to the bank. Bank boards cut staffing, and launched new strategies, sometimes yearly; all in order to gain and hold shareholders’ attention; not because it was in the bank’s best interest or that of its clients and employees. So, one might say that by focusing on “managing for value” only, banks lost track of what is required to maintain the right balance. Banks play a crucial role in our economy. A role that goes beyond maximizing profits for their shareholders. Banks are intermediaries: people deposit their savings at a bank, and a bank provides credit to those who need money. This is a bank’s chief task, and its main role in our economic system and in our society. It is a bank’s societal responsibility. Just like other companies – such as Shell, KPN, and Akzo Nobel – a bank, too, has a specific role to play. A bank should strive to perform this role properly, in a balanced way, in order to hold the trust of its customers and potential customers. This trust will be eroded if a bank fails to do so and has no mechanisms is place to prevent the excesses we saw in the years before the 2008 crisis. And how serious this loss of trust can be is evident, for to this very day we are still working hard to restore trust in the financial sector. Let us now turn to the possible remedies for the gap between bankers and the rest of society; the gap that has partially been created by the unethical behavior displayed by some bankers.The first possible remedy is to criticize bankers severely and persistently. This remedy has been applied in recent years, for bankers have been “bashed” quite severely over the past years; in many cases for the right reasons. BIS central bankers’ speeches But, while some feel this bashing should continue until banks own up to their errors, let’s not forget that we cannot do without banks. They provide services that are vital to the functioning of a modern economy. Also, let us bear in mind that the ongoing criticism may have a negative side-effect. As anthropologist Joris Luyendijk – who observes bankers in London’s financial district – points out: instead of subjecting themselves to self-criticism, bankers tend to grow indifferent to the public’s view. Some even go as far as to argue that “clearly we must have done something right, now that so many people seem to be jealous of our success”. Rather than changing their ways, bankers tend to wait until the crisis and the criticism have blown over. Perhaps, they hope that once the economy picks up again, everyone will have forgiven and forgotten their errors. To quote Rajan once more: severely criticizing “the immorality of bankers has made for good rhetoric and politics throughout history, but it is unlikely to address the fundamental reason why they can do so much harm”. So, if bashing is not the solution, how then should we close this “gap” between society and bankers? Surely, a charm offensive by banks wouldn’t do the trick. Any such course would be futile, since many people distrust them too deeply for that. And “actions speak louder than words” anyway. I therefore think the best way out for bankers may instead be to quietly and properly do their job, just as society would want them to. Or should we solve this problem by establishing an “ethics office” at every bank, as is sometimes suggested? Of course, the attention we see these days for ethical dilemmas is laudable. But the risk of having a dedicated ethics office is that the rest of the organization may come to think that they no longer need to worry their heads over ethics. If this should be the effect, an ethics office would even be counterproductive. For instead of making the organization as a whole more ethical, it would prompt a “box-ticking” attitude. Therefore, rather than focusing on establishing ethics offices as a “second line of defense”, we should focus on the ethics of the “first line of defense”: the bankers themselves. Another option would be to impose more rules on the financial sector. Of course, some of the extra regulation that has been introduced was necessary. For instance, the Basel III rules which provide that capital ratios have to be raised. Yet, in my opinion, extra rules cannot solve all of our problems. For every new rule will lead to creative solutions to evade that rule. By making new rules, we won’t make bankers less greedy, nor will we make them more ethical. Instead of overregulating every detail, we should focus on the decisions bankers make. This point – how decisions are to be made – deserves to be discussed in greater detail. A bank is governed by a board of directors and by senior management. These officers decide on the bank’s strategy and key targets. Their decisions have far-reaching consequences for the bank’s operations, as the example of “managing for value” demonstrates: a misguided decision may have undesirable effects. This considered, I would like to focus on the way bankers should make their decisions. The classical virtue “Prudentia” – in modern English, “Prudence” – can help us here. Prudentia is the virtue that stands for “making careful decisions”. It requires a capacity for reflection, careful analysis, and balanced judgment. This sounds like a goal worth striving for, but what does it mean in banking practice? In banking practice, it means that, instead of focusing on one interest in particular, bankers have to balance all of their stakeholders’ interests. They should neither focus on their shareholders alone, nor on a specific category of their clients. Bankers practicing prudence take their societal responsibility to heart, which is: to be a trustworthy intermediary. BIS central bankers’ speeches Therefore, to be “prudent” decision-makers, bankers should: • scan which interests are at stake, • balance the different interests involved, • reflect on the consequences of their actions, • and show themselves “moderately risk-prone”. By making careful and balanced decisions, and reflecting on their societal responsibility, bankers will regain the trust they need to function optimally. What does DNB do as prudential supervisor to improve the “prudence” of bankers? In recent years, we have focused more heavily on good corporate governance, and expanded our supervisory scope to include business models, behavior and culture. By looking closely at business models, we want to increase our understanding of how banks actually make money and become better able to discern high-risk strategies. In our supervision of behavior and culture, we aim to make banks’ senior management more capable and more careful decision-makers. Let me give you two examples. First, our “fit and proper” tests for aspiring board members have become more thorough. We have added requirements such as: • being sensitive to external developments; • being able to take balanced decisions; • and taking responsibility for the outcomes. We have done so as we want banks to have more competent decision-makers on their boards. Second, our supervision of governance now also covers board effectiveness. We measure this aspect by observing the behaviour of board members during meetings. We analyze their performance, and reflect on the way they operate, asking challenging questions like: • Is the chairman too dominant? • Is the board really “in control”? • How does the board communicate? and • Is there room for differing points of view? • Through these new developments, we aim to foster prudent decision-making and stimulate reflection. Ladies and gentlemen, I’m going to summarize the main points of my speech. I’ve approached the theme of this gathering, “Ethics and the crisis in the financial sector”, from my perspective as executive director responsible for prudential supervision. I’ve made a case for how banks can restore confidence as an essential building block for a healthy economy. The remedy for the current confidence crisis neither lies in bashing bankers, nor in a charm offensive, nor in establishing ethics offices, nor even in imposing more rules. Bankers need to become prudent decision-makers again. This will restore the balance required for them to function optimally. BIS central bankers’ speeches This is how I look at the issue. I’m aware that others may hold different views and will be happy to answer questions during the panel session. Finally, I wish all students and faculty members gathered here good luck in their new academic year and hope to see some of you back at De Nederlandsche Bank one day, when your career takes you where maybe you hadn’t expected to go. ;) Thank you. BIS central bankers’ speeches | netherlands bank | 2,013 | 9 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Bank of Mexico international conference "Central bank independence - Progress and challenges", Mexico City, 15 October 2013. | Klaas Knot: Central bank independence and unconventional monetary policy – challenges for the European Central Bank Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Bank of Mexico international conference “Central bank independence – Progress and challenges”, Mexico City, 15 October 2013. * * * Ladies and gentlemen, It’s a great pleasure for me to have been invited to speak at this conference of the Banco de México. Especially so as this event marks the 20th anniversary of its autonomy. And I gladly congratulate the Banco de México on this important milestone. The topic of this Conference – central bank independence: progress and challenges – is very well chosen, I would say. For from the dawn of the financial crisis, back in the summer of 2007, the role of central banks and particularly the relationship with governments has been controversial. In light of the theme of this session, my remarks will focus on one of the most independent central banks of the world, the ECB. I do so as the ECB’s unconventional actions have also sparked intense debate about its independence. The main question I try to address is how the ECB should respond to today’s complex and challenging environment in which its independence could be at risk. I would like to start off my remarks by reminding people the long-standing wisdom that it is imperative to protect central bank independence. Already in the early 19th century, the economic theorist David Ricardo explained why it wasn’t a good idea to entrust governments with the power to issue paper money. For governments, he argued, would almost certainly abuse this power. For instance, if circumstances compelled them to create money, such as at times of war. Instead, Ricardo reasoned, central banks must be governed by individuals who should be “entirely independent” of the government, and who “should never, on any pretence, lend money to the Government, nor be in the slightest degree under its control or influence”. Clearly, Ricardo’s original ideas are still valid today, for most of the world’s major central banks enjoy a substantial degree of independence. In fact, it is generally undisputed that central bank independence is the way to protect governments against the temptation to misuse monetary policy for short-term goals – for example, by creating sudden inflation to ease budget pressures. By granting monetary policy to the discretion of an independent central bank, the focus can be on long-run stability. Research has also shown that independence enables central banks to run more credible monetary policy, making it “easier” to achieve their goals. A final merit of central bank independence, especially relevant in the current juncture, is the scope it creates for unorthodox measures during crisis periods. In fact, the greater a central bank’s independence and credibility in normal times, the greater its flexibility and credibility to engage in unconventional monetary policy during critical times. Thus, during crises, an independent central bank has much more flexibility to take actions that might otherwise fuel inflationary fears. This brings me to the essence of this session. Much of the current controversy surrounding central bank independence is related with central banks’ ability to engage in unconventional monetary policy. BIS central bankers’ speeches As many have argued, their large-scale purchases of financial assets and other unorthodox measures have taken central banks into “unchartered waters” and explicitly challenged the notion of central bank independence. The unprecedented expansion of central banks’ balance sheets since the start of the crisis is certainly revealing. It shows that central banks’ balance sheets are becoming more and more exposed to economic risk and political pressure. Eventually, this may result in a substantial amount of negative capital in a central bank’s balance sheet. This is undesirable, because it could undermine a central bank’s credibility and independence. On the one hand, a government guarantee to cover potential losses would protect a central bank’s financial position. But, if the government has to invoke this guarantee, the fiscal dimension of monetary policy becomes very visible, and the previously solid line between fiscal and monetary policy will be blurred. An additional concern for central banks is that unconventional monetary policy increasingly comes with some sense of “public unease” about the role central banks play. While the majority of the public doesn’t understand the way central banks operate, many consider central banks at the same time as the only player with room for maneuver. The fact that criticism of central banks is creeping more and more into the mainstream debate – whether or not this is justified – implies that the public is looking increasingly critically at central banks. While this may not put central banks’ independence or room for maneuver immediately at risk, it does signify that central banks may need to step up their efforts on transparency and accountability. This is a topic I will return to later. Now I would like to turn to how central banks should operate in this more complex and challenging environment with a particular focus on the ECB. In my view, there are six points of special interest for the ECB, which I will deal with in the remainder of my remarks. To start with, it is imperative that the ECB sticks to its mandate to maintain price stability over the medium term. This, despite the many calls to widen its mandate to explicitly include financial stability considerations and/or domestic employment goals. In theory, delegation of a task to an independent authority is more acceptable – when the delegated task is clearly specified and has no overlap with other policy tasks; – when there are relatively few distributional implications; – and when a clear-cut measure of accountability can be achieved. These conditions are largely satisfied when monetary policy is primarily geared at achieving price stability. Especially if we compare this with monetary policy disciplined by a dual mandate, which is – in Volcker’s words (2012) – “operationally confusing and ultimately illusionary”. Second, the ECB should continue to explain the rationale behind its unconventional monetary policy measures to the public. While most major central banks have employed unconventional monetary policy in response to the crisis, the exact measures and foundations have differed significantly across central banks. The ECB’s approach differs from that of the other major central banks in that its unconventional monetary policy measures aim to support the effective transmission of monetary policy to the economy, instead of delivering a direct stimulus. In this sense, ECB’s unconventional monetary policy measures are a complement to, rather than a substitute for, standard monetary policy. They aim to restore a more normally functioning transmission mechanism and contribute to an environment where standard BIS central bankers’ speeches measures can operate effectively. Underlying this approach is the euro area’s financial structure: in the euro area, banks are the main agents for channeling funds from savers to borrowers, while in many other countries market-based financing predominates. The largely bank-based structure of financing in the euro area is reflected in the ECB’s monetary policy and in the design of its unconventional monetary policy. It could hence be argued that ECB’s unconventional monetary policy measures are “purely” monetary policy. And, I would add, should also remain there. Third, the ECB should take the specific modalities of the unconventional monetary policymeasures into account. For these modalities might influence the extent to which central bank independence is at risk. After all, large-scale outright asset purchases will result in a different risk profile for the central bank’s balance sheet than unconventional monetary policy directed at providing liquidity support to the banking system in collateralized operations. In my view, one particularly nice feature of the bulk of ECB’s unconventional monetary policy measures concerns its “natural” or “embedded” exit. This makes the ECB less sensitive to political pressure than in a situation in which it would have to make an explicit choice for unwinding. For instance, one of the key elements of the ECB’s response to the intensification of the sovereign debt crisis was the design of the Longer-Term Refinancing Operations or LTROs. These LTROs ensured that banks had sufficient liquidity over the medium term, while at the same time embedding phasing-out as a design feature. Or in other words, the exit was taken into account up-front. Fourth, the ECB should be clear about the limits of monetary policy and manage expectations of what it can achieve. This is important because central banks are – undeservedly – considered to be the only player with room for maneuver and therefore subject to unreasonable expectations of what monetary policy might achieve. These expectations should be downplayed to avoid disappointment with the public and the political pressure that might follow. In particular, the ECB should stress that the problems in the euro area are not problems that monetary policy can completely solve, as they are rooted in weaknesses in banks’ balance sheets, weak government finances and supply side rigidities in many economies. All the ECB could do is provide “breathing space” for banks and governments to act, and it has done so. Fifth point, at the same time, the ECB should try to sustain or provide the right incentives to governments and banks. As regards governments, sound public finances are an important underpinning of central bank independence. Conducting an independent monetary policy is made significantly more difficult in the event of large budget deficits. A similar story could be told for labour and especially product market reforms. That is why I very much argued for and welcomed the explicit conditionality in the form of an ESM programme in the Outright Monetary Transactions scheme. This ensures that governments make the necessary efforts to restore the sustainability of public finances, reform of the supply side of their economies and in doing so contribute indirectly to central bank independence. For banks, such conditionality hasn’t been used so far. However, given that it is very important to provide the right incentives, it might be worthwhile to explore whether some kind of conditionality might be introduced for banks in the as yet unforeseen case of new liquidity stress in the euro area. For instance, it might be investigated whether the provision of additional liquidity could be made conditional on strict asset quality reviews or efforts to build up adequate capital. BIS central bankers’ speeches This would contribute directly to restoring the health of the financial system and the transmission mechanism. As a consequence, this would lessen the need to sustain unconventional monetary policy over a longer period, and hence also contribute indirectly to reducing the pressure on central bank independence. Finally, such an approach would help to address the unpleasant side-effects of earlier unconventional monetary policy measures. [I’m referring for instance to how banks have used LTROs to buy higher-yielding sovereign bonds, and thus contributed to the diabolic loop between governments and banks instead of having provided an impulse to lend to the real economy.] Finally, as we all know, central bank independence is sustainable only if it is accompanied by strong accountability and a high level of transparency. As the ECB’s role in policy making has increased significantly during the crisis, it needs to find ways to further enhance transparency and accountability. The public needs to be explained in the clearest possible terms why the ECB has opted, or not opted, to take certain measures. A richer way of communicating our deliberations would definitely contribute to this. More openness would also give the public a more balanced impression of the discussions conducted in the Governing Council. This, in turn, would support the predictability and credibility of our monetary policy. At the same time, we should avoid that more openness about the deliberations in the Governing Council leads to enormous pressure on the Governors of national central banks and puts the independence of individual Governing Council members at risk. Members are acting in the interest of the euro area as a whole, but often have to explain these decisions to a predominantly national audience. A richer way of communicating our deliberations will sharpen the European mandate. Increased transparency should not jeopardize this important building block of our institution. I therefore believe we should stick to the principle of collective rather than individual accountability. Let me conclude: “Independence can’t just be a slogan”. The preservation of central bank independence in a democratic society ultimately depends on asking reasonable deliverables from the central bank. At the same time, as society changes, the interpretation of “reasonable deliverables” might change over time, and hence the preference for central bank independence. This has implications for both central banks and governments. Central banks should not take their independence for granted, but protect it continuously. Governments, on the other hand, should not put all their hopes on central banks. Instead, they should explain the fundamental reasons behind their choice to delegate powers to an independent central bank, and at the same time do their own job. BIS central bankers’ speeches | netherlands bank | 2,013 | 10 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the 20th RiskMinds Global Risk Regulation Summit, Amsterdam, 2 December 2013. | Klaas Knot: Simplicity in the financial sector Speech by Mr Klaas Knot, President of the Netherlands Bank, at the 20th RiskMinds Global Risk Regulation Summit, Amsterdam, 2 December 2013. * * * Ladies and gentlemen, Thank you for inviting me to speak at the Risk Minds conference today, also as this enables me to congratulate you on its 20th edition. Twenty years have passed since the first Risk Minds conference, and I’m glad to say that risk management has made substantial progress during this period. The past few years have certainly underlined the importance of proper risk management. As I see it, risk management is a key building block for ensuring sufficient capital and liquidity buffers in the financial system. Strong and reliable financial institutions are one of the vital elements of financial stability. And financial stability in turn is of prime importance to De Nederlandsche Bank as a central bank and prudential supervisor. And that is because central banks have a mandate to promote financial stability. And we’ve seen in recent years, that this is not an easy task. In hindsight, we can say that the financial sector had become too complex and non-transparent. Technological advances had created various new financial products and instruments whose risks were often unclear. This particularly held for products and instruments involving the packaging and repackaging of exposures, the sale of CDOs (Collateralized Debt Obligations) and CDO2s, and the use of SIVs (Structured Investment Vehicles). The financial sector’s increasing globalization has also made it more difficult to assess risks properly. It was because of Lehman Brothers’ global presence that its failure had such an impact on the world. In every country where Lehman Brothers had a branch, its bankruptcy had to be filed for and resolved. The financial environment that we faced in the run-up to the crisis – and, by “we”, I mean the public, investors, counterparties, supervisors and regulators – was non-transparent, and the risks were getting more and more complex. And then it all went wrong, and many financial institutions had to be bailed out by governments. It was no wonder that the public’s confidence in the financial sector fell sharply. And it still hasn’t recovered. How can we regain the public’s trust? For one, by making the financial sector less complex and more transparent. The crisis has highlighted various fundamental problems in the design of the financial system. The level of complexity, the mutual dependence – where everyone is dependent on everyone else – and the rapid speed of transactions – where there is no time to resolve problems that may arise – all these factors together make the system more prone to failure. In existing and new regulations, including the forthcoming Basel III framework, regulators have focused on the problem of institutions being Too Big To Fail. This is because of the pressure that having to rescue financial institutions has put on public finances. But, actually, we should be more worried about banks being Too Complex To Fail. If institutions are too complex, it’s even more difficult and therefore perhaps more expensive to resolve them. The need for change is obvious. And responsibility for this change lies in your hands, too! I see three areas where you can contribute to achieving this change. BIS central bankers’ speeches First of all, banks’ business models must not be unduly complex. In the past, we have seen financial institutions offering lending services, participating in trading activities, setting up joint ventures and combining their activities with insurance companies or businesses outside the financial sector. The products they offered ranged from traditional loans and lend-to-invest structures to all kinds of complex off-balance sheet derivatives. Their activities were spread all over the world, while the risks and rules varied from one country to another. The big picture was therefore often lost. At the same time, the benefits of diversifying their activities in these different ways and at these different locations have proved disappointing. Experience has shown that combining banking and insurance activities is not as effective in offsetting cash flows and exposures as was once thought. Risks run on one side of the world are difficult to monitor from the other side of the world. And, this time around, the crisis has not been confined to one country or region, but has been felt all over the globe. A clear and simple business strategy and a streamlined business model will help reduce