Financial Stability Between Aspiration and Reality – How Predictable is the Next Crisis?

Check against delivery.

How predictable is the next crisis, ladies