complexity. Banks need to focus once again on their traditional roles of maturity transformation and lending to the real economy. This ties in closely with the question of how best to structure the banking sector. This is a relevant issue when we’re discussing the activities a bank should engage in. Committees all around the world have examined this issue, as the Volcker Rule in the US, the Vickers Report in the UK and the European Commission’s Liikanen report show. All of them have one thing in common. They argue for a simpler banking sector focusing on traditional banking activities. These reports have resulted in calls for traditional banking activities to be separated from trading operations by being held in different entities. This will make banks less complex and improve their stability. However, complete separation may not be efficient if these trading operations also provide services to the bank’s clients, like market-making services. That’s why the Liikanen Report suggests that trading activities should be separated from the other parts of the bank only if these trading activities exceed certain limits. Although this debate is far from over, the direction of the change needed is clear. In other words, we need to move towards a less complex sector, with more focused activities. A second way to increase simplicity and transparency in the sector is to simplify the internal organization of financial institutions. The financial sector in general, and banks in particular, can be seen as one of the most complex areas in today’s world. But we all know that complex organizations are hard to manage. Having complex internal structures and many management layers can make it more difficult for organizations to respond to external developments. Complex organizations are like oil tankers: it takes a long time to turn them around. And that may mean they miss out on business opportunities. A simpler organization, by contrast, can take decisions more quickly. This enables it to respond more flexibly to new business opportunities, and also to risks that arise. It can also help staff feel more involved in, and committed to, change. Thirdly – and this may be the most difficult one – people working for financial institutions need a prudent mindset. It’s ironic, isn’t it, that, instead of using sophisticated financial risk models to identify risks, “smart” people in the financial sector used these models to circumvent financial regulation. Remember the trend towards moving exposures off balance sheet? What about the way benchmark rates were manipulated, and separate legal entities were used in the shadow banking sector? This behavior was obviously encouraged by the fact that variable benefits BIS central bankers’ speeches were based on achieving short-term results. This is all changing. And I am happy to see this happening. De Nederlandsche Bank, for instance, now explicitly includes “organizational culture” as a separate aspect in its risk assessment of institutions. In a clear, open environment, employees should have the interests of their clients at heart. And having a prudent mindset will also make it easier for them to be transparent. For simpler institutions, regulation and supervision can be simpler as well. The more complex an organization and its business model are, the more complex its risks will be. The rules that are meant to capture these risks will then be at least equally complex. The reverse is also true. In other words, the regulatory rules for banks engaging only in traditional lending and funding needn’t be as complex as those for banks specializing in more sophisticated products. The volume of regulations applying to less complex institutions can also be more limited. Banks that don’t have investment operations, for example, can skip many of the trading book regulations. Greater regulatory simplicity also has other advantages. Detailed rules may make it more difficult for supervisors and financial institutions to spot actual risks. The requirements applying to risk models, for example, are quite detailed. Institutions spend a lot of time and resources on them. You might think that if a model complies with all these requirements, the outcomes it produces will also be right. But it is still only a model, and you have to look at risks in more depth. Overly detailed rules may also make decision-making less effective. For decisions may be based on compliance with rules instead of being true risk trade-offs. Simple rules, by contrast, could help focus on the major risks. Take, for example, a simple rule that states that all exposures must be covered by some form of capital. Such a rule would automatically also apply to any new products or instruments. And it would include exposures that now – in my view, unjustifiably so– have a 0% risk weighting, such as certain exposures to governments. A leverage ratio used as a backstop to these risk models would also achieve this, while still being easy to calculate and understand. And this is why supervisors are now taking leverage ratios into account when assessing institutional risk, in addition to the standard risk-weighted ratios. This allows for a multiangled view of institutions’ risk profiles. Other rules, such as limits on LTV ratios, may set clear limits on loan portfolios’ risk profiles. That way, a smart combination of simple rules can help to highlight risks in an institution’s balance sheet. To be sure, risks should obviously be regulated in similar ways, whatever the sector. Otherwise, risks will simply shift to less or non-regulated entities. Simple rules can also offer guidance for the future. Problems we experience in the future are unlikely to be exactly the same as in the recent past. We also cannot foresee exactly where new risks will arise. Simple rules can form a clear benchmark in uncertain situations, and there is a lot of academic theory to back this up. The economist Frank Knight introduced the concept of “Knightian uncertainty” by making a distinction between uncertainty and risk in the sense that uncertainty cannot be quantified. Indeed, we don’t know where we are heading, or what we will encounter along the way. We simply have to learn to live with unknown unknowns. Another economist, Hayek, also saw imperfect knowledge as a central issue. Simple, robust rules can make a difference in such an uncertain and imperfect world. In a complex environment, we cannot possibly consider or measure all the conceivable outcomes. As well as being too expensive from an information point of view, it is also too complex to weigh up all the different options. BIS central bankers’ speeches Although we like to assume our economic models are rational and omniscient, this is certainly not the case in reality. It would be more accurate to describe our world as having bounded rationality and imperfect information. Simple rules are a way of reducing a complex problem with many unknowns to simpler tradeoffs, like yes or no, above or below, or left or right. It’s as in traffic: in the vast majority of situations, driving on the correct side of the road is good advice. Or reducing your speed in misty weather. If we can progress along the road of simplicity, I’m sure we can also stop the pace of regulatory expansion. As Leonardo da Vinci said, “Simplicity is the ultimate sophistication”. Simplicity and transparency can help restore the public’s trust in the financial sector. Financial institutions can achieve this by switching to clear business models, with streamlined structures and a prudent mindset. If they do so, the amount of regulations to be complied with can be reduced and the remaining regulations can be simplified, if and where applicable. In addition, simple rules can help us focus on key risks, as well as forming a guide for the future. Greater trust, increased transparency and less complex risks will ultimately make the overall financial system more robust. And that in turn will make it easier for central banks to promote financial stability. Thank you! BIS central bankers’ speeches | netherlands bank | 2,013 | 12 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Duitsland Instituut, Amsterdam, 7 April 2014. | Klaas Knot: Germany and the quest for a stable monetary union Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Duitsland Instituut, Amsterdam, 7 April 2014. * * * Introduction It is sometimes joked that the Netherlands is in fact Germany’s 17th Bundesland. The excellent remarks by Jens Weidmann remind me of this joke, because there are so many points I agree with. I will not go into them, to avoid that the rest of this afternoon becomes rather uninspiring. Instead, please allow me to reflect on the future and stability of EMU from my own perspective. Even those who don’t agree with Jens Weidmann should take the views of the Bundesbank seriously, for two reasons. First, Germany is the anchor country of the euro. Europe simply cannot afford to alienate the anchor by moving towards an EMU that would make Germany very uncomfortable. We also need to take the views of German policymakers and voters into account. Second, when it comes to economic stability, Germany has one of the best track records in the world. Most advanced economies made at least three serious policy mistakes in the past decades: excessive inflation in the 1970s, excessive budget deficits in the 1980s and excessive credit and house price growth in recent decades. Quite remarkably, Germany is one of the few countries that succeeded to contain all three problems effectively. Of course even Germany had difficulties at times, for instance after the reunification, when it was even called “the sick man of Europe”. But the patient recovered after following a tough prescription of wage moderation, fiscal consolidation and structural reforms. Ants and grasshoppers The historian Harold James shows that Germany’s stability has led to economic tensions within Europe for several times in the past few decades. Germany often developed current account surpluses vis-à-vis other European countries, that led to discussions about the burden of adjustment. Such was for instance the case in the late 1970s, after the collapse of the Bretton- Woods system of fixed exchange rates. And it was the case in the late 1980s, around the time when the Louvre and Plaza-agreements on exchange rates were concluded. It was also the case in the monetary union, where these tensions gradually built up again since the start of EMU. Growing current account surpluses in Germany and countries like the Netherlands matched growing deficits in southern European countries. In retrospect, these current account imbalances were at the heart of the sovereign debt crisis. It would be unfair to only look at Germany for this situation, as many serious policy mistakes were made in southern countries. First, several countries failed to implement the structural reforms that were needed to function smoothly in a monetary union. Rigidities in product and labor markets contributed to severe losses of price competitiveness. Second, several countries experienced booms in domestic demand on the back of unsustainable growth of credit and house prices. Third, several countries failed to use the windfall of lower interest rates due to EMU- membership for a lasting improvement of public finances. Between the mid-nineties and the financial crisis, interest rate expenditure on public debt in the periphery decreased by 4.5% of GDP on average. Only Spain used this fully to reduce budget deficits. Unfortunately, in the other countries, on average almost half of this percentage did not translate into lower deficits. These policy mistakes suggest that the burden of adjustment mainly lies in southern Europe. But it would also be unfair to turn the crisis into a moral caricature between the virtuous and the profligate, between ants and grasshoppers. As Jens mentioned in one of his recent speeches, several so-called core countries are not in great shape either. Think of low BIS central bankers’ speeches competitiveness and high public debt in France. Think of low productivity growth in the German service sector. And think of the painful correction of house prices here in the Netherlands. This clearly illustrates that all EMU member states need to carry out reforms to improve their economic growth potential. Moreover, policymakers in all European countries made misjudgments regarding the functioning of EMU. Most didn’t see these flaws when we celebrated 10 years of EMU, only months before the collapse of Lehman Brothers. At the time, we all failed to see how the growing importance of financial factors had fundamentally changed the monetary union. It wasn’t recognized that the euro area was experiencing asymmetric financial cycles rather than asymmetric business cycles. This is serious omission as recent research shows that these financial cycles are much larger and longer-lasting than normal business cycles. They created divergences that EMU was not designed to deal with. In addition, we thought that the strong increase of financial integration after the introduction of the euro would enhance risksharing. But we didn’t realize that it also spurred contagion and pro-cyclical capital flows. For example, the financing of southern credit booms also came from banks in France, Germany and the Netherlands. From this perspective, Europeans are in this together, and can only get out together. Situation has improved The good news is that the Eurozone indeed seems to be emerging from the crisis, if slowly. The situation has improved significantly since the height of the crisis in the summer of 2012. At that time, financial fragmentation in the euro area reached alarming levels and several countries were suffering from a strong outflow of capital. Financial markets probably responded too pessimistically at times, fuelled in part by fears of the break-up of the euro area. But less than two years later, markets have calmed down and the crisis entered a new phase. This change is not only due to the ECB’s Long-Term Refinancing Operations and its Outright Monetary Transactions program, actions that will always to some extent remain controversial. After all, monetary policy cannot solve the problems of EMU. It can only buy time that should be used effectively. No, the situation also improved because European policymakers took measures that seemed unthinkable until recently. And because they did so in a relatively short time span. This holds to individual countries in the first place. Many vulnerable member states have reduced their current account deficits and improved their competitiveness. They have also made progress with reducing budget deficits and implementing structural reforms. Countries like Ireland and Spain have therefore successfully ended their financial assistance program. But it also holds for the European level, where governance has been strengthened. European policymakers established common supervisory and resolution mechanisms for banks. This banking union will help to reduce the toxic feedback loops between banks and sovereigns. Many countries have also introduced macro-prudential policies, with the ability to co-ordinate these at European level. These recent measures come on top of the enhanced Stability and Growth Pact and the introduction of the Macroeconomic Imbalances Procedure. Challenge for the coming years One crucial challenge is to continue on this course, even now financial markets have calmed down. Much remains to be done, and the calm will only be sustainable if vulnerabilities decrease further. For individual countries, this means more structural reforms. Countries with a support program implemented reforms, but some of the larger founding fathers are lagging behind. Moreover, reforms mainly focused on labour markets so far, while much less progress is made on product and service markets. The gains of further reforms could be significant. According to the OECD and the Commission, they could raise potential GDP by up to 6% on average. Another priority is a further reduction of public debt, which now stands at 96% of BIS central bankers’ speeches GDP in the euro area as a whole. Countries should strive to return below the 60% threshold of the Maastricht Treaty. This will probably take many years for most countries, but will significantly improve the stability of EMU. For the European level, many elements needed to repair the design flaws in the monetary union are now in place. But the effectiveness of these new governance measures depends crucially on their application in practice. A strict implementation is absolutely necessary. This not only holds for the Stability and Growth Pact and the Macroeconomic Imbalances Procedure, but also for macro prudential policies and the Asset Quality Review of bank balance sheets. Should any problems in the application arise, European policymakers will need to continue to forcefully tackle them. This enables us to keep the monetary union stable also in the long run. BIS central bankers’ speeches | netherlands bank | 2,014 | 4 |
Opening speech by Mr Klaas Knot, President of the Netherlands Bank, at the Conference De Nederlandsche Bank 200 years: central banking in the next two decadesŽ, Amsterdam, 24 April 2014. | Klaas Knot: The changing role of central banking Opening speech by Mr Klaas Knot, President of the Netherlands Bank, at the Conference “De Nederlandsche Bank 200 years: central banking in the next two decades”, Amsterdam, 24 April 2014. * * * Distinguished speakers, dear colleagues, friends, I am thrilled to welcome you to our conference. I’d like to extend a special welcome to the governors of our constituency countries. Over the past fifty years, your history has become increasingly interwoven with ours, and I’m therefore glad that you’re all here. Ladies and gentlemen, You accepted our invitation to celebrate the bicentennial of De Nederlandsche Bank. And you all cleared your agendas to discuss the future of central banking. At this festive moment I will tell you more about the history of De Nederlandsche Bank. And against that background, I’d like to address my central question: has the recent financial crisis stirred up the role of central banks, and if so, how? In other words: are we in the midst of a paradigm shift? I do so in light of the theme of this conference: where central banks will be heading over the next two decades. The point I want to emphasise here today is that our understanding of the role of central banks, has constantly changed over time. Let’s begin with the easy stuff: the origins of De Nederlandsche Bank; DNB. If you look at our history, you can see how DNB evolved over time. We used to be a mainly Amsterdam-oriented credit institution that performed commercial activities. And now we’re a truly pan-European institution, with public duties and a centre of gravity in Frankfurt. How did this come about? Our history starts with King Willem the First’s decision to set up a central bank. Two hundred years ago. At the time, the Netherlands had just been liberated from the Napoleonic days. Our economy was in really bad shape. Not much was left of our Golden Age. The new King – also known as the King-Merchant – however, was determined [quote] “to lift up Commerce – the nerve of this State – , from the derelict condition to which past times and circumstances reduced her”. [unquote] He established De Nederlandsche Bank, to realise his plan for a national circulation bank. DNB had a difficult start in life. As a newcomer it was greeted with distrust. It took quite some time for DNB to evolve into the kind of national bank the King had in mind: a bank granting credit and distributing banknotes throughout the country. It wasn’t until the end of the 19th century that DNB turned from a principal lender to trade and industry into a real lender of last resort. By protecting the Netherlands from several financial crises, DNB gradually became – in the words of my then predecessor Vissering – “the absolute central institution, around which everything was concentrated”. In those unsettled times, DNB evolved from “a sleeping old lady” into a vibrant institution with a wide range of activities, and increasingly interwoven with society. We gained prominence as a national monetary institution. And the foundations where laid for the modern, post-war Dutch central bank. DNB was nationalised. And the 1948 Bank Act made DNB responsible for preserving the value of the currency. BIS central bankers’ speeches From then onwards, DNB was known as the “Guardian of the guilder. We were responsible for circulating banknotes and for managing the payment system. And finally, DNB was given the task of supervising all financial institutions. Around the beginning of this millennium, financial supervision was reorganized along functional lines. I can be a lot briefer about DNB’s remaining history, given that many of you have shared our various milestones in recent years. By this, of course, I mean the Treaty of Maastricht, which established the Economic and Monetary Union, and the introduction of the single currency. These major events paved the way for DNB, and 17 other central banks, to become a truly pan-European institution within the European System of Central Banks. And the most recent milestone, of course, is the European Council’s decision in 2012 to create a European banking union; a project which is still under construction. In the first few decades after European co-operation got underway, we were able to reach some kind of consensus on the role of central banks. And their relationship with society. This general view was threefold: one: central banks served society best if they focused primarily on price stability. two: central banks played a relatively narrow role in financial stability. Yes, they should be ready to provide emergency liquidity, while promoting the stability of the payment system, but that is where it stopped. three: central banks should leave micro-prudential supervision and regulation to other, independent parties. That generally meant outside the central bank! (although there were some exceptions, including DNB). These were the times that we now sort of nostalgically refer to as the Great Moderation. But then, however, came the Great Financial Crisis. And we moved from the Great Moderation to the Great Recession. And, here in Europe, to the EMU crisis. These events painfully reminded us that financial instability can indeed severely damage the broader economy. Has the recent crisis altered the general view we held for so long? This is a relevant question for us, central bankers, given two well-known pitfalls we have to avoid as monetary policy-makers. The first pitfall is reacting too late. During the interwar years, for instance, central banks in the major economies were “prisoners” of their own economic orthodoxies and so made mistake after mistake. My institution, too, was dogmatic in believing in the benefits of the gold standard, even in the face of the huge losses due to the devaluation of the British pound. The second pitfall is that we’re so afraid of reacting too late, that we respond too soon. How can we avoid both these traps? I believe there are two preconditions that we must meet. First, we should protect the independence of central banks in monetary policy matters, in all circumstances. The 19th century economist David Ricardo already explained that governments would almost certainly abuse their power to issue paper money if, for instance, they were forced by war into creating money. He argued that central banks should instead be governed by individuals entirely independent of government. Central banks should – [quote] “ never, on any pretence, lend money to the Government, nor be in the slightest degree under its control or influence”. [unquote] BIS central bankers’ speeches There are certainly many episodes in our history, when the central bank’s relationship with the State has come under pressure. For example, after Belgium – at that time known as the Southern Netherlands –became independent in the 1830s, the Dutch government’s deficit soared to unprecedented levels. And when, at that time, DNB was unwilling to provide credit to the State in return for Treasury notes as security, the King sighed that he could expect little help from this institution. All I’m saying here is that preserving central bank independence is a delicate balancing act, but also one that’s vitally important to pursue. The second precondition to stay clear off the pitfalls of either reacting too late or too soon, is that we must never forget that central banks are very exceptional institutions. Because of their ability to lend and so to create liquidity for banks. In normal times, this may just mean day-to-day management of liquidity in the financial system. But in times of financial stress, as we’ve seen in recent years, it may mean having to act as lender of last resort. Being the “bank of banks” means central banks have always been at the heart of the payment and settlement process. But here, too, central banks will continue to face major challenges in keeping up with innovation and technological change. The difficulty here is that payments systems have characteristics of a public service, while most of them are actually operated by private agents. Given the overall economy’s reliance on the payment system, these private sector activities require a certain degree of public policy guidance. And they also require an increasing amount of public oversight to make sure they take account of the needs and wants of the public at large. And so, as well as preserving their independence, central banks also need to continue to support and improve the safety, the reliability and the efficiency of the privately operated payment and settlement systems. I’ve tried to shed some light on the history of DNB. And I’ve tried to point out the two pitfalls we have to avoid at present. Let me now address my central question, which touches upon our future: Has the recent financial crisis stirred up the role of central banks, and if so, how? In other words: has the financial crisis resulted in a paradigm shift for central banks? I would say it has. Let me explain that by looking with you at three major lessons that the crisis has taught us. Three lessons that have challenged the pre-crisis consensus on what central banking was about. The first lesson. The crisis has reminded us that price stability alone is not enough to ensure macro-economic and financial stability. By now it’s therefore become widely accepted that the pre-crisis view of central banking, which was based on central banks focusing mainly on price stability, was too narrow. Or, to quote Willem Buiter, “the financial stability role of central banks has returned with a vengeance”. The second lesson. The crisis has shown us that central banks are on the front line when the financial system comes under stress. This has fed arguments in favour of entrusting central banks with the prudential supervision of financial institutions. Since central banks are the only parties with enough information to decide whether lending on exceptional terms is reasonable. The crisis may, therefore, have reversed the pre-crisis tendency to separate microprudential supervision and central bank regulation. A clear example of this, close to home, is of course the ECB’s preparations for taking on new banking supervision tasks as part of the Single Supervisory Mechanism. BIS central bankers’ speeches The third lesson. The crisis has also taught us that price stability alone is not enough to ensure financial stability. And that adopting a micro-prudential perspective does not suffice either. We know that the key factors in the crisis were the links between various financial players, and the links between financial institutions and sovereigns. And so we are aware of the need to also have a macro-prudential perspective as well. This perspective places the financial system as a whole, including its pro-cyclicality, under constant scrutiny. Unfortunately, this scrutiny was clearly lacking in the pre-crisis framework. There is also some acceptance of a key role for central banks here, given that monetary and macro-prudential policies are very much interdependent. Here in the Netherlands, DNB has indeed been entrusted with this role. From 2014 onwards, enhancing financial stability is now also explicitly embedded in DNB’s mandate. We’re now on the verge of adopting a broader view of what constitutes central banking. The financial crisis has clearly brought the core functions of central banks closer: Monetary and liquidity policy, micro- and macro-prudential regulation and supervision, stability and reliability of payment and settlement systems…. They all complement each other! So we are gradually beginning to see this broader view taking shape. Yet there are still many operational questions we need to answer. For instance: What are the implications for monetary policy strategy of incorporating financial stability risks? How should we deal with the interactions between macro-prudential policy and monetary policy and between monetary policy and supervision of banks? How can central banks contribute to cross-border payment cooperation and ensure level playing fields without discouraging competition and without creating undue uncertainty about regulations? And above all, and this is very important in my view, how are we to deal with the major institutional challenges of bringing these core functions of central banks closer together and preserving the synergies between them? Luckily, these are some of the very questions that you’re here to discuss today and tomorrow. But these are also questions that are not easily answered. For there are several concerns that we need to take into account: – For one, giving central banks a larger role in financial stability may blur the lines between different policies. – And the fact that financial stability involves so many different actors, makes things even more complicated. – Also: central banks may end up becoming more political than they were in the decades before the crisis. – And this, of course, will then give rise to a legitimate concern about a possible democratic deficit. The all-important question, therefore, is: How we can preserve our independence with regard to price stability, while at the same time broadening our responsibilities? In my view, it is therefore vital to foster a clear understanding of what central banks can and cannot do in each of their responsibilities and in each of their roles. Not until then can we avoid unreasonable expectations about what central banks can – and cannot – achieve. One way of improving the understanding of the role of central banks is to find new ways to increase transparency and accountability. After all, independence on the one hand, and transparency and accountability on the other, are two sides of the same coin. Ladies and gentlemen, BIS central bankers’ speeches Let me end by returning to the start of our conference. I’m confident that this conference in celebration of our bicentennial is going to give us plenty of food for thought, and will also shed some light on the questions I just identified. The decades before the crisis were perhaps a period of relative calm. The aftermath of the crisis challenges us to look into the future, into the role of central banks over the next two decades. If only, because we need to bring our core functions more closely together, while preserving our independence where required. Given our long history as an institution at the heart of society and our continuing dedication, I believe we have proved to be of immense value as a contributor to sustainable prosperity. And I am confident that we will continue to be so. I thank you for your attention. And I wish you all a fantastic conference. BIS central bankers’ speeches | netherlands bank | 2,014 | 4 |
Speech by Mr Frank Elderson, Executive Director of the Netherlands Bank, on the occasion of the signing of Further Agreement II ("the PIN Agreement 2014"), The Hague, Ministry of Finance, 3 September 2014. | Frank Elderson: 2014 PIN Agreement – incentive for socially efficient and innovative payments Speech by Mr Frank Elderson, Executive Director of the Netherlands Bank, on the occasion of the signing of Further Agreement II (“the PIN Agreement 2014”), The Hague, Ministry of Finance, 3 September 2014. * * * Your Excellency, ladies and gentlemen, PIN Agreement 2014 crowning glory of cooperation of market parties As chairman of the National Forum on the Payment System, I am very pleased about the Further Agreement II that was signed just now. This agreement, also known as the PIN Agreement, is an up-to-date adaptation of the objectives stated in the original Covenant dating back to 2005. That meaningful Covenant at the time paved the way for banks and joint retailers to encourage consumers to use their debit cards in order to reduce the social costs of the payment system. Because, as we all know, cash is expensive. That said, I would like to stress here that banknotes and coins will continue to play an essential role in payment transfers, and will therefore continue to be at everyone’s disposal. The 2005 Covenant cleared the air between the market participants. This was urgently required following the heated debate about the social costs and revenues of payments, and the question where these end up. The mutual understanding that cooperation and trust pays off was at the root of a series of measures to promote debit card use. And not without results. The sectors not keeping pace with the introduction of payment terminals have since also started using them, and smaller amounts can now be paid by debit card virtually everywhere. Yet more debit card payments And today the era of the 2014 PIN Agreement has started. One billion extra debit card payments should definitely be feasible by 2018. This would bring the total to 3.7 billion, and would surpass the number of cash payments at the till. The Foundation for the Promotion of Efficient Payments has proved that it is very capable of producing tangible plans to achieve this. Progress in minimising disturbances in payments systems But users of course think that electronic payment systems should always work. That is a bit much to ask as it is simply inherently unachievable. For that matter, the market participants represented in the National Forum on the Payment System have made great efforts to further increase the robustness and safety of payments transfers, partly in response to last year’s repeated disturbances of payment systems. For instance, almost the entire PIN chain has a fall-back facility. BIS central bankers’ speeches – and numerous other measures were implemented to guarantee that debit card payments go through without fail, and – the introduction of the Connect reporting system has improved communications and guidance among banks, providers, and retailers when payment systems fail. In addition to this, the Forum is working hard on initiatives to reduce the dependencies between online banking, mobile banking and iDEAL. This will definitely be discussed at the Foundation’s autumn meeting. PIN Agreement 2014 prelude to European efficiency and innovation With the introduction of IBAN, European payment transfers and European direct debits, the migration to the Single Euro Payments Area was successfully completed on 1 August 2014. In 2012, SEPA had already been brought closer when the magnetic strip on bank cards was replaced by the EMV chip. You all made an impressive contribution to the successful migration to SEPA, which warrants a well-deserved compliment from De Nederlandsche Bank. But SEPA is only the start of efficiency in payments transfers. We are on the brink of a new payments world in which businesses, retailers and consumers will be able to reap the benefits of the European market even more. Road clear for innvations The 2014 PIN Agreement has provided an excellent stimulus by explicitly promoting innovation. It builds on the rapid technological innovations and the quickly changing consumer preferences and market conditions. To my mind, the Dutch Agreement is an example that the Netherlands can convey to the single European payments market. This will not be done overnight. Changes to the large European market require great commitment from market participants. To streamline these changes, the Euro Retail Payments Board, the ERPB was launched last May with a view to SEPA. This new European payments governance body may grow into a European version of the Forum on the Payment System with users and suppliers working together on the further development of SEPA. The ERPB therefore definitely deserves the chance to prove itself in the years ahead. Contactless paying may be generally adopted a few years from now Currently half of all bank cards and over one tenth of the 280,000 payment terminals have been equipped for contactless payment. The latest generation of smartphones can also be used for contactless payments. Particularly for payments up to EUR 25 – the most frequent ones – this saves a lot of time, as they take nine seconds as opposed to 20 seconds for contact payments. If we assume that some two billion debit card payment up to EUR 25 will be made by 2018, this means that a total of 500,000 hours of queuing up to pay will be saved. BIS central bankers’ speeches With this enormous advantage, most payment terminals ought to be adapted to contactless payment within the next couple of years. Contactless payment is already a success in other countries and may really take off in Europe. Also prompted by the societal and political call to up the speed of payment transfers, and create the possibility to make payments at all days and hours of the year, the Forum is working together with the Covenant parties on a plan to be presented at its autumn meeting on 21 November 2014. I’m already looking forward to it, as this plan may even spark real-time payment transfers. This will in fact also demand comprehensive renewal of the payments infrastructure, which will have to be paid for. In fact, the call for faster payments transfers has already led to tangible improvements in Sweden, Denmark, the UK, and Australia. So payments transfers are on the brink of numerous innovations. The agreement that was just signed is an excellent response to this and is decidedly forwardlooking. On the road to state-of-the art European payments. I call on all parties to include the agreement in the ERPB debates to work on new European payments products. DNB will also do this, of course. This requires from all representative organisations, and in fact from us all, the willingness to take a more European perspective, and work closely together at a European level. We will now bring the national representative organisations and the European ones closer together. I look forward to a near future, in which European retailers, businesses and consumers will be even more able to reap the benefits of a safe, robust, socially efficient and innovative payments system. This is in fact also one of the stated objectives of the Economic and Monetary Union. I sincerely congratulate the signatories, and with them essentially all retailers, consumers and banks, on the start of the innovative European payments era. Thank you for your attention. BIS central bankers’ speeches | netherlands bank | 2,014 | 10 |
Welcoming speech by Ms Joanne Kellermann, Executive Director of the Netherlands Bank, at the 21st Annual Conference of the International Association of Insurance Supervisors (IAIS), Amsterdam, 23 October 2014. | Joanne Kellermann: Welcoming speech at the IAIS Conference 2014 Welcoming speech by Ms Joanne Kellermann, Executive Director of the Netherlands Bank, at the 21st Annual Conference of the International Association of Insurance Supervisors (IAIS), Amsterdam, 23 October 2014. * * * Good morning ladies and gentlemen, • I hope you all had an enjoyable evening last night. For those who arrived this morning, welcome to Amsterdam and to this year’s IAIS Conference. My name is Joanne Kellermann and I have the honour of representing De Nederlandsche Bank or DNB and welcoming you as host to our beautiful city. The governor of DNB, Mr. Knot, regrets that he is unable to be here today to welcome you. However, he’ll be able to attend the gala dinner on Friday. • Amsterdam has played a key role in the cultural, nautical, financial and trading history of the Netherlands. In the 17th Century, the Dutch Golden Age, ships set sail from Amsterdam to trade across the globe. This boosted the economy of what was then known as the Republic of the Seven United Netherlands. Amsterdam became the trade and financial hub of the Netherlands and – as the Dutch like to believe – the trade center of the world. • Insurance has a longstanding connection with maritime affairs and it is therefore no coincidence that the setting for the Gala Dinner tomorrow evening and sponsored by the Dutch Association of Insurers, will take place at the National Maritime Museum. There you will have a chance to learn more about our country’s intense relationship with the seas. • Two hundred years ago this year, King William the First founded DNB. At that time DNB was the first truly national credit institution incorporated to boost the ailing Dutch economy. Today, DNB is a central bank, part of the European System of Central Banks and member of the Single Supervisory Mechanism, as well as the prudential supervisor of the pension and insurance sector of the Netherlands. • The IAIS, too, is celebrating an anniversary – it was founded 20 years ago. To mark this event, there will be special ceremony during the last session today. I believe the IAIS has put together an excellent and varied programme that will inform and inspire. The six panels of this conference bring together perspectives on the past, present and future of the insurance industry. Allow me to look briefly into that past and glimpse into the future. Insurance is a dangerous game; risk being the industry’s business model. Ever since the merchants in Edward Lloyd’s coffeehouse began covering maritime risks, the industry has helped others absorb the effects of damaging events. In doing so insurers have helped people progress and businesses boom. Of course, as we at DNB know all too well: Those who deal within an industry based on trust and reliability must themselves show outstanding behavior. In other words: Insurers must adhere to the highest of principles. • And luckily many of them do and more than that! I can give you several impressive examples of insurers stepping in to help rebuild and reimburse damages, even beyond what was promised. • Take for instance a Lloyd’s member named Cuthbert Heath: in 1906 a massive earthquake destroyed much of San Francisco. BIS central bankers’ speeches Heath insisted on paying not just for earthquake damage but also for what was destroyed by the fires that raged thereafter for three days. He instructed his San Franciscan agent to pay all policyholders in full, irrespective of the terms of their policies. The agent followed his orders and the insured were promptly paid. • More recently and closer to our home: just days after the tragic event of the downing of flight MH17 in July of this year – in which 298 passengers lost their lives, 198 of whom were Dutch citizens – Dutch Insurers collectively announced they would pay out all damages to policyholders, even if certain terms of their policies would prohibit this. • And to give you a few more examples of the industry helping people to get back on their feet: – It paid out damages after cyclone Sandy flooded large parts of New York City; – It paid policyholder claims when floods and bushfires destroyed lives and properties in Australia; – and it helped people and businesses in Japan recover from the destruction caused by the 2011 tsunami. • In doing so in all of these cases, the industry helped those in need and also cemented its reputation as a solid and reliable industry. This promptness to deliver gives people the means to carry on and businesses the confidence to start over. • As for the future, it will be interesting to see how the insurance industry deals with new and emerging risks such as climate change, but also cyber-crime and reputational damage. Or how the advent of selfdriving cars will affect their business model. • IAIS’s role in in this cannot be overstated, as it sets standards for supervisors for the development and maintenance of fair, solid and safe insurance markets. • I am confident that this conference will provide excellent platforms for insurers, regulators and supervisors to exchange ideas on these subjects and more, and to enhance our understanding of the key issues of the day. • This morning His Excellency Jeroen Dijsselbloem, the Minister of Finance of the Netherlands and President of the Eurogroup, will be sharing with us his ideas on the subject of insurance and financial matters. I am very grateful for his making time, in what must be a very busy schedule, in order to speak to us today. • In closing I would like to thank everyone who contributed to making this year’s event possible, and I wish you all a successful and productive conference. And of course a pleasant stay with us in Amsterdam. • Thank you. • I will now give the floor to Mr. Peter Braumüller, Chairman of the IAIS, who will take you through the programme of the next two days. BIS central bankers’ speeches | netherlands bank | 2,014 | 10 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the 47th International Capital Markets Association meeting and conference, Amsterdam, 4 June 2015. | Klaas Knot: How Capital Markets Union can bolster Monetary Union Speech by Mr Klaas Knot, President of the Netherlands Bank, at the 47th International Capital Markets Association meeting and conference, Amsterdam, 4 June 2015. * * * Mr. Chairman, Your Excellency Minister of Finance, Jeroen Dijsselbloem, Commissionner Lord Hill, Esteemed ICMA-members and conference participants, 1. Thank you for this opportunity to share my views on the European Capital Markets Union. First, let me express my full support for the views expressed by his Excellency, the Minister of Finance. I, too, very much welcome the initiatives by the Commission geared at the further development and integration of European capital markets. I am confident that through the harmonization of regulation and the introduction of common standards we’ll be able to unlock important new ways of finance; productive ways that will increase the resilience of the European economy, going beyond the traditional financing channels of banking. 2. It is true that in the euro area, small and medium-sized enterprises are still very much dependent on financing by banks. This implies that business investment in the euro area also depends on the availability of bank credit. And this creates vulnerabilities to the European economy. For example, when banks need to deleverage in order to strengthen their balance sheets. 3. The European bank-based financial system is often contrasted to the situation in the US, which is presumed to be more market-based. I should note that this difference is a bit more nuanced than is commonly acknowledged. For in the US as well, SMEs are similarly dependent on bank financing, in particular the smallest of firms. To the extent that smaller firms do access capital markets, this is mostly confined to specific sectors. A well-known example is the Silicon Valley industry, start-up tech-companies that are able to attract large sums of financing from venture-capitalists. 4. This refinement notwithstanding, in general it has been shown that well-developed access to market financing can complement bank financing. And economic research confirms that this can improve economic performance. The Minister has eloquently explained how this would apply specifically to the European economy and set out how the Capital Markets Union relates to the recently established European Banking Union. In my address, I want to focus on yet another perspective. I will give you my views on why the completion of a true European Capital Markets Union is beneficial from a monetary policy perspective, for there are several reasons why better developed and integrated capital markets can make the lives of European central bankers much simpler. 5. As you know, the Governing Council of the European Central Bank aims to maintain price stability in the euro area as a whole. To achieve this, the ECB conducts monetary policy. Based on the outlook for inflation, we set our policy rates to steer overall financing conditions for households and firms in the euro area. A homogeneous transmission of our monetary policy decisions throughout the financial system enhances the appropriateness of our policy decisions. For the euro area as a whole, and for the participating Member States. That is why monetary policy benefits from a level-playing field in financial markets across countries. 6. Note that I do not intend to suggest that all economic agents should be able to lend against the exact same conditions. Actual financing conditions for individual households and firms are to be determined by the market and not by the ECB. And these should appropriately reflect differences in earnings capacity and risk. 7. This is exactly what went wrong in the run-up to the crisis. Lending rates converged throughout the euro area, and no longer reflected actual underlying risks. Several potential BIS central bankers’ speeches explanations have been put forward for this. One reason often mentioned is the search-foryield as a consequence of the low interest-rate environment. Or the fact that the no-bail out clause in the EU Treaty was perceived as not credible. Yet another explanation is that gaps in banking regulation were the primary cause of the mispricing of risks in the run-up to the crisis. In my view, all three explanations have been relevant. In fact, these factors are likely to have reinforced each other. 8. In a similar way, I believe that a lack of harmonization in regulation and common standards in euro area capital markets can also be viewed as an aggravating factor. For heterogeneity and inconsistencies in regulation can obscure how losses will be distributed once financial risks materialize. And this can exacerbate the mispricing of risk in financial markets. 9. I think this is a key issue that the Commission agenda on Capital Markets Union should address. In my view, one of the obstacles to be tackled is the lack of harmonization in insolvency laws across countries. Unfortunately, in the Commission’s early proposals initiatives to that effect do not feature very prominently. Yet, I nevertheless believe it could be an effective way for Capital Markets Union to contribute to consistent pricing of risk across countries. For it will help ensure a homogeneous, but risk-consistent transmission of monetary policy decisions. 10. But Capital Markets Union can deliver on more than just that. It can also greatly increase the efficacy of monetary policy. Common to all monetary policy decisions is that their transmission to the real economy is sluggish and can sometimes be incomplete. For example, the extent to which banks are able to lower lending rates following a rate cut depends on many factors beyond the control of monetary policymakers. One can think of the level of competition in the banking sector, or the health of bank balance sheets. A successful Capital Markets Union will open up entirely new channels for the transmission of monetary policy to the real economy, making central bankers much less dependent on a single sector for the transmission of its policy decisions. In that sense, central banks can diversify the channels through which they can influence the economy, adding to its effectiveness. 11. Note that economic agents can benefit from Capital Markets Union in a very similar way. Households and firms can diversify their dependency on financing, if alternative sources of finance are in abundance, making themselves less vulnerable to risks stemming from a single sector. A well-diversified financial structure increases the resilience of the balance sheets of households and corporations to shocks. And the resilience of the economy as a whole. And when an economy is better able to cope with external shocks, monetary policy will not get distracted from pursuing its primary remit: delivering price stability. 12. The latter is even more relevant for monetary policy in a monetary union. Structural differences between national economies imply that the euro area economy is prone to asymmetric shocks. Private sector risk-sharing across countries can greatly enhance a smooth transmission of such shocks. This is what Capital Markets Union can accomplish, for an increase in the cross-border holdings of financial instruments will enhance risk-sharing across the euro area, thus improving the functioning of the monetary union. 13. However, Capital Markets Union is no silver bullet. Clearly, its introduction does not absolve us from pursuing prudent policies in other policy areas, too. Moreover, it will take time before we can reap the full benefits of Capital Markets Union. But there can be no doubt that it will prove an important complement to Banking Union in enhancing the functioning of our monetary union. 14. At the same time, Capital Markets Union will also bring new challenges and risks. For example, as a result of the shift in the relative importance of the transmission channels of monetary policy. Interest-rate decisions may transmit to the real economy differently through markets than they do through the banking sector. This calls for careful analysis. And possibly a reassessment of the effectiveness of our monetary policy instruments. These instruments are BIS central bankers’ speeches currently primarily geared at the banking sector. However, to be able to influence financing conditions beyond the banking sector we may need to introduce new instruments. 15. Another possible consequence is that risks may shift to the shadow banking sector. A sector that is currently less transparent and less regulated than the traditional banking sector. It is yet unclear what could be the financial stability implications if such a development were to occur. In any case, it would warrant enhanced monitoring of developments in the sector. One could even argue that a more formalized supervisory framework should be put in place. Finally, it could be conceivable that macro-prudential policy measures would have to be applied beyond the banking sector. 16. As for the potential risks associated with developing capital markets, let me highlight one more issue. Some might worry that by developing financial markets we will again see the introduction of complex financial instruments. The type of obscure instruments that according to many were the root cause of the global financial crisis. Here, I would like to reiterate firmly that this is clearly not what I envisage. Rather, the goal of Capital Markets Union is to create a level-playing field by introducing simple standards that improve transparency. Only then, can Capital Markets Union foster financing flows that support economic growth in a sustainable way. Dear participants, let me wrap up my address. 17. I presented to you a central banker’s view on Capital Markets Union, and why I think this a very important initiative. Today, the discussion on Capital Markets Union is still at an early stage. The agenda is being set as-we-speak. Having an exchange of views on such an important topic with esteemed members of the capital markets community could not have come at a better time. Therefore, I very much look forward to the discussions later today. I’m confident that this conference will yield many interesting insights. New ideas that will bring us closer to completing this important pillar of our Economic and Monetary Union. Thank you for your attention. BIS central bankers’ speeches | netherlands bank | 2,015 | 6 |
Opening speech by Mr Klaas Knot, President of the Netherlands Bank, at the Sustainable Finance Seminar, organized by the United Nations Environmental Program and the Sustainable Finance Lab, and hosted by the Netherlands Bank, Amsterdam, 27 November 2015. | Klaas Knot: The role of central banks; the Netherlands Bank and sustainable finance Opening speech by Mr Klaas Knot, President of the Netherlands Bank, at the Sustainable Finance Seminar, organized by the United Nations Environmental Program and the Sustainable Finance Lab, and hosted by the Netherlands Bank, Amsterdam, 27 November 2015. * * * Ladies and gentlemen, It is my great pleasure to welcome you to De Nederlandsche Bank at this seminar organised by the United Nations Environment Program and the Sustainable Finance Lab. I am glad to see so many leaders from the banking, insurance and pension sector. It tells me that sustainability is given the prominent attention it deserves. And today’s programme reflects that belief. It features respected colleagues from around the world, who will argue in their own way that sustainable finance is crucial to our industry and the stakeholders we serve. It has taken us a while. We have been occupied by the global financial crisis and its consequences for financial stability and economic growth. Now that the worst seems to be over, we have to carefully consider the future. It is evident to me that a stable financial industry and sustainable economic growth are only possible if we integrate sustainability into our operations and business models. This is a complex discussion full of dilemmas and unanswered questions, and we are still in the early stages of charting a course. My hope is that today’s speakers and discussions will contribute to more clarity and action. This morning Simon Zadek from the United Nations Environment Programme will summarise the UNEP’s inquiry into the role of the financial system in achieving sustainable development. Ma Jun, Chief Economist at the People’s Bank of China, will join us via video link and share China’s expertise in the area of sustainable finance. And eminent economist Herman Wijffels will facilitate two roundtable discussions. You are also invited to join this afternoon’s session, which will be open to a broader audience. This will feature: – - Simon Zadek, Co-director of the UNEP Inquiry into the – Design of a Sustainable Financial System; – Professor Dirk Schoenmaker from the VU University; – James Orr, Chief Actuary for General Insurance at the Prudential Regulation Authority, which is part of the Bank of England Group. – In addition, my fellow Governing Board Member Frank Elderson will elaborate on De Nederlandsche Bank’s vision on achieving sustainable development. The role of central banks De Nederlandsche Bank is hosting today’s event because it shares the sense of urgency that is felt across industries and territories. BIS central bankers’ speeches Global population growth, climate change and dwindling natural resources are threatening the wellbeing and welfare of every person on this planet over a period of many decades. Furthermore, the financial crisis has awoken us to the fact that many existing approaches to business and finance are unsustainable. Economic development cannot be considered durable when: – natural resources are being depleted; – growth rates do not fully reflect potential long-run costs to society; – - and short-term gains of a small group are achieved at the expense of the long-term health and stability of the system as a whole. Now, originally, sustainability was driven by the climate debate and its many passionate stakeholders. As a result of the recent crisis, however, the financial industry has become fully aware that sustainability is its responsibility, too. After all, climate change, economic growth, financial stability and social wellbeing are inextricably and systemically linked. The UNEP’s inquiry comes to a similar conclusion. As Simon Zadek will discuss later, central banks and regulators are considered key to achieving a financial system that contributes to sustainable development. This potential is unfulfilled, however, in spite of many encouraging efforts by peers from around the world. The Bank of England is one of them. In a recent address, Governor Mark Carney spoke about the profound and long-term effects of climate change on issues such as property, migration, political stability and food and water security. In spite of the threat this poses to our financial resilience and long-term prosperity, little is done to mitigate it. This is because of short planning horizons related to short business cycles, short political cycles and the mandate of central banks. Carney called this the Tragedy of the Horizon and he argued it could be broken by combining data, technology and expert judgment. This, he said, can help us achieve: – a better understanding of risks; – better pricing for investors; – better decisions by policymakers, – - and a smoother transition to a lower-carbon economy. These and other concerns are being shared by the Financial Stability Board, of which I am member and which Carney chairs. In April, G20 Finance Ministers asked the Financial Stability Board to consider how the financial sector could take account of the risks climate change poses to our financial system. In response, the FSB initiated the plan to set up an industry-led disclosure task force on climate-relate risks in 2016. This initiative was welcomed by the G20. BIS central bankers’ speeches De Nederlandsche Bank and sustainable finance Now, as Frank Elderson will elaborate on this afternoon, De Nederlandsche Bank believes it can – and must – contribute to sustainable development. It follows from our legal mandate. And it follows from our mission, which is to contribute to the sustainable prosperity of the Netherlands by safeguarding the financial stability. To achieve this, we have begun to incorporate sustainability into our core business. We are conducting research into the carbon bubble, the energy transition and sustainable investments in the pensions industry. The outcomes will be used to advice policy makers and to guide financial institutions into incorporating sustainability more fully into their business. And we are exploring ways to integrate sustainability more fully across our own range of instruments. Over the coming period, we will define the exact scope and scale in close co-operation with all our stakeholders. What we do know, however, is that we will increasingly take a forward-looking approach and assume the role of catalyst. This way, we hope to ensure that: – business models of financial institutions are sustainable over the long run; – the interests of financial service clients are not subordinated to those of the industry’s shareholders; – the organisation of social welfare does not lead to an unintended distribution of wealth and income among generations or groups; – solid government finances contribute to solid economic development; – no financial or economic disbalances occur; – and finally, that the external effects of the economy – including the generation and usage of energy – are adequately priced and regulated. Closing remarks Ladies and gentlemen, We are at a crossroads. The challenges to our system will have serious, long-term consequences unless we act now. And sustainable development is key to securing the wellbeing and welfare of this generation and the many that will follow. De Nederlandse Bank is eager to play a catalysing role and use its instruments to promote sustainability. I challenge you to do the same. Thank you. BIS central bankers’ speeches | netherlands bank | 2,015 | 11 |
Keynote speech by Mr Klaas Knot, President of the Netherlands Bank, at the conference "Africa Works!", Royal Tropical Institute, Amsterdam, 10 November 2016. | Keynote speech by Klaas Knot “Innovation in Finance makes Africa work!” at conference “Africa Works!”, Amsterdam, Royal Tropical Institute, 10 November 2016 Amsterdam, Royal Tropical Institute – Innovations in finance will help Africa get on in the world, especially when combined with a further strengthening of institutions. This was the message Klaas Knot conveyed in his speech marking the opening of the two-day conference “Africa Works! See below for the full speechL Ladies and gentlemen, I’m delighted to speak here today. How could I not be? For one, the purpose of this conference is to inform, inspire, connect and catalyse the Dutch private sector with Africa’s business opportunities. This is something I wholeheartedly support. For if there’s been one continent that has seen many changes for the better in the last two decades, it is Africa! Indeed, only 16 years ago, The Economist portrayed Africa as the “Hopeless Continent”, a nickname which would make every businessman or woman hesitant to invest. In less than one-and-a-half decennium, The Economist changed its mind and came up with the pet name “Hopeful Continent”. What made The Economist, like many others, change its mind? Well, basically two developments, I think. First, its economic achievements. The years since the turn of the millennium have marked a period of sustained economic growth for the African continent. Importantly, this boom has been shared by all countries in Africa, except for a few countries where armed conflicts took place. Admittedly, for some larger commodity-exporting African countries, such as Nigeria or Angola, the boom has been driven largely by the commodity super-cycle. We, in the Netherlands, are well aware that natural resources can be a mixed blessing for an economy. It’s what earned this phenomenon the nickname “Dutch Disease”!, referring to the possible decline in competitiveness following the appreciation of our currency after the discovery of natural gas resources in the North Sea. The currently declining economic conditions in these commodity-exporting countries seem to illustrate that the “results of the past are no guarantee for the future”. But this doesn’t take away the fact that the lives of many Africans have started to change as a result of the “African economic boom”, lifting millions of people out of direct poverty and gradually creating a rising well-educated middle class. And, while the outlook for the commodity-exporters may have darkened, the outlook for the non-commodity exporters remains bright, with growth rates of more than 6 percent in countries such as Côte d’Ivoire, Ethiopia, Kenya, and Senegal. The other development that altered many people’s view of Africa, were the political and security-related improvements. While Africa is, unfortunately, still the continent where most conflicts take place, the absolute number of conflicts in Africa has declined over the past 25 years. Many of the wars of the 1990s have ended, and despite some ongoing and intensifying conflicts in North Africa and the Middle East, overall Africa nowadays seems to be more peaceful than in the early 1990s. Moreover, since the start of this millennium democratic governance has improved and institutional reforms have taken place in many countries, be it from a low level. At the same time, business environments have taken a turn for the better. While the starting point was perhaps less than auspicious, it is very encouraging to see that African countries as Benin and Senegal nowadays often appear among the global top 10 reformers in the World Bank’s “Ease of Doing Business” indicators. Due to these promising developments, Africa has become a region that boasts strong business opportunities, both for African entrepreneurs and for foreign ones. Also Dutch firms are increasingly aware of these opportunities. For instance, nowadays more than 2,000 Dutch firms are doing business in Africa, ranging from smaller – mainly trade-oriented – companies to major Dutch companies such as Heineken, Unilever and Philips. Africa is also increasingly important for Dutch exports and imports. Among the 20 most important emerging countries to which Dutch exports are destined, 9 are situated in Africa, with Togo, Ghana and Senegal even in the top 5. And, according to Statistics Netherlands, about 70 percent of our imported roses come from Africa, where, by the way, also Dutch rose growers are active. Certainly, Africa works for Dutch entrepreneurs!The second reason why I am delighted to be here is the theme of the conference: Innovation in Finance. In my view, this is a very well-chosen topic. New technologies are changing our lives and our industries. Also finance is undergoing a rapid transformation, most visibly in the field of payment transfers, but also in lending, insurance and, importantly, remittances. The advent of smart phones, for instance, has led to the development of new mobile wallets, which makes it easy to “send money home”: Goodbye long unsafe travels, hello smart phones! Innovations in finance offer new opportunities to the financial sector. This may especially be the case in Africa, where these innovations are perhaps less of a “threat” to the traditional banking sector than in “overbanked” Europe. But even more important in my view are the benefits of innovation for consumers and businesses. New technology in finance brings more choice, lower costs and greater convenience for users. This not only holds for advanced countries with well-developed banking sectors, but certainly also for Africa with its many remote areas and still many “unbanked” inhabitants. Indeed, a sustainable and prudent development and use of new technologies in finance will help to further promote financial inclusion in Africa. And this is of vital importance. For this relationship between financial inclusion and economic growth has been clearly established time and again. Financial services are the lifeblood of an economy. Access to financial services allows households to smooth out consumption and invest in their future. For businesses, access to credit enables them to expand and to create jobs. Financial inclusion, in short, is one key for promoting strong and stable economic growth. Innovations in finance are perhaps the most promising way to advance financial inclusion. That is why it is so important that new technologies in finance are being exploited in Africa, as this will help unlock the continent’s massive “unbanked” population. For companies involved in supplying this new type of services this implies that they will continuously need to embrace innovative strategies. In this way, they will be able to shape financial products to fit consumers’ rising financial sophistication needs. Recent history suggests that African companies are able to do so quite successfully. Kenya, for instance, has led the world in innovative financial services based on mobile telephony by introducing M-PESA and M-PESA-derived systems such as M-Shwari and M-Kesho. This has made several financial services available to anyone with a mobile phone at a fraction of the cost. Exploiting innovations in finance is one. Strengthening institutions is the other. One of the most fundamental questions in economic science is “why are some countries richer than others”? Differences in the quality of legal, political and educational institutions between countries turns out to be an important part of the answer. Indeed, the strengthening of such institutions often goes hand in hand with higher economic growth: countries with stronger institutions experience stronger economic growth compared to countries with weaker institutions. There are several reasons why this turns out to be the case. Strong institutions provide for the protection of property rights; foster contract enforcement; create a healthy investment climate and help the development of abilities. This makes for an economic environment in which individuals and firms can cooperate, to everyone’s benefit. And, importantly, an environment in which innovations in finance can develop and thrive. Therefore, strong institutions will enable countries to realize the full benefits of innovations in finance. Research by the IMF and the World Bank shows that there is still plenty of room for Africa on this front. Continuing efforts to further strengthen institutions are therefore highly needed. Personally, as an economist, I consider tackling deficiencies in property rights protection as the key challenge for African countries. After all, as several studies have shown, well-defined and strongly protected property rights go hand in hand with economic growth and development. Let me conclude. I am optimistic on Africa. Innovations in finance will help Africa get on in the world, especially when combined with a further strengthening of institutions. It goes without saying that this will also create new opportunities for Dutch firms and entrepreneurs. I hope that this conference will contribute to exploiting these opportunities yet further. I thank you for your attention and wish you a fruitful conference! | netherlands bank | 2,016 | 12 |
Keynote speech by Mr Klaas Knot, President of the Netherlands Bank, at a seminar entitled "Tomorrow's banking and how central banks have developed in last 15 Years", organized by the Bank of Finland, Helsinki, 16 January 2017. | Klaas Knot: Are we all macroprudentialists now? Keynote speech by Mr Klaas Knot, President of the Netherlands Bank, at a seminar entitled “Tomorrow’s banking and how central banks have developed in last 15 Years”, organized by the Bank of Finland, Helsinki, 16 January 2017. * * * It is a great pleasure for me to speak at this conference at the Bank of Finland, in which we pay tribute to Pentti Hakkarainen. As Deputy Governor and Chairman of the Finnish FSA, Pentti has played an important role in the areas of monetary policy and macroprudential policy. In my remarks, I would like to focus on the increased importance of macroprudential policy for central banks, and elaborate on some of Pentti’s main insights. I want to raise three main points. My first point is that financial crises have always happened and will always happen. And they do not result from some exogenous, extreme event. Rather, to use Pentti’s words, financial crises can “be interpreted as an extreme manifestation of the financial cycle phenomenon”. 1 By financial cycle we understand systematic patterns over time in the financial system that can have important macroeconomic consequences. Typically, financial crises are preceded by booms characterized by a combination of intensified financial innovation, robust and widespread appetite for risk, and a favorable economic environment. This favorable environment could for example reflect new growth impulses from technological innovation, international trade, and mobile and volatile international capital flows. These patterns are indeed not specific to the Global Financial crisis, nor – if we look back in time – to the Great Depression. In fact, the first truly global financial crisis in modern history – the South Sea Bubble of 1720 – originated in England, France and the Netherlands. 2 All key ingredients of an extreme financial cycle gone wrong can be found here. (The famous tulipmania that hit the Dutch Republic in 1636-37 shared some but not all of these elements, and its dynamics can be compared to the dotcom bubble rather than a global financial crisis.) The burst of the South Sea Bubble followed a period of strong economic growth. The discovery of the economic potential of the New World had led to a shift in global trade towards the triangle that brought manufactured goods to Africa, Africans as slaves to the New World, and commodities to Europe. There had been rapid innovation in financial engineering, spurred by some form of deregulation. This allowed greater risk sharing and supported exuberance in the financial sector. “Shadow banking” (the English insurance companies and international investors) played a pivotal role. As liquidity stress morphed into solvency problems, the bubble burst with a dramatic international stock market crash. You can see how the mechanics of this crisis do not differ much from those of the recent Great Financial Crisis, and all other crises traced through history by Charles Kindleberger. 3 P. Hakkarainen (2015) Finance cycles and macroprudential tools - the case of Finland within the euro area. Speech at the Seventh High-Level Policy Dialogue of the Eurosystem and Latin American Central Banks, Madrid, 11 November. R. Frehen, W. Goetzmann and G. Rouwenhorst (2013) New evidence on the first financial bubble. Journal of Financial Economics. Vol. 108 (3), pp. 585–607. BIS central bankers’ speeches My second point is that there is a consensus that macroprudential policy is an essential toolkit but its effects and transmission channels are still not fully understood. Since the 1930s, policymakers have used prudential means to enhance system-wide financial stability, with a view to limiting macroeconomic costs from financial distress. Some measures taken in the 1930s, 1950s and 1960s to support the domestic financial system and to influence the supply of credit have been viewed as macroprudential tools. 4 Still, when Andrew Crockett pleaded for a macro perspective on prudential policy in 2000, the idea was controversial. 5 It took the Great Financial Crisis to forge a consensus on the importance of macroprudential policy. As Pentti put it, “Macroprudential policy is needed in addition to other economic policies. It is very important that authorities have also macroprudential instruments available. Now, after the Great Financial Crisis, we have instruments and framework in place.” 6 But in his usual sharpness Pentti also highlighted the challenges to using macroprudential tools: “the effects of the said instruments are uncertain and second, processes for their usage are unnecessarily complicated. These points are intertwined.” 7 My third point – and here I would like to elaborate a bit – is that we should not look at macroprudential policy and its effectiveness in isolation. As Pentti argued in a speech last year, it is important to coordinate macroprudential policy and monetary policy. 8 Let me elaborate. The effectiveness of macroprudential policy depends importantly on its interaction with monetary policy. In particular, it hinges on the “side effects” that one policy has on the objectives of the other. On the one hand, monetary policy can thwart the intentions of macroprudential policy. We all agree that the monetary policy stance affects risk taking of the financial system as a whole. While macroprudential instruments typically target specific vulnerabilities, monetary policy affects the cost of finance for all financial institutions – including the shadow banking sector. As such, in the words of Jeremy Stein, it “gets in all of the cracks and may reach into corners of the market that supervision and regulation cannot”. 9 This is most evident in a crisis situation, such as the one we are still witnessing in the euro area. Standard and non-standard monetary policies that provide ample liquidity may avoid a collapse of the banking sector. But they can come at the expense of reduced incentives for C. Kindleberger and R. Aliber (2015) Manias, Panics and Crashes: A History of Financial Crises. Palgrave Macmillan. 7th edition. A. Haldane (2011) Risk off. Speech delivered on 18 August. A. Crockett (2000) Marrying the micro- and macroprudential dimensions of financial stability. BIS Speeches, 21 September. P. Hakkarainen (2016a) Capital-based macro-prudential instruments - what type of policy tools are needed to address macro-prudential risks in the banking sector? Notes for the panel discussion on "Capital-based macro-prudential instruments - what type of policy tools are needed to address macro-prudential risks in the banking sector?” EU Commission's Public Hearing on the Review of the EU macro-prudential framework. Brussels, 7 November. Ibidem. P. Hakkarainen (2016b) Monetary policy - which road ahead. Notes for the session “Monetary Policy: Which Road Ahead?”. Frankfurt European Banking Congress, Frankfurt am Main, 18 November. J. Stein (2013) Overheating in Credit Markets: Origins, Measurement, and Policy Responses. Speech at the Federal Reserve Bank of St. Louis research symposium on “Restoring Household Financial Stability after the Great Recession: Why Household Balance Sheets Matter”, 7 February. BIS central bankers’ speeches banks to recapitalize and restructure. They may actually promote the evergreening of nonperforming loans and regulatory forbearance. It is argued that targeted macroprudential policies can offset these side effects. But I do not side with this Panglossian view and am afraid that there are limits to what macroprudential tools can achieve in practice. On the other hand, macroprudential policy can thwart the intentions of monetary policy. Changes in (micro and macro) prudential policy will affect banks’ risk-taking, their financing conditions and balance sheet composition. They will therefore have an impact on the real economy and on price stability. The fact that the ongoing unprecedented monetary policy stimulus does not translate into rapid credit growth in the euro area might then not imply that monetary authorities are not doing enough. Rather, banks are reacting to stricter regulatory rules that have been introduced in the wake of the global financial crisis in an attempt to make the financial system more resilient. These regulatory changes therefore weaken the pass-through of monetary policy measures to the supply of bank credit and, ultimately, to aggregate demand and inflation. Let me conclude. The claim that “we are all macroprudentialists now” seems to suggest that macroprudential policy has become fashionable. 10 Are we then all macroprudentialists? In the spirit of Pentti’s thinking my answer is: Yes – as long as we stay eclectic, pragmatic and flexible. And we take the interactions of monetary and macroprudential policies into account, and coordinate the two policies. Thank you. C. Borio (2009) The macroprudential approach to regulation and supervision. VoxEU, 14 April. BIS central bankers’ speeches | netherlands bank | 2,017 | 2 |
Speech by Mr Frank Elderson, Executive Director of the Netherlands Bank, at the DNB Banking Seminar "The art of transformation - will banks keep up?", Amsterdam, 8 February 2017. | Speech by Frank Elderson at DNB Banking Seminar “The art of transformation - will banks keep up?”, Amsterdam, Hermitage, 8 February 2017 Ladies and gentlemen, Throughout time, mankind has been shaped by wave after wave of changes. Economic boom and bust. Social and political upheaval. Scientific developments that transformed how we travelled, produced and consumed. These changes were reflected in - and influenced by - the evolution of banking. In Babylonia, merchants made grain loans to farmers. In ancient Greece, lenders began to accept deposits and change money. And in the 17th century, Amsterdam became a centre of derivatives, short selling and proprietary trading. Today, banking is a global industry. One that sells complex financial products and executes trades over high-speed networks using algorithms. Banks have a systemic impact on every aspect of our lives. They catalyse commerce between nations, enable businesses to grow and enable people to buy a house. Now, the banking industry is facing several challenges. Fintech is rising, consumer trust is damaged and Basel 3.5 is on the horizon. Then there is doubt about the future of Europe, growing criticism of globalisation and uncertainty about the geopolitical landscape. Meanwhile, the world is trying to achieve the Sustainable Development Goals and implement the Paris Agreement. Banks will have to adapt – perhaps contribute – to this and the question is how. What is an appropriate business model or strategy? And what is the best form for the key functions that banks perform, such as safeguarding money, providing loans, and determining risk and return? Or is there a future in which non-banking entities perform banking functions? In discussing these questions, perhaps it’s worthwhile to distinguish between change and transformation. To me, change implies an increase or decrease over time of something while its nature remains constant. Money was first metal, then paper and now digital, but it’s still money. And today’s stock exchanges are in essence quite similar to those established centuries ago. Transformation is different. It implies something essential changes and a new order emerges. A caterpillar transforming into a butterfly. A child transforming into an adult. Philips, as Hans de Jong so eloquently described it, transformed from a consumer tech company into a health tech one. Transformation takes time, vision and the courage to take tough decisions. And it is anything but easy to genuinely transform an organisation’s culture. Having said that I wonder: is the banking industry changing or transforming? Perhaps both? I am sure this is something we can debate at our tables later on. For now, I would like to stress that transformation is not just an inspiring concept, but also a practical and operational process. People and organisations have a capacity to transform that can be nurtured. In today’s turbulent environment, banks would do well to evaluate this capacity. It could mean the difference between relevance and irrelevance. But what exactly influences the capacity of organisations to transform? How can you grow this capacity? DNB has conducted research into the capacity of pension funds to transform and we found several things I am sure apply to other industries. For example, we found that leadership is key. Specifically, individual leaders with the capacity to identify changes in the landscape, develop best-case and worst-case scenarios and create a compelling vision. Also leaders who are able to develop a strategy around this vision and then execute it. The leadership team is of importance, too. There needs to be openness, trust and diversity in terms of personalities and competences. We also found that pension funds need to be appropriately equipped. They need to be agile, have an up-to-date IT infrastructure, have sufficient budget and task the right people with the transformation process. And pension funds need to have their house in order. For unless everything runs smoothly, the organisation will focus its attention on managing the present rather than designing the future. Finally, we found that pension funds need to be proactive. If they wait until the environment forces them to change, they are at risk. Instead, they should proactively adapt. Some pension funds began to transition from a defined benefit to a defined contribution system years ago and they are now in a good shape. Those who haven’t, are struggling to adjust to changing realities. So transformation is a process that can be managed. But the process needs to lead to something. Transformation is a means, not an end. So what is or should be the end result of a bank or the whole banking industry transforming? In exploring possible answers to these questions, it may be worthwhile to make another distinction, this time between goals and purpose. The way I see it, goals are operational and action-oriented. Bigger returns. More efficiency. Lower risks. Goals can be quantified and our progress towards them can be measured. Goals are important: they focus our attention and our resources. Purpose to me is different. Purpose answers the question: why do we exist? And who or what do we serve? If we live and work purposefully, we serve the greater good, an ideal, or future generations. It means acting in line with our deepest values and beliefs, our sense of humanity, our personal calling. So if goals are about doing and achieving, purpose is about being and becoming. Over the past decade or so, an increasing number of businesses have embraced purpose. Philips strives to make the world healthier and more sustainable through innovation, and by improving the lives of 3 billion people by 2025. DSM’s purpose is to create brighter lives for people today and generations to come. Unilever’s purpose is to make sustainable living commonplace and the company believes this is the best long-term way for its business to grow. What about banks? Do banks have a purpose and, if so, what place should it have in their culture and strategy? And should banking transformation have a purpose? Or is it sufficient for a bank to focus on changes that will help them increase profit, mitigate risk and comply with regulations? These questions warrant passionate debate and clear answers. Answers that banks need for themselves, but also that society expects. In recent years, consumers have felt that banks served only themselves at the expense of society at large. Perhaps purpose can help to restore trust, by bridging the needs of a bank with the needs of society. De Nederlandsche Bank believes in the value of having a purpose and we cherish ours. We are in this world to contribute to the sustainable welfare of the Netherlands by promoting financial stability. Through this, we also contribute to the realisation of the Sustainable Development Goals. This inspires us and guides us in relating to our stakeholders. And it seems we are not alone in this. Last December, the Dutch Banking Association published a report in which it explored how banks can contribute to the Sustainable Development Goals. I wholeheartedly encourage such explorations. Ladies and gentlemen, Genuine transformation is hard. It means letting go of what we know, what is comfortable, what we are used to. It means submitting to a long, and often perilous journey. And it means committing to a path whose outcome is far from certain. Whether banks change or transform, and whether they embrace purpose or not, their functions and functioning are crucial. As banks adapt to a changing world around us, their decisions will impact all of us for a very long time. I wish banks courage, perseverance and vision as they plot their course to the future. Thank you. | netherlands bank | 2,017 | 2 |
Keynote speech by Mr Klaas Knot, President of the Netherlands Bank, at the Finanzmarktklausur Wirtschaftsrat, Berlin, 26 January 2017. | TILTING THE POLICY MIX IN THE EURO AREA Keynote Speech by Klaas Knot, Finanzmarktklausur Wirtschaftsrat, Berlin Thursday 26 January 2017 Ladies and Gentlemen, Thank you for inviting me to speak at this event of your Wirtschaftsrat. I would like to give you a central banker’s perspective on the appropriate policy mix in the euro area. I’m referring to the range of measures that policymakers take to influence economic growth. And as you no doubt will know, we central bankers have played a large role in helping the economy stabilize and recover from the crisis. INTRODUCTION – TILTING THE POLICY MIX Since the onset of the financial crisis in 2008, the euro area economy has had to cope with a series of negative shocks. The private sector has been in a deleveraging mode for nearly a decade. And also many governments had to make large fiscal adjustments to ensure their debts remained sustainable. These deleveraging efforts have been holding back growth, making this recovery one of the slowest in recent history. As a result, over the past decade, economic policy mainly involved crisis management and demand stimulus. In part because of the limited fiscal space in many euro area countries, monetary policy has done the bulk of the work. Even after policy rates had been brought to zero, central banks have shown to be creative in finding ways to fight the cyclical problems the crisis had left behind. Now, gradually, the economic outlook is more promising. 2016 was an eventful year, with the Brexit Vote, the surprising outcome of the US election and the Italian referendum. But not only did the recovery of the euro area economy turn out to be resilient to these shocks, it is even gaining some momentum and becoming more broadly based. The gradual firming up of the recovery allows us to refocus our attention to longerterm challenges. As the late, widely-respected Hans Tietmeyer stated back in 1998: “Die Geldpolitik kann den anderen Politikbereichen – weder der Finanz- noch der Sozial- und Lohnpolitik – ihre Aufgaben nicht abnehmen”. It now becomes time to rebalance the policy mix away from demand stimulus through unprecedented monetary accommodation, towards measures aimed at improving the longer-term outlook. UNPRECEDENTED MONETARY POLICY ACCOMMODA-TION To get where we are now, the Eurosystem has had to take far-reaching measures. We have lowered our main policy rates substantially, even into negative territory, to stimulate consumption and investment. Moreover, several non-standard monetary policy measures were taken to bolster the pass-through of low policy rates when tensions in financial markets persisted. In spite of these policy actions, over the course of 2014, the outlook for inflation was deteriorating. Even though the fall in inflation partly reflected a sharp drop in oil prices, persisting cyclical underperformance also played a role. There were fears that low inflation expectations would become self-fulfilling, with concerns about downward deflationary spirals as we haven’t seen since the 1930s. Given that the policy rates were close to their lower bound, in 2015 the Eurosystem launched an asset purchase programme to provide further monetary policy accommodation and fight low inflation; a policy better known as QE. By lowering long-term interest rates, our asset purchases have helped to further loosen financing conditions for households and firms. This in turn should have a positive impact on their spending decisions, and ultimately on inflation – but the exact impact on output and inflation is more uncertain. 2/15 MONETARY POLICY STRETCHED TO ITS LIMITS All in all, monetary policy has truly been stretched to its limits to achieve price stability in the face of negative economic shocks. There has even been some public discussion on whether the ECB has over-stretched its mandate. In particular, some question the legitimacy of public asset purchases as a monetary policy tool. In my opinion, and this is confirmed by the EU Court of Justice, asset purchases are a legitimate albeit non-standard monetary tool, provided that the ECB complies with the limits and restrictions as set out in the Treaty. Examples of such restrictions are the prohibition of monetary financing and the requirement that the Eurosystem shall act in accordance with the principle of an open market economy. To make sure that we act within this legal framework, we have set up several safeguards. One important safeguard is that we have introduced limits on the share of outstanding securities we can buy from a given issuance. These limits prevent us from becoming a dominant creditor of euro area governments and help to safeguard the functioning of the market. In our December meeting the legal importance of maintaining these limits has been reconfirmed. NON-STANDARD MEASURES NOT WITHOUT SIDE-EFFECTS Of course, the fact that a certain monetary tool is available to us doesn’t mean that its use is always automatically justified. We should always ask ourselves whether the expected benefits – in terms of the extent to which the measure helps us achieve our mandate of price stability - outweigh any potential costs. After all, our monetary policy measures are not without side-effects; adverse side-effects that could actually be detrimental to maintaining price stability. Let me briefly discuss two. First, our non-standard monetary measures could result in an inefficient allocation of resources. Price signals are being suppressed, and the role of financial market discipline is weakened. Cheap credit may help unproductive and non-viable firms to survive for too long. 3/15 This hampers the process of creative destruction, an important driver of productivity growth and, thus, increases in living standards. Second, the low interest rate environment becomes increasingly harmful for financial institutions and poses risks for financial stability. With interest rates declining further and retail bank deposits remaining sticky, banks’ interest margins continue to narrow, reducing their profitability. Going forward, this may reduce their willingness to lend. A related concern is that the reduced profitability prospects encourage banks and other financial institutions to take excessive risks and build up leverage. BALANCE BETWEEN BENEFITS AND COSTS INCREASINGLY LESS FAVOURABLE Importantly, the longer our non-standard policies last, the larger the side-effects are expected to be. Fortunately, the improved economic outlook reduces the need for additional monetary stimulus. Our decision in December to continue our purchases until the end of 2017, but to very gradually begin reducing our monthly purchases from 80 bln euro to 60 bln euro, reflects this. Importantly, the tail risk of a deflationary spiral is no longer imminent, removing one important rationale for large-scale asset purchases. TILTING THE POLICY MIX While central bankers are rebalancing their monetary policies, a better balance needs to be struck in the broader policy mix in the euro area. Reliance on monetary policy to help us get where we are now, has been high. But at the end of the day, monetary support alone is not enough to achieve sustainable economic growth. Although the cyclical problems are waning, there is no time for complacency. Several longer-term causes are still holding back growth. In that spirit, it now becomes the time to open the debate on rebalancing the policy mix towards these long-run factors. And this means that other policymakers will have to take on the baton from central banks. They should tackle a number of structural and institutional factors. 4/15 STRUCTURAL CAUSES OF LOW GROWTH Indeed, one important cause of the low growth prospects is structural. Many countries have failed to adapt to the changing environment in recent decades, most importantly technological change and globalisation. In addition, the monetary union removed the exchange rate as an adjustment mechanism for member states. By 1999 it was clear that structural reforms were necessary for individual countries to strengthen alternative adjustment mechanisms, like wage and price flexibility. But despite efforts like the Lisbon Strategy, structural differences only increased since then. The European Commission now projects potential growth in the euro area a meager 1.1% per year. This is a problem; one that calls for structural reforms that increase the growth potential and adaptability of member states. Measures to this end could focus on product markets, including the service sector, and on stimulating innovation and the application of ICT. In many countries the quality of institutions could also improve, like the efficiency of the judiciary system in settling disputes, protecting property rights and resolving non-performing loans. The OECD estimates that the adoption of best practices in areas like these could increase GDP by 4-7%. Still, it often remains difficult to find sufficient support for reforms. Reforms may hurt the vested interests of specific groups in order to serve the common interest for society as a whole. It is sometimes feared that structural reforms may increase inequality. But that need not always be the case. For example, practically everybody would gain when legal disputes are settled more quickly. Except perhaps lawyers that are paid by the hour. Existing regulations may not always protect against inequality either, because they protect some at the expense of others. Several member states have highly protected permanent labour contracts, but as a result young people may have no other option than to settle for temporary jobs. STRENGHTENING EMU FURTHER 5/15 Another part of the European growth problem is related to design flaws in the monetary union. Much has already been done to tackle them. The Stability and Growth Pact was strengthened and the Macroeconomic Imbalances Procedure was introduced. The ESM was launched to provide financial assistance to countries in difficulties. And the sovereign bank nexus was reduced with the banking union. While this has diminished the risks of severe financial turbulence, EMU could still do with additional improvements. First, we need a better balance between liability and control, as my dear colleague Jens Weidmann often emphasizes. Member states now share risks via mechanisms like the ESM, but the rules to reduce risks should be enforced more effectively. Compliance with the Stability and Growth Pact is reasonable in bad times when budget deficits are above 3%, but poor in good times when countries should balance their budget. Compliance with the Macroeconomic Imbalances Procedure and the European Semester should also improve. Of the recommendations issued in 2015, only 4% was implemented with substantial progress. Around 46% was implemented with some progress while 52% showed limited or no progress. Such a lack of enforcement increases the likelihood of new imbalances and future calls on European risk-sharing. Second, EMU would benefit from more private risk sharing. During the crisis European governments provided support with taxpayers’ money. But private companies, investors and banks shared far fewer risks. Private risk sharing is underdeveloped in EMU, and there is much to gain on this score. Academic research suggests that in the U.S., private risk-sharing smoothes out a larger percentage of shocks (around 62%) than does public risk sharing via the federal budget (around 13%), findings that are more or less confirmed for Germany as well. DOES THE ANSWER LIE IN MORE INTEGRATION? 6/15 The key question of course is how EMU should be strengthened further. It is often assumed that further European integration is the answer, for example by way of more binding policy coordination, which implies a transfer of sovereignty to Brussels. Many also favour more public risk sharing, such as a European budgetary stabilization fund. Further European integration would probably improve the functioning of EMU. But these steps are controversial, and may not be politically feasible in the current environment. In countries like Germany and The Netherlands, the controversy especially concentrates on a further increase in public risk-sharing. The fundamental problem is that Member States still differ substantially in terms of adaptability, overall competitiveness and institutional quality. If starting positions differ so much, a stabilization fund might not result in fair risk sharing, but in a permanent one-way transfer system. Therefore, any further increase in public risk sharing should be accompanied by stronger risk reduction. That would restore the balance between liability and control. However, this would also necessitate a further transfer of sovereignty to Brussels; a policy that is equally controversial in many Member States. As a result, large leaps forward in integration are hard to conceive at the moment. But fortunately small steps may also combine to achieve a great deal of improvement. Let me conclude by mentioning four no-regret options. First, improve compliance with the Stability and Growth Pact and the Macro-economic Imbalances Procedure by simplifying and strengthening the rules. Second, introduce some form of sovereign debt restructuring mechanism. In the future, it should be ensured that the public debt is sustainable before countries get access to financial support from the ESM. Third, regulate the sovereign exposures on bank balance sheets to further weaken the sovereign bank nexus. Many banks still hold large government bond portfolios of their own sovereign. While these exposures are treated as risk-free, the crisis has demonstrated that this is not always true. 7/15 Finally, encourage private risk-sharing via more robust financial integration. The European Capital Markets Union is a good starting point in this regard. CONCLUSION Ladies and Gentlemen, allow me to conclude. Over the past decade, the policy mix was mainly directed at the short-term, with a large involvement from the central bank. But the outlook is improving, and policy should rebalance towards the long-term factors that hold back growth. That still requires significant effort, but not necessarily from central banks. Let me again quote some wise words of Hans Tietmeyer, that he mentioned at an event of this very Wirtschaftsrat in 2006. “Es reicht […] nicht aus, auf konjunkturelles Wachstum zu setzen. Es geht vielmehr darum, die Strukturprobleme […] nachhaltig zu lösen. Nur so erreichen wir ein nachhaltig höheres Wirtschaftswachstum, nachhaltig mehr Beschäftigung, nachhaltig stabile Sozialsysteme und öffentliche Finanzen.” Ich danke Ihnen für Ihre Aufmerksamkeit. 8/15 | netherlands bank | 2,017 | 2 |
Word of welcome by Mr Klaas Knot, President of the Netherlands Bank, at the GUUG-CPMI-IOSCO HG workshop, Amsterdam, 25 April 2017. | Word of welcome by Klaas Knot, GUUG-CPMI-IOSCO HG workshop – De Nederlandsche Bank, 25 April 2017 Welcome to you all here at De Nederlandsche Bank. Welcome to this highly relevant workshop. Today you’ll be paving the way for an optimal governance model for the Unique Transaction Identifier, the UTI. That’s quite a challenge. For without an effective and efficient governance we cannot ensure a globally consistent high quality of the data used in the industry. And high-quality data are just what the industry and regulators alike urgently need. Since being a member of the Financial Stability Board, I have become increasingly aware of this. For both the public and private partners attending today, I won’t need to stress the great benefit that high-quality data will bring. Ever since the 2008 crisis, OTC derivative counterparties have been facing a rise in the burden, and consequently, cost of mandatory reporting. A trend that is the effect of bad quality data. This trend can be reversed once we have UTIs in place, along with Unique Product Identifiers, which will be briefly discussed as well today. For then a trade report will be suitable for use by various regulators as well as for micro- and macroprudential analyses. High quality data are independent of jurisdictions. If designed and implemented well, we can finally match transactions between counterparties on either side of the Atlantic. Supervisors with a microeconomic scope need high-quality granular data. And international regulators want the full picture, based on high-quality aggregated data. Evidently, regulators and the industry both need financial data that are comprehensive in scope on the one hand and detailed enough, on the other. Detailed enough for assessing and monitoring risks and vulnerabilities on the part of counterparties and on that of the financial system. High-quality granular data fit for aggregations can provide the analytical input policymakers require to make informed decisions. In order to serve this purpose, the data must have the right scope, be easily accessible and meet the highest quality standards. The Legal Entity Identifier project is a case in point. Finally, here’s a global register for identifying all counterparties active on the OTC markets; a register that can be used by both the industry and all regulators. So, ideally, the governance structure you are building today, should ensure we can continue to have usable and reusable high quality data. And once the core transaction details of all OTC derivatives are kept and stored by Trade Repositories all using the same high-quality data model, the reporting burden will not just cease to grow; it will even decrease, as the TRdata may then serve various regulators. And we, as FSB, will be able to ascertain precisely which transactions have taken place, and how exactly they should be aggregated, which now can still be ‘a bit of problem’. We can only measure the size of a global market if we use a uniform measuring method everywhere, thus ruling out the risk of double-counting owing to a lack of unique numbering or overlapping product definitions. It being a foregone conclusion that further use of bad data quality will only add to the regulatory reporting burden, we must lose no time and join forces, not only to enhance the quality of the data used in the trade reporting, but also to ensure they are globally consistent. And that is why you are here today! This is where you come in! For UTI is a critical data element in making the global OTC derivatives markets transparent. For this reason it is vital that you, the regulators and private sector representatives gathered in this room, are going to pay particular attention today to the governance aspects of the UTI. As you will no doubt be aware, work on the governance of the UTI is already underway. Last month, the FSB launched a consultation on proposed governance arrangements for the UTI. Later this year, similar proposals for the Unique Product Identifier will be put out for consultation. But, welcome as this development may be, I would add that the proposed arrangements should be considered with great care. For, as probably no one knows better than you, the world of hedging and related derivatives is changing continuously. Governance mechanisms must therefore be designed to ensure that the reporting framework can cope with those changes in order maintain a high data quality level. I hope that with this caveat in the back of your minds, you will collaborate successfully in today’s workshop. And that you will do so in the knowledge that the fruit of your efforts will be for the benefit of both the private and public sectors, both authorities and counterparties, if only by helping to reduce the reporting burden. As a member of the FSB, I would like to thank you in advance for your effort to make our work easier and – possibly – more effective! Thank you. | netherlands bank | 2,017 | 5 |
Speech by Mr Frank Elderson, Executive Director of the Netherlands Bank, at the Conference "Climate is Big Business", organized by the Ministry of Infrastructure and Environment and the Californian EPA (Environmental Protection Agency), San Francisco, 24 May 2017. | Speech by Frank Elderson, at the `Climate is Big Business´ conference – San Francisco, 24 May I have a confession to make. I’m a banker. Not just a banker, but a supervisor of banks. A central banker. So what on earth is someone like me doing at a conference about sustainability? After all, my industry has a reputation for being grey, not green. Concerned with greenbacks, rather than green banks. Pinstripes, not pine trees. But today I’d like to talk to you about why the smart money is on green finance. Why we have to take on the challenges together. Why we need to make the sustainable development goals work. Why bankers should act Today I want to reach out and share with you some of the insights we have learned as a central bank. Because most of these issues are not just confined to the financial sector. First I’d like to explain why you should focus on sustainability. Twenty years ago a company often would only ‘go green’ for reputational reasons. But today there are other reasons why you cannot afford to ignore sustainability. Sound risk management means the financial sector needs to worry about sustainability risks. We simply cannot sit back. Because we have reached the stage where the cost of inaction is greater than the cost of action. Suppose you have major investments in high-carbon assets. These assets have retained their value for many years in the past. But can we just assume that these assets will retain their value in the years to come as well? Of course not. During the transition to a low-carbon economy, these assets could become unwanted or obsolete, as new, cleaner and cheaper energy replaces them. This audience is full of disrupters that work day and night to bring about that very transistion. Under new laws limiting the use of fossil fuels, ‘old’ forms of energy may even need to stay in the ground. These valuable assets could become stranded. In the financial sector we call this the carbon bubble. And we must make sure that the big green bang does not cause this carbon bubble to burst. So be aware of the risks and manage them properly. But besides risks, a more sustainable economy also offers us opportunities. We are seeing this happening right now in the financial sector, where the issuance of green bonds is growing fast, but it is of course evolving across all sectors in all continents. How – and where to start While it is clear that the business community needs to take on the risks and opportunities related to sustainability, it is less clear how it should go about this. Usually, the first thing companies want is a strategy. Now, if we want to combat climate change, if we want a sustainable economy. Wouldn’t it be wonderful if individual companies’ strategies would somehow be aligned with a much broader world strategy? Wouldn’t it be wonderful if such a strategy for the world existed? If we are all in the pursuit of happiness, if all men are created equal, not just those of us living today, but all men and women that will come after us, shouldn’t we urgently formulate a strategy for the world? Fortunately, the world does already has such a strategy: The Sustainable Development Goals of the United Nations. And, keeping that in mind, a suggestion I would give to companies is: Innovate, while using what’s already there. Join a platform, cooperate, form strategic alliances; get an overview of what’s happening; connect with others. Today is a great example of just that. For example, the Netherlands Banking Association has recently launched a public consultation document proposing how the Dutch banking sector can support a number of the UN Sustainable Development Goals. Businesses could follow suit by launching a similar initiative. We cooperate on this matter as well: The Dutch central bank is part of the G20 Green Finance Study Group and of the European High Level Expert Group on Sustainable Finance. This expert group is mandated by the European Commission to come up by the end of this year with nothing less than a comprehensive strategy to turn EU financial regulation green. It will publish its interim report by means of public consultation by the end of next month. If you want to directly influence EU green finance strategy and policy please don’t hesitate to send in your comments. Using our convening power on a national level, the Dutch Central Bank created a national cross-sectoral Platform for Sustainable Finance, bringing together representatives from all over the financial sector as well as the relevant ministeries, and stimulating the creation of working groups that take on a range of sustainable finance issues. One of these working groups works on SDG Impact Measurement and consists of a several Dutch insurers, pension funds and banks together with major multinationals such as Philips and Unilever. Their goal is to develop a methodology that will allow them to assess the impact on the SDGs of any investments they make. If investors around the world start doing this on a large scale, you can only imagine what effect it will have on the companies that cannot deliver sustainable goods or services. This illustrates that one area where the Netherlands is a frontrunner is impact investing. Impact Investing is all about seeking measurable social and environmental benefits alongside financial returns. The Dutch financial sector is a global leader in this field. It helps create opportunities for investors wanting to generate a positive impact through their investments. As for the energy transition, the rate of the change is an important element. For the energy transition to succeed and cause as little damage as possible to our economies, it must proceed as orderly and gradually as possible. This will allow companies and financial institutions to have enough time to adapt and to make the right investments. This means that governments should start taking the appropriate measures to put us on such a smooth and gradual path as soon as possible. Public and private It is also crucial that we cooperate internationally on carbon goals. The global climate change agreement that was signed in Paris was an important first step. But we need an effective carbon price. If the cost of carbon reflects the real costs to society caused by carbon emissions, immediately green projects will have positive business cases and brown projects will no longer be profitable. An effective carbon price is the single most powerful tool we have in greening our societies, economies and financial sectors. At the Dutch central bank we are currently researching he effects of an increase in the carbon price on different sectors in the economy. Nations and regions should also develop climate laws, in order to provide investors with more security about long term developments, helping them to incorporate these long-term issues into their investment decisions. Climate is too important to depend on the volatility of all too short political cycles. This longterm clarity will foster the much needed surge of investments in sustainable projects. Since the energy transition is one of biggest challenges we face this century, cooperation between the government and the market is also crucial and, as we have learned in the Netherlands, most certainly possible. The Dutch government recently introduced a new law requiring all office buildings to have an energy label of at least C by 2023. While that gives the owners of these offices about 5 years to adjust, financial markets responded immediately. Dutch Financial institutions wrote letters to their clients, requesting them to hand in plans to reach Label C on time if their offices did not already meet this label. Even though it is a tough challenge, the market is thus already responding, and their efforts seem to be working. This shows how important cooperation between the public and the private sector is. If the government states clear deadlines, the market will respond effectively. I have spoken about the importance of sustainability. How the business community can get involved in sustainability. Why it is important to start now, and how the market and government can complement each other. Before I finish, I want to remind you that even the smallest of changes can make a world of difference. The power of a single word: sustainable A few years ago we changed our mission statement to include the word ‘sustainable’. “DNB seeks to safeguard financial stability and thus contributes to sustainable prosperity in the Netherlands”. “You’re the Dutch central bank, not an NGO!”, said some. Well, our institution has been around for over two centuries. We take the long-term view. And believe me, central bankers and prudential supervisors love the concept “long term”. It is in our genes. It’s our business to know that the insurance company we pay our premiums to today, will still be around if our house burns down twenty years from now. That when our children start saving for their retirement, they will be able to collect their pensions half a century later. And that’s also what sustainability is about: what works in the long term. Conclusion Adding just one word to your mission statement can set an entire organisation in motion. And if that organisation brings together other organisations, if it actively seeks cooperation with other parties, that word will not only spread, but it will lead to real actions. To a great many real actions. And if the word is well-chosen, these actions might do a great deal of good. I have a statement to make. I am a banker. Not just a banker, but a supervisor of banks. A central banker. Our mission is sustainable prosperity. But I am not just a banker. I am also a citizen, a father, a fellow traveller on Space Ship Earth. Sustainability is our core business as a Central Bank. This holds true for all of us. By its very definition, we will not be able to survive in an unsustainable world. Already the Framers of the American Constitution knew this: “in order to secure the Blessings of Liberty, to ourselves and Posterity”. Posterity. The Framers considered this concept of such utmost importance that they placed it most prominently in the very first sentence of the Constitution. Even before the first Article. Posterity. Sustainability. Now I’d like to end by reaching out and passing the baton on to you. With a five-point call to action: 1. Cooperate – only together we can make a difference 2. Manage the risks 3. Seize the opportunity 4. Be inspired by the Sustainable Development Goals 5. Start now!, and now that this is a room full of individuals that have already started: Continue ! Thank you. | netherlands bank | 2,017 | 6 |
Keynote speech by Mr Frank Elderson, Executive Director of the Netherlands Bank, at the UBS - ECOFACT Conference "Exploring the Next Frontier in Banking and Insurance: Responding to Sustainability Regulation", London, 6 June 2017. | When Bank of England governor Mark Carney gave his famous speech on climate change almost two years ago, he mentioned ‘the tragedy of the horizon’. He was referring to how the catastrophic impact of climate change will be felt beyond our traditional horizon – imposing a cost on future generations that the current generation has no incentive to fix. The country where I’m from is a striking example of this phenomenon. One quarter of the Netherlands lies below sea level. This area is home to nearly one third of the population, and the heart of our economy. Although we are highly vulnerable to the effects of global warming, we still have one of the most carbon-intensive economies in Europe. As well as being heavy oil and gas consumers, we are also a major producer and exporter of it. So perhaps I’m not in the best position to preach to the world about the risks of climate change. But as a representative of an organization whose mission is to safeguard financial stability and contributing to sustainable prosperity in the Netherlands, climate change is a serious concern for me. Fortunately, a number of recent events have presented us with a new horizon, the horizon for action on climate change. The most notable of these is the Paris Climate Agreement, which entered into force last November. I will briefly mention the unfortunate recent development in that respect later on, but today I’d like to concentrate on what this action on climate change might look like. I’d also like to offer some observations on the importance of managing climate-related risks for you as financial institutions. And lastly I want to provide you with an insight into the business opportunities that are available to you. And as the right rules and incentives are introduced, these opportunities will only become ever more numerous and attractive. The theme of this conference is ‘Responding to Sustainability Regulation.’ What I want to stress to you is that, rather than waiting for the regulators, you must act now: To manage climate-related risks and seize the opportunities that the transition to a low-carbon economy offers. In the words of Axel Weber, written on the invitation to this conference: ‘Finance is about seizing opportunities and managing risk.’ That’s the spirit of the British financial sector. That is what you’re good at. So what could this action look like? After decades of scientific research on climate change, we have now entered the era of action. Climate change is no longer exclusively the preserve of scientists. Today it is also a challenge for policymakers and business people. A crucial driver of this is the Paris Climate Agreement. The agreement establishes a global commitment to limit global warming to well under two degrees Celsius. Very importantly, it provides for monitoring the reduction of emissions, and forges a pathway for more ambitious efforts, if current policies fall short of that goal. The Paris agreement has sent out a very strong signal that policymakers and regulators will intensify their efforts over the coming years. The fact that the United States has withdrawn its support is of course no small setback. But I am confident that the international community will rally together, set the right example, and press on with implementing the Paris agreement. Today’s announcement of a climate accord between the State of California and China is a vivid example of this. China, once being amongst the world’s largest polluters, is now becoming one of the global champions of renewable energy. Just a few days ago, the EU and China reinforced commitments to the Paris Agreement, pledging to: - cut back on fossil fuels - develop more green technology and - help raise $100 billion a year by 2020, to help poorer countries cut their emissions. So despite the setback, this is an encouraging development. Numerous other initiatives, both on the national and international level, are already underway. Allow me to name a few. At the end of 2015 the Financial Stability Board launched a private sector Task Force on Climate-related Financial Disclosures (TCFD). Led by Michael Bloomberg, the task force also draws its members from the British financial sector, including UBS. The consultation period for the report ended just a few days ago. The report contains recommendations for an efficient and voluntary framework for climate-related financial disclosures. And these recommendations can be used by companies across all sectors. The potential impact of this framework, when put in practice, can hardly be overstated. For the first time, it will provide investors, lenders, insurers and other stakeholders with information about the concentrations of carbonrelated assets in the economy and exposures to climate-related risks. Reliable, comparable and forward-looking information that will significantly improve your ability to assess, for example, how exposed potential investment targets are to the clean energy transition, and what they intend to do about it. Information that is crucial for kickstarting a functioning market for climate-related risk. At a European level, the High Level Expert Group on Sustainable Finance will submit its interim report to the European Commission within the coming weeks. The Group’s mission is to provide recommendations on hardwiring sustainability into the EU’s regulatory and financial policy framework, identifying obstacles to sustainability in finance, and mobilizing more capital flows for sustainable investments. I have the privilege of being a Group observer, so I can already tell you that the interim report will contain policy options that will be both concrete and far-reaching. It is now too early to go into any detail, but I would urge all of you to closely study it once it comes out and participate actively in the public consultation. It is also important to pay attention to prudential regulation of financial institutions: incorporating climate factors in the risk management of banks and insurance companies will become both a mainstream and a regulatory requirement. And this will happen sooner rather than later. Regulators don’t even have to completely change the rules for this. After all, already under current regulations, financial institutions must manage all relevant risks. Well, climate change is a relevant risk. Financial supervisors could implement this focus on climate risk management tomorrow. As a matter of fact, we do. In my view, all should. Similarly, financial institution should be aware that regulations on disclosure of sustainability factors, including climate risk, are likely to be tightened. For instance, in France, specific reporting obligations are already set out for a range of financial institutions, on how they should integrate sustainability factors in their risk management. Regulators could also encourage or require sustainability knowledge and competence of board members, for example as part of fit and proper testing. And that’s not all. Government intervention will not be confined to the financial sector, but will cover the entire economy. The UK, back in 2008, was the first country in the world to enact comprehensive general climate legislation. More and more countries, from Sweden to Mexico, from France to Singapore, are following up on their commitments under the Paris Agreement by adopting and implementing climate transition laws. The Dutch Central Bank has publicly advocated for a climate law being passed in the Netherlands as well. These laws are intended to provide a predictable pathway to a low-carbon economy. These include clear targets, and new regulation to meet them on time. The point of all this is not to give you a comprehensive overview of all the new regulation coming at us, but to signal that when it comes to climate change: governments mean business. And that has profound implications for the risks and opportunities your company faces. And even the greatest climate sceptic on Earth cannot afford to ignore these risks. At the same time, new regulation will create great opportunities for those who invest with foresight. And as the financial sector, seizing opportunities and managing risks is your core business. Being a prudential regulator, you’ll forgive me if I start by discussing the risks. There are generally two types of climate-related risk. First, physical risks: the impact today on insurance liabilities and the value of financial assets arising from climate-related events, such as floods and storms that damage property or disrupt trade. Second, transition risk: the financial risks that could result from the process of adjustment towards a low-carbon economy. Changes in policy, technology and physical risks could prompt a reassessment of the value of a large range of assets as costs and opportunities become apparent. While some are still debating the scientific evidence for climate change, representatives of the insurance industry know that physical climate risks are already a reality, affecting their underwriting strategies. As Governor Carney stated in his climate speech, a Lloyd’s of London study estimated that the twenty centimeter rise in sea-level around Manhattan since the 1950s increased insured losses from superstorm Sandy by 30% in New York alone. Ever since Hurricane Andrew in 1992 led to serious losses, the insurance industry has used natural catastrophe models to analyse and measure risk more accurately. Use of these instruments is now the norm. Insurers therefore seem well-prepared to manage physical risks in the near term. But further ahead, beyond the typical insurer’s horizon, previously unimagined levels of physical risk could shift the balance between premiums and claims significantly. This threatens solvency, and may even make some risks uninsurable. If high levels of greenhouse gas emissions continue, scientist predict that oceans could rise by close to two meters by the end of this century. Just think of the threat to the combined value of coastal property. And by the way, this estimate could turn out to be on the conservative side, given current uncertainties surrounding the stability of the Antarctic ice shelfs. While physical risks pose a serious threat, transition risks may be even more important for financial institutions. Transition risk could also be called the risk of success. Take for example the commitment made in Paris to limit global warming to well under 2 degrees Celsius. Estimates vary, but it is certain that the remaining budget for carbon emission relating to this target will make large amounts of existing reserves of oil, gas and coal unusable. The exposure of financial institutions to the resulting write-offs of these stranded assets and the repricing of companies is potentially huge, and could pose a threat to financial stability. Possible delays in policy changes do not remove these risks, but magnify them. This is because we may see more significant and abrupt policy changes and market adjustments further down the road. This is very important: the longer we wait, the more radical the measures need to be. What I want to stress to you is that despite the uncertainty, or even controversy, about the pace at which new policies are implemented, financial institutions and regulators have to take transition risks into account. Also here, the horizon for action is approaching fast. Climate-related risk is rapidly becoming a mainstream risk that financial institutions have to manage, using for example scenario analysis. And it’s not just the regulators. Increasingly, markets and investors are asking: how do you model and identify relevant trends and risks? How robust are your strategies given different scenarios and contingencies? Some institutional investors see climate risk management as a key indicator for the quality of board-level risk management. Similarly, if you’re an investor, and you’re not already asking questions about how companies you invest in approach these risks, then it’s high time you did. We’ve looked at the risks. Now let’s turn to the opportunities. Financing the transition to a decarbonized economy presents a major opportunity for financial institutions. It implies a sweeping reallocation of resources and a technological revolution. Estimates for investments required in areas such as efficiency improvements, renewable energy, nuclear energy, carbon capture and storage amount to as much as 1 trillion euro annually. Technological innovation is assisting this transition. This includes developing efficient heating solutions, advances in LED lighting technology, utilizing geothermal power, and developing electric vehicles. I know there is still considerable uncertainty about the potential returns on these investments. But I expect this uncertainty to diminish significantly as international disclosure standards make climate risk more transparent, and governments introduce clarity by setting targets, rules and deadlines. This has the potential to transform green investment from a niche market into a major investment class of its own.. Let me give you an example of how public policy can kick-start a whole new market for green investment: early this year the Dutch housing ministry introduced new rules requiring all commercial real estate in the Netherlands to have an energy rating label of C or better as of 2023. Buildings that fail to meet this requirement can no longer be used as offices. Dutch banks are getting involved by adding surcharges to, or outright withholding, funding for non-sustainable buildings. At the same time they are offering energy efficiency plans and financing to owners that need to upgrade their buildings. Expectations are that the estimated 860 million euro in investments necessary to meet the target will be realized much earlier than 2023. There are more examples. I name but two: All new public transportations busses in The Netherlands will be emission-free as of 2025. According to current government policy in The Netherlands the same holds true for all new passenger cars of 2035. My expectation is that this process will play itself out over and over again in an increasing number of sectors within the economy. Public authorities will set deadlines. Deadlines for zero-emissions/climate neutrality to be reached by a certain date: • in public transportation • in shipping • in aviation • in housing • in agriculture • in manufacturing etc etc And the private sector will jump on the opportunity. And often beat the deadline. As it makes business sense to do so. After all, by acting now, financial institutions have a first mover advantage over their competitors. They can build up specialized knowledge that is valuable for assessing risk and return. For example, over 90% of wind farms in the Netherlands are financed by one bank. The same argument applies to all kinds of financing for frontrunners in sustainability. Despite uncertainty over how public regulation will develop, there is still plenty of opportunity for no-regret actions. Ladies and gentlemen, International consensus has been growing for some time that climate change is an urgent problem. What is new is the growing resolve among governments across the globe to do something about it. And I am convinced that the recent setback because of the decision of the present US administration will serve only to strengthen the resolve of the global community, including many, many public and private actors in the US, and foster even greater international cooperation. Both climate change and government action will create new risks and opportunities. Risks and opportunities that you can and should anticipate today. So sit around the table with your authorities to discuss the obstacles for sustainable finance, and what changes in regulation are necessary. As our experiences with the Platform on Sustainable Finance in the Netherlands show, your input is highly valuable. Don’t get me wrong: I am not here to sell you anything. As a regulator it is not my place to convince you to start financing green investment, or to buy green bonds just for the sake of it. Some of you may even be skeptical about the scientific evidence for climate change, still others may doubt the ability of governments to take action. Coming from an oil and gas-addicted little country below sea level, I would understand you for not believing me. But you don’t have to. As uniform disclosure standards start to be adopted better information will become available about the carbon intensity of companies, and how they manage their risks and prepare for a low-carbon world. Information that will allow you to assess for yourselves how their valuations might change over time, and what the risk is to your capital. Information that brings the horizon more sharply into focus. On this very day, 6th of June, 73 years ago as part of operation Overlord 62,000 British soldiers crossed the Channel to liberate Western Europe from barbarism. Churchill said of the Normandy landings: “This vast operation is undoubtedly the most difficult that has ever occurred. It involves tides, wind, waves, and contact with conditions which cannot be fully foreseen.” Those soldiers overcame the challenge brilliantly by showing courage, devotion and skill. And I believe this spirit is still alive and well in the British business community. It’s the spirit that does not walk away from a challenge, but stands up to meet it, and turns it into an opportunity. Not oblivious to risk and danger, but with your minds and motives sharpened by it. Aware that what is in your company’s interest also helps preserve a world that is rapidly changing. The challenge today is called climate change. Let’s be aware of the risks and turn them into opportunities. Ladies and gentlemen I wish you a productive, stimulating and memorable conference. Thank you. | netherlands bank | 2,017 | 6 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the 10th jubilee edition of the National Bank of the Republic of Macedonia's Conference on Payments and Market Infrastructures "Drivers of European Payment Integration - Innovations and Cooperation", Ohrid, Macedonia, 7 July 2017. | DRIVERS OF EUROPEAN PAYMENTS INTEGRATION: INNOVATION AND COOPERATION Op 7 juli 2017 sprak Klaas Knot over samenwerking en innovatie in het betalingsverkeer, op het tienjarig jubileumcongres over het Europees betalingsverkeer Drivers of European payments integration: innovation and cooperation Ohrid, Republic of Macedonia, 7 July 2017 Ladies and gentlemen, First of all, I would like to thank the organizers of this conference for inviting me to speak in this beautiful location. The beauty of Ohrid and its lake is already well known to us in the Netherlands, mainly through the books of A. den Doolaard. There is even a monument to the Dutch author here in the city. While I was out jogging this morning I was able to admire the lake’s beauty for myself. However, I’m not just here for the scenery, but also for this conference of course. This event is already in its tenth year, which is reason to celebrate! It is the result of fruitful cooperation between the National Bank of the Republic of Macedonia, Banco de Portugal and De Nederlandsche Bank. Over the past decade, the conference has become a meeting place for central bank officials from the region and beyond. It provides an ideal platform to exchange knowledge and experiences on a wide range of important issues affecting the payments industry. And the theme of this year’s conference could not be timelier. I will start by reflecting on European integration and cooperation, before discussing two specific innovations in the payments industry. European integration So let’s begin with the issue of European integration. It means, put simply, removing, or at least lowering, borders between countries for people, goods, services and capital. The basic idea is to enlarge markets. This results in increased competition, which generates economic growth and prosperity. Now, you may know what some say about European integration: ‘two steps forward, one step back.’ However, this metaphor has been used to describe political integration in the EU. I do not believe it applies to economic integration. With the obvious exception of Brexit, economic integration in Europe is progressing at a constant rate – and it is undoubtedly very successful considering the steady growth in prosperity. European economic integration can entail coordination or even unification of economic policies. A prime example of this is the EMU, which establishes a common monetary policy for the euro area. Even when policies are not aligned, economic integration is still possible. This can occur through for example harmonized technical standards and systems, like the Single Euro Payments Area, or SEPA. SEPA became operational in 2014. As a result, the fragmented national markets for euro payments became a single, European market. The project involved developing common financial instruments, standards, procedures and infrastructure, through cooperation in the payments sector. Two drivers of integration This conference’s theme refers to two drivers of payments integration: innovation and cooperation. However, in my view, another important driver for integration is legislation and regulation. Perhaps it is even a precondition for integration, because reducing or removing national borders requires the legislator to take the necessary action. In the case of SEPA, for example, it was the European Commission which established the legal foundation through the SEPA Regulation, and other secondary regulations. Cooperation is also vital for integration. The commercial and technical standards for payment instruments in SEPA were developed through close cooperation between European banks. Cooperation between central banks is of course also very useful. It involves developing effective policies and institutions, through for example staff training. This enables central banks to learn from each other. I am therefore delighted with the long-standing relationship between NBRM and DNB, and the resulting cooperation and knowledge transfer. Integration and innovation Now let me turn to the relationship between integration and innovation. Is innovation a driver for integration? Yes, to some extent. If an innovation is easily accepted in various countries, replacing other, older technologies or instruments, international differences disappear. Internet and smartphone technology are great examples. They are relatively new and form the basis for common and new payment methods across Europe. I will come back to this in a minute. Yet, I think that there is also a reverse causality. In plain English, integration is also a driver for innovation, at least in the eyes of economists. When borders are removed and trade increases, new ideas and new technologies emerge, enabling creative entrepreneurs to turn these into new products. For payments in particular, having the same standards boosts innovation, which produces network effects. The entry of a new merchant or consumer increases the value of the network for all participants. When many people use the same internet payment method, for example, more e-merchants will want to offer this to attract more customers. And when these customers find the payment method convenient, they will tell others. This word-of-mouth advertising leads to more use of that payment instrument. This creates economies of scale, lowering the cost of each transaction. What I have just described, is economic theory, the ideal world. In reality, of course, integration and innovation are not as smooth. Integration, for example, may require compromise, and comes with adjustment costs. There is a silver lining, though, as adjustment to new technologies also presents opportunities to renew the infrastructure and do away with legacy. Network effects and economies of scale may also result in concentration. While concentration can offer efficiency benefits, there is a risk that the resulting market power will be misused. Apart from the two-way causality, integration is not the only driver for innovations in payments. There are several other possible drivers. In 2012, the Bank for International Settlements (BIS) published an in-depth report on the matter. It was based on an analysis of over 120 innovations reported by 30 central banks. The report distinguished a number of exogenous and endogenous factors that could serve as either a driver or barrier for retail payments innovations. The report revealed that the two main endogenous factors are cooperation and standardization, which we have already discussed. The three key exogenous factors are, not surprisingly, technological developments, regulation, which we have also dealt with, and user behavior and user demand. The report suggested that user demand may even be the most important driver for innovation, since it forms the basis for a valid business case for suppliers. It is ultimately the users, normal people and businesses, who determine an innovation’s success. What is then role of central banks in payments innovation? This role is, in my view, two or threefold. Central banks can monitor and assess the relevant developments. It is also up to them to give some guidance to markets, explain what their policy objectives are, and help foster public awareness of specific issues, like security. And last but not least, they can also facilitate new developments, particularly if changes are needed in settlement procedures, which is their natural domain. Trends in retail payments Although the BIS paper was published five years ago, I think its findings are still highly relevant, and indicate what we can expect in terms of retail payments innovation. The report identified a number of trends. First, the market is dynamic, so although there are many new developments in payments, only a few survive. Second, most innovations are developed for the domestic market, and not many have international reach. Similar types and categories of innovations were reported in many countries, although the exact functionalities differed according to domestic market conditions. This is striking, in view of today’s theme. Again, it implies that the relation between integration and innovation is not so clear. Other trends were an increased focus on higher processing speed, and a greater role for non-banks. Specific recent examples Let me illustrate this by discussing the two most significant innovations in European payments right now, PSD2 and instant payments. PSD2, the revised EU Payment Services Directive, is an example of legislation intended to increase competition and stimulate innovations in the European payment market, while harmonizing market conditions and encouraging a level playing field. The most important element of PSD2 concerns payment account access. That is: consumers, when making an online payment, have the right to make use of new service providers. Banks are obliged to grant these service providers access to their accounts. In exchange, the payments initiation service providers, and account information service providers will be regulated and supervised. They will therefore need to fulfill various prudential requirements, as well as requirements in the field of data protection. The strategic importance of PSD2 can hardly be overestimated. It is potentially enormous. PSD2 is not only legislation that banks must comply with. It also provides banks and the new service providers with opportunities to develop new products, by working together. Open Banking, as it is called, unleashes third party creativity. Banks’ online interfaces become platforms for new services. Interestingly, we are still not sure what many of these services will be. In view of this outlook, DNB supports the objectives of PSD2. It promises to a deliver a breakthrough in banking and in payment services in Europe. Another trend is instant payments. This means that when the payer initiates a transaction, the payee’s account is credited and the payer receives confirmation, all within a matter of seconds. It implies immediate or close-to-immediate interbank clearing of the transaction. Instant payment services must be available continuously, 24/7/365. Quite a few countries already have instant payments. In the euro area, it should become available by the end of this year due to the efforts of the Euro Retail Payments Board (ERPB), chaired by Yves Mersch. I am sure that Yves will discuss this subject later. The clearest benefit of instant payments is that the end-user is able to quickly complete time-sensitive payments, wherever and whenever necessary. Corporate customers will receive funds faster, which makes a substantial difference in terms of cash flow and liquidity management. Another advantage is the finality of instant payments, which is particularly useful in e-commerce and other situations where goods or services are only delivered against the payment. Clearly, instant payments will become an alternative for cash, which also offers finality, and for credit cards in an online environment. More strategically, instant payments are reason to develop a new payment infrastructure. This may provide the basis for service enhancements and value-added services. The combination of instant payments and PSD2 also offers new opportunities. New services will be offered online, by banks and non-banks, and payments will be settled in a few seconds, which is what consumers and retailers expect in today’s increasingly digital word. Traditional obstacles in terms of time and space are gradually being removed. Payment markets will become fully integrated! Conclusions I want to end with this positive outlook in mind. Payment integration clearly contributes to greater efficiency and economic growth. Which is why we must continue our efforts. Rather than the previous metaphor on European integration, I prefer what Jacques Delors said: ‘Europe is like a bicycle. If it doesn’t move forward, it will fall over’. I find this perspective much more appealing, not only because I’m Dutch and we cycle everywhere. It shows that economic integration needs momentum. Moreover, innovation needs to be stimulated by other means than just striving for integration. Legislation and regulation can be helpful, central banks can provide guidance, like the ERPB did with instant payments. They can also stimulate cooperation between market participants and public authorities, which can further innovation. This brings us back to the overarching theme of the conference. I hope that today’s program and the panel discussion will shed new light on the various issues in payments and payment innovations. I would like to encourage you to use this opportunity to actively participate in exchanging views. I wish all of you another day of lively and productive discussions! So let’s make the organizers proud, and ensure this tenth edition is one of the most memorable conferences of the year. | netherlands bank | 2,017 | 8 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at Econopolis' Twain Talks, Brussels, 20 September 2017. | “Striking the right balance in policies and institutions in the euro area” Speech by Klaas Knot, At Econopolis’ Twain Talks Brussels, 20 september 2017 Good morning all, Thank you for inviting me here to speak about economic policy in the euro area in the spirit of Mark Twain. In the instructions to this Twain Talk, the organizers asked me not to focus too much on socalled “known knowns”. This is an easy task for a central banker in current times. In recent years, we have faced many unprecedented policy challenges. And we have had to implement policies that reached well beyond what we considered conventional before the crisis. Yet, by doing so, central banks have played an important role in stabilizing the economy. As a consequence, we now face a much improved economic environment. Today, I will give you my views on the way forward for the euro area against the backdrop of this improved outlook. Acknowledging there are still many unknowns along the way, I will stress that the time has come to rebalance our economic policies. Away from non-standard monetary policies to addressing the structural and institutional factors that have been holding back growth. Monetary policy during the crisis First, however, let me quickly talk you through how we got to where we are now. Since the onset of the financial crisis in 2008, it has not been an easy ride for the euro area. We have seen drastic adjustments in three different macroeconomic sectors: The financial sector has had to repair its balance sheets. The private sector has been in a deleveraging mode for nearly a decade. And governments have also had to make major fiscal adjustments. These deleveraging efforts have been holding back growth. As a result, over the past decade, economic policy in the euro area has mainly involved crisis management and stimulating demand. Partly owing to limited fiscal space in many euro area countries, monetary policy at times became the only game in town. Even after policy rates had been brought down to zero, central banks have proved creative in finding ways to fight the economic problems caused by the crisis. In this environment, the ECB had to take far-reaching measures. We have substantially lowered our main policy rates, even into negative territory, to stimulate consumption and investment. Moreover, several non-standard monetary policy measures were taken to bolster the transmission of low policy rates in the face of persisting market tensions. In 2015 there were serious concerns that the euro area could slide into a deflationary spiral, a selfreinforcing spiral of falling prices and output. Against this backdrop, in 2015 the ECB introduced quantitative easing, QE, to provide further monetary policy accommodation. By lowering long-term interest rates, QE has helped to further loosen financing conditions for households and businesses. This in turn should have a positive impact on their spending decisions and, ultimately, on inflation. Rebalancing necessity, effectiveness and risks When deciding on monetary policy measures such as QE, decision-makers typically assess policy options along three dimensions: necessity, effectiveness and side effects. Since these guiding parameters change over time, continuous monitoring and reassessment are needed. And this is exactly what we are reconsidering right now when reflecting on how to proceed with our QE-program beyond 2017. Against this backdrop, let me discuss in a bit more detail how I reflect on the dimension of necessity of at the current juncture. A dimension along which the considerations have changed quite significantly since we first started with QE in early 2015. Allow me to highlight four specific elements. First, financing conditions in the euro area are currently very accommodative and highly supportive to growth.This is largely a consequence of previous ECB monetary policy measures. Second, financial fragmentation between euro area countries has been reduced. This is reflected in a more homogenous transmission of monetary policy decisions across jurisdictions compared to what we observed during the crisis. Third, the economic outlook has improved significantly. Specifically, we have now registered twelve quarters of reflationary growth. In other words, three years of economic growth above potential. Finally, and most importantly, against the backdrop of an increasingly reflationary environment, the tail risk of a deflationary spiral is no longer imminent. Consequently, the main rationale for central bank asset purchases has disappeared. To summarize, assuming the robust economic developments continue we can be confident that inflation will return to levels consistent with our aim of below but close to 2% over the medium-term. In this environment the necessity of QE is clearly less obvious. At the same time, some may be concerned with the challenges of normalizing monetary policy. However, while there will indeed be challenges along the way, I see no reason to be overly dramatic. Let me discuss some considerations that are often overlooked by commentators. First, even if we no longer expand our QE-program, we are still committed to a reinvestment policy. This reinvestment policy implies that the ECB will maintain a large portfolio of assets on its balance sheet for a pronounced period of time. Alongside low policy rates this will ensure that financial conditions will remain accommodative even when the net asset purchases have been reduced to zero. This way monetary policy will continue to support the economy and a gradual increase of inflation to levels consistent with our aim over the medium-term. Second, some have looked at the recent appreciation of the exchange rate of the euro as a source of concern. And indeed, excessive exchange rate volatility and overshooting can be detrimental to economic growth and price stability. However, it is often overlooked that exchange rates move endogenously in response to changes in the economic outlook and market sentiment. For example, the recent appreciation of the euro area reflects to an important extent a more benign assessment of the economic outlook vis-à-vis the rest of the world. And safe-haven capital inflows have also increased in response to increased political uncertainty in other major economies. Through this lens, the appreciation of the euro should be considered a reflection of the relative strength and stability of the euro area economy. A clear indicator of the factors that underlie the reduced necessity of continued asset purchases that I have outlined earlier. All supporting the call for a gradual but decisive rebalancing away from non-standard towards traditional instruments of monetary policy. Tilting the broader policy mix Thus, monetary policy has played and will continue to play its part in helping to keep the economy at solid footing. By itself, however, monetary policy is not enough to achieve and maintain sustainable economic growth. Indeed, structural factors play a key role in the low prospects for growth. Calling for yet another reorientation of macroeconomic policies. Let me explain this in more detail in the remainder of this talk. Many countries have failed to adapt to the changing environment in recent decades, most importantly in terms of technological progress and globalisation. In addition, the monetary union removed the exchange rate as an adjustment mechanism for member states. By 1999 it was clear that several member states needed structural reforms to strengthen alternative adjustment mechanisms, like wage and price flexibility. In practise, however, structural differences between EMU countries have not lessened, unlike in the rest of the EU. The lack of structural convergence has had important real effects. Since 1999, income differences between the initial EMU member states have not been reduced. The structural nature of the disappointing growth in the EMU calls for structural reforms. These reforms should expand the growth potential and adaptability of member states. Measures to this end could focus on product markets, including the liberalization of the service sector. In many countries the quality of institutions also needs improvement. This includes the efficiency of the judicial system in settling disputes, protecting property rights and dealing with non-performing loans. The OECD estimates that the adoption of best practices in areas like these could increase GDP by four to seven percent. Strenghtening EMU further Every country faces its own particular challenges. In addition, there are some common elements in the problems faced by euro area countries. Indeed, part of the European growth problem is related to design flaws in the monetary union. Much has already been done to tackle them. I’m referring to: - the strengthening of the European fiscal rules and the introduction of new rules aimed at preventing macroeconomic imbalances; - Launching the European Stability Mechanism, the ESM, to provide financial assistance to countries in difficulties; - And finally, establishing the banking union to unravel the sovereign-bank nexus. While these measures have reduced the risks of severe financial turbulence, the EMU could still do with additional improvements. First and foremost, we need a better balance between liability and control. Let me explain what I mean. In the long run, a monetary union is only politically stable if the countries that are liable for certain risks, also have the means to control and mitigate these risks. The original EMU setup was thought to strike the right balance in this respect. Policy coordination was relatively mild, with the European fiscal rules as the most binding element. In return, Member States promised not to assume liability for other member states’ debt, the so-called no-bailout clause. But during the sovereign debt crisis, adherence to the no-bailout clause proved too costly. Both public risk-sharing and coordination increased since then, in a move towards the upper right-hand quarter of the charts. However, in practice the move has been larger in terms of risk sharing, than in terms of policy coordination. This is mainly because compliance with both new and existing rules is still lacking. Compliance with fiscal recommendations is reasonable in bad times when budget deficits are above 3%, but poor in good times when countries should balance their budgets. Compliance with the Macroeconomic Imbalances Procedure and the European Semester should also improve. Of the recommendations issued in 2015, only 4% were implemented with any substantial progress. To improve the balance between liability and control, we therefore need to improve enforcement of the rules. This would help reduce the likelihood of new imbalances and future calls on European risksharing. Secondly, the EMU would benefit from more private risk-sharing across borders. During the crisis, European governments used taxpayers’ money to provide support. But private companies, investors and banks shared far fewer risks. Improving private risk-sharing would help reduce dependence on public risk-sharing. It could also help smooth idiosyncratic business cycle shocks, as appears to have been the case in the U.S. and Germany. Does the answer lie in more integration? Of course, the key question is: how do we further strengthen the EMU? It is often assumed that deeper European integration is the answer, for example by way of more binding policy coordination. Many also favor more public risk-sharing, such as the introduction of a European budgetary stabilization fund. Further European integration would indeed probably lead to a better functioning EMU. However, major steps forward are controversial, and may not be politically feasible in the current environment. In countries like The Netherlands, controversy mostly centers around a further increase in public risksharing. The fundamental problem is that Member States still differ substantially in terms of adaptability, overall competitiveness and institutional quality. If starting positions differ so much, a stabilization fund might not result in ex-ante fair risk-sharing, but in a quasi-permanent one-way transfer system. Therefore, any further increase in public risk-sharing is only desirable if it is accompanied by a significant risk reduction. This however requires a further transfer of sovereignty; a policy that is equally controversial in many Member States. As a result, large leaps forward in integration are presently hard to conceive. Given all the steps that have already been taken over the past years, I however believe that with a series of relatively small steps aimed at restoring the balance between liability and control we can already achieve a great deal of improvement. Let me therefore conclude by mentioning four no-regret options. First, improve compliance with European fiscal and macro-economic rules, by simplifying and strengthening the rules. Second, introduce some form of sovereign debt restructuring mechanism. In the future, it should be ensured that the public debt is sustainable before countries gain access to financial support. Third, complete the banking union. Reducing systematic differences between banks from different Member States will pave the way for a European Deposit Insurance Scheme. Finally, encourage private risk-sharing across borders via more robust financial integration. Conclusion Ladies and Gentlemen, allow me to conclude. Over the past decade, euro area policy making was mainly directed at short-term stabilization, with the ECB occupying an important role. But with the immediate economic crisis behind us, and with the economic outlook improving, we need a recalibration of euro area policy. The focus of policy makers should shift to the structural and institutional problems that are still holding back growth. This is where relatively small steps can make a big difference. Or to quote Mark Twain: “Continuous improvement is better than delayed perfection.” Thank you for your attention. *** | netherlands bank | 2,017 | 9 |
Speech by Mr Frank Elderson, Executive Director of the Netherlands Bank, at the NpM CEO event Platform for Inclusive Finance, Den Haag, 7 September 2017. | Towards a better, more digital, financially inclusive world I'm sure we've all been in this situation. You've got something really important to do, but it never makes it to the top of the agenda. Instead, there's always something more urgent that comes along and takes up all your time. Something you need to deal with right away. Which means putting everything else on hold. A wise man once said: "Most things that are urgent are not important. And most things that are important are not urgent". Today I'd like to present you with three pearls of wisdom from this man. You've just heard the first. I didn't mention this because you don't appreciate the urgency of financial inclusion, but because you so admirably manage to keep the subject constantly on the agenda. The man I just quoted was a Republican President of the United States. Although the president I am referring to spoke these words in nineteen fifty-four, they form the basis for a time management technique which is still widely in use today. Unfortunately – among some young people – this historical figure is better known for this technique rather than for all his other achievements. I am of course talking about Dwight D. Eisenhower. The man who was not only President of the United States, but before that was the general who played such a paramount role in liberating Europe from fascism, putting an end to the Second World War. Eisenhower was committed to freedom, racial equality and fighting poverty. He believed in equal opportunities for all. And he had some very astute and powerful words to say on these matters. Words which are still reflected in the management theories we use today. The technique I referred to is called the Eisenhower matrix. I'm sure some of you are familiar with it. This simple matrix provides you with an insight into how urgent something actually is, and helps you set your priorities. But today I'm not just going to draw on Eisenhower for inspiration. I'm also going to look to you for inspiration. Because you have succeeded in bringing a sense of urgency to a very important matter. And you have done this despite facing a deadline that's a long way off, while also having to contend with a constant stream of other issues. Over the years you have taken great strides towards financial inclusion. And you continue to seek further cooperation. This brings me to the second of Eisenhower's maxims. He reiterated how cooperation is a critical success factor for every mission: ”Leaders need to work with others and build coalitions if they want to get things done.” He said. What things do we want to get done? And why are we concerned with financial inclusion at De Nederlandsche Bank? Financial inclusion relates directly to sustainable prosperity. And that's definitely an area that concerns us at the central bank. Because contributing to sustainable prosperity is an issue at the top of our agenda. That is why, six years ago, we added the word 'sustainable' to our mission statement. Although that's just one word. It can make a big difference. Our mission statement now reads: We seek to safeguard financial stability and thus contribute to sustainable prosperity in the Netherlands. We don't just do this by focusing on ourselves, following the principles of corporate social responsibility, however important that is. We also focus on the outside world, considering how we can incorporate sustainability in our role as central bank and supervisor of the financial sector. This is what our stakeholders ask us to do: Use that influence, use your influence, your convening power, use the leverage that you have. International and national That is why, in the sustainability debate, we act as a catalyst, and bring our convening power into play. Because we're committed to sustainable prosperity, we're also concerned with raising awareness of financial inclusion. And we aim to do this both at home and abroad. On the international stage, we share our knowledge and insights of payment systems. Many countries do not have the same level of basic efficiency in this area as we do here in the Netherlands. We do what we can to help improve these systems around the world. We did so in Indonesia, Macedonia and Aruba, for instance. We visit these countries to help them develop a stable and secure payment system. I'm sure you're fully aware of the challenges facing many countries. As members of this platform, you are active in over 90 countries and together you invest almost 2.8 billion euros in the financial inclusion sector. Praiseworthy efforts indeed. But we also still face challenges here in the Netherlands. Although these challenges are of a very different order to those in many other parts of the world. That's because in the Netherlands, a lot is already very well arranged. For example, we have a stable system of payments, and everyone has access to financial products and services, such as bank accounts, insurance and pensions. Over 99% of Dutch citizens have a bank account. Plus, in the Netherlands, we also devote a lot of attention to financial education, another important aspect of financial inclusion. You also play a big role in this respect. These initiatives include the Money Week project for primary school pupils, the Money Wise platform, as well as the activities of Child and Youth Finance International. Yet there's another aspect of financial inclusion I'd like to see us pay more attention to in this country: resilience. We strive for financially resilient consumers in society. Consumers should, in order to be resilient, make prudent and sound decisions. That's one aspect on which we still have much work to do in the Netherlands. It is apparent in several areas. Let me give you a few examples: National issue #1: vulnerable groups For one, the impact of innovation, and the widespread digitization of financial products and services. This development means that many more people are now able to gain access to, for instance, insurance and banking services for the very first time. It's fantastic to see what innovation can deliver in this respect. However, in the Netherlands we have seen how innovation has also led to certain sections of society becoming more financially vulnerable. This is due to banks closing more of their branches and reducing the number of ATMs. At the same time, the new products and services that FinTech companies offer are sometimes still inaccessible for certain groups. These include the elderly, the handicapped, and people with low digital literacy. These days, innovative firms focus on specific or younger target groups. The early adopters. This is a logical business strategy. However, during this transition we must also consider the needs of more vulnerable groups. After all, access to these products and services should be available to everyone. While we are dismantling old systems and introducing new ones, the vulnerable among us may not always be able to keep up. They run a risk of becoming disenfranchised – a risk of being left out in the cold. National issue #2: exclusion The second development I'd like to call your attention to under the aegis of ‘financial resilience’ is the use of data analysis to make services more personalised. Again, we can see how this has had a very positive impact internationally. For example, if a financial service provider, based on data analysis, can see a customer is reliable, then such service provider is more likely to grant that person a loan to set up a small business. But there is also another darker to this coin, also in The Netherlands. In addition to the potential violation of privacy, data analysis can also lead to the exclusion of some customers. They may, for example, be excluded from certain financial services, if, by shrewdly combining various databases, it becomes clear that they have a high risk profile, or low profit expectations. National issue #3: understanding The third and final aspect of financial resilience I'd like to discuss concerns people's understanding of financial products. Getting a mortgage or choosing a pension is not an easy process. The information provided is often highly complex. If someone takes out a mortgage they can't afford, or chooses the wrong pension, it can lead to serious financial problems. The combination of honest communication and understandable products is an important concern in this respect. ‘Consider the vulnerable people’ I'm sure you're familiar with these examples. But I've mentioned them for a very good reason. When you're designing a product or a service, I urge you, as representatives of the financial sector, to please always stop and ask yourself the question: "have I considered the more vulnerable people among us?" Examples systemic DNB approach At DNB, we don't just consider the impact on individuals or groups, we also look at the bigger systemic structures in society. And how they could affect financial inclusion. Let me give you a couple of examples of these. Starting with pensions. Now you may be thinking: isn't that actually a great example of inclusion? And you're right – it is. The way pension schemes are organised in the Netherlands – with mandatory participation – means a large group of Dutch citizens will be provided for in their old age. The flip side of this is that we currently have a system which makes a substantial number of people feel non-included. Our pension schemes leave relatively little room for people to make their own choices. There's a large group of people out there, who don't really know what's going into their pension pot. And they may only realise their pension does not meet their expectations when they retire. This may negatively impact people’s confidence in the system. This is the kind of systemic vulnerability we need to address. That's why we're committed to a modern pension system, that engages people with their own financial future. Long household balance sheets are a second example of how a system can affect the financial resilience of Dutch society. With pension entitlements on one side, and mortgage debts on the other, a lot of money is tied up in these balance sheets. In bricks and mortar and retirement provisions. This reduces people's flexibility, making them less resilient. These are the kind of systemic aspects we must consider as central bank and supervisor. We conduct economic research so we can provide the government with independent economic advice. For example, we're now studying whether there's a relationship between the level of financial inclusion in a country and financial stability in a country. I hope we can make progress in this area, as insights like this help shape the agenda. They can also lend added urgency to an issue. How to make the difference? Planning It is clear that there is still a long way to go. Both here in the Netherlands, and certainly abroad. But how do you make the difference? To answer this question I'd like to turn to Eisenhower again, and to share with you the third of his maxims. Looking back on his work as a general he said: ”In preparing for battle, I have always found that plans are useless but planning is indispensable.” Good planning therefore makes all the difference. This is something that society has come to realise more and more. We've recently set increasingly demanding objectives for essential developments. Take the United Nations Sustainable Development Goals, which contribute to financial inclusion, and the Paris Climate targets. But just setting a deadline isn't good enough. You also need a timetable. Establish milestones and make good transition arrangements. That's what works. This doesn't have to be difficult, as we've seen with improving the sustainability of buildings. At the end of last year, the Dutch government introduced a new transitional measure which maybe hasn’t attracted much attention this far, but which I consider to be very important. The new measure requires all office buildings to have at least a C energy label by 2023, and an A level by 2030. The move forces the financial sector to take action. Various initiatives are already underway to meet the new requirements. I think this is an inspirational example. It shows these aims can be achieved, by the public sector establishing ambitious but feasible deadlines, and the power of the private sector being mobilized to meet them. This could also be true for our aims for financial inclusion. Because as we've concluded today: financial inclusion is both urgent and important. We are working together to make progress on this issue. And if we set out a good timetable we will get there. I have every confidence that together we will prevail. And to that end, I have one last piece of Eisenhower wisdom for you: "Neither a wise man nor a brave man lies down on the tracks of history to wait for the train of the future to run over him." What I see here is a room full of wise and brave men and women, not passively waiting to be overrun, but actively wanting to jump on that train to shape that future. A future for all. Especially the most vulnerable, an Inclusive Future! * * * | netherlands bank | 2,017 | 10 |
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the annual Single Resolution Board (SRB) Conference, Brussels, 29 September 2017. | “Pendulums and pitfalls on the road to resolution” Speech by Klaas Knot at the annual SRB Conference, Brussels, 29 September 2017 In his address to the visitors of the annual SRB Conference in Brussels, Klaas Knot touched on three issues: 1) linking resolution to the objectives of the ECB 2) the attractive but false metaphor of the so-called “regulatory pendulum” 3) funding in resolution As rightly alluded to by previous speakers, a decade has passed since many of us lost our innocence. I certainly did! Ten years ago today I was feverishly working around the clock to design emergency safety nets and restore public confidence. The financial crisis fundamentally challenged how we regard the resilience of financial institutions. It also made clear that apart from stricter supervisory requirements, a solid crisis management framework was necessary. To that effect, The BRRD provided the tools, and the SRM regulation gave a central role to our hosts, the SRB. I have been a keen supporter of the resolution framework from the outset. As a member of the FSB, I contributed to the development of the GSIB framework and TLAC standard. Significant progress has been made since then, for instance, in establishing the rules and building institutions, as you just heard. But much remains to be done. Making banks resolvable is clearly a journey. The key challenge is to stay the course. Today, I would like to give you my perspective as a central banker on bank resolution. I will touch on three issues: First, I will explain why making banks resolvable is central to the objectives of the ECB. I will then counter the attractive metaphor of the regulatory pendulum, swinging towards looser regulation. Finally, I will address the elephant in the room called “Fury”, or funding in resolution. The crisis revealed that the resilience of the banking system is vital to the functioning of monetary policy. If banks are not sound and their balance sheets are impaired, they cannot fulfill their critical functions, such as lending to the economy. This affects monetary policy transmission. It means banks’ capacity to pass on monetary impulses to the real economy is impaired. This can hinder central banks in pursuing price stability. Before the crisis, the interaction between monetary policy and the banking system was well understood. During the crisis, this interaction was starkly highlighted. The banking system failed as a channel of monetary policy impulses, and instead contributed to propagating shocks. Banks became mired in painful but necessary balance sheet repair efforts. As a result, they have been restrained in supporting economic recovery. Banks’ crucial role in the financial intermediation of the euro area explains why many monetary policy interventions during the crisis were aimed at repairing the bank lending channel. The ECB was confronted with a systemic liquidity squeeze, and had to accommodate the funding needs of the banking sector. As such, we averted a self-fulfilling solvency crisis and resulting monetary contraction. Nevertheless, many euro area banks lost their willingness and ability to keep pumping credit into the real economy. This required further flexibility in our policy framework, such as targeted long-term refinancing operations and a negative interest policy. Partly as a result of these extraordinary measures, the monetary transmission is working more smoothly. Lending rates have eased, and the credit supply has picked up. To sum up, the crisis illustrates the importance of quickly restoring the banking system, both for the real economy and the effectiveness of monetary transmission. It has also exposed the limits and downsides of monetary instruments. Central banks can provide liquidity support but cannot restore the solvency of banks. Excessive reliance on central banks in fact delays the necessary adjustments. Cheap funding may prop up non-viable banks for too long, while making them less and less resolvable. The significance of resolution for the monetary and banking unions is without question. In the euro area there are clear further constraints to resolving banking problems. Unlike the US, there is no single fiscal policy that can dampen shocks across Member States. And unlike the US, we do not yet have a single deposit insurance system that can provide confidence to all depositors, even if an idiosyncratic shock hits a particular Member State. Also, capital markets as alternative to bank intermediation are relatively underdeveloped compared to the US. Hence, to ensure the stability and sustainability of the euro area, making banks resolvable is essential. As this session is about the road ahead for resolution, let me raise two specific issues for discussion. The first one concerns pressure on regulators to soften rules designed following the financial crisis. It is often said that financial regulation moves like a pendulum, swinging back and forth between opposite states. When a crisis occurs, there is a call for tighter rules, and the pendulum swings. Over time, as memory fades, there is a push for deregulation and fewer rules. Thus the pendulum swings back, possibly sowing the seeds for the next crisis. I would like to reiterate the concerns that my US colleagues Stanley Fischer and Janet Yellen have also voiced. Signs that ten years on, lawmakers now want to roll back post-crisis regulations, are troubling. The analogy of the swinging pendulum might be conceptually appealing, but it is overly simplistic. It suggests an inevitability and automaticity that should be resisted. Let me take MREL as an example. The BRRD and subsequent regulatory technical standard developed by the EBA provided a good basis to determine MREL. On top of that, the FSB delivered the TLAC standard for G-SIBs. The FSB rightly added that loss-absorbing capacity should be subordinated and of sufficient quantity to truly shield taxpayers and depositors from losses, if we are serious about ending not merely reducing too-big-to-fail. Now that we are close to setting binding MREL targets and are about to implement TLAC in Europe, I do see some classic symptoms of cold feet. There is no denying that pressure is mounting to soften the rules and their application. Concerns focus on impact, the costs to banks and the real economy of resolvability requirements on top of supervisory requirements. But in this discussion, the essence of the measures – the large benefits of resolvability to the real economy and society – tends to be neglected. I do not claim that the resolution framework runs like clockwork. Here and there rules could be revised, without compromising their objectives. For instance, we need to consider current heterogeneity in the euro area. And think about solutions for banks that have large MREL shortfalls and lack market access. To those who claim that the MREL framework needs a major overhaul: please be specific. Then we can have an informed discussion about the pros and cons. As I said, attractive as it may be in its simplistic inevitability, the image of the pendulum is ill-suited to breaking a paradigm like too-big-too-fail. My second message to the panelists and the audience is to address the elephant in the room: “fury”, or funding in resolution. In theory, adequate resolution planning should enable the resolution authority to restore the viability and solvency of the entity under resolution. As a result, the phoenix that rises from the ashes on Monday morning should be able to command market confidence right away. With this in mind, the BRRD explicitly requires resolution authorities to exclude the use of extraordinary liquidity support when developing resolution plans. In fact, the bank should ideally be able to repay any emergency liquidity support before resolution. It’s all in the name: ELA is intended for emergency situations. After a credible resolution, one should assume that the emergency has been dealt with and that ELA is no longer needed. That’s why we need to address this elephant in the room. We need to tackle the issue of funding in resolution. New instruments may be needed. We can’t assume that with their limited resources, the central bank or resolution fund will fully take care of funding in and immediately after resolution. Even a well-recapitalized bank may experience increased liquidity needs generated by market volatility, and by asymmetrical information on the bank’s viability. Market participants may be discouraged from providing liquidity – and existing creditors may be encouraged to run – if there is uncertainty over the new entity’s ability to meet increased liquidity needs. For banks that are solvent and sound following resolution, the first port of call would then be the standard liquidity facilities of central banks. Having said that, resolution authorities and banks cannot take liquidity support for granted. And prolonged support should in any case not be factored in ex ante as part of the solution. This is because, firstly, central banks will critically assess the viability of the bank post-resolution and need assurance that support would indeed be only temporary. Second, the bank needs to have sufficient eligible collateral, after haircuts, to access central bank facilities. While this may seem obvious, there is a risk that such collateral has been largely pledged in the run up to resolution. In addition, the provision of ELA itself could effectively postpone the point of resolution, while further reducing the availability of collateral during and after resolution. In that sense, central banks and resolution authorities have a common interest in resolving banks in a timely manner, i.e. before asset encumbrance reaches uncomfortably high levels and collateral runs out. In short, don’t forget about funding in resolution. Sources of funding – including private ones – should be identified and prepared in tranquil times and quantified conservatively. Asset encumbrance should be closely monitored and timely intervention may be required to assure sufficient funding in resolution. Let me briefly restate my main points. I gave my perspective as a central banker on the importance of resolution and the limits of monetary policy. To be ready for the next crisis – or rather to avoid it – we need to resist the analogy of a swinging pendulum. We must also be critical of relaxing post-crisis regulation such as MREL. I also identified funding in resolution as the critical missing link in the framework. I wish you all pleasant and productive discussions. I trust that after today, you will be better equipped in your journey to make banks resolvable. | netherlands bank | 2,017 | 10 |
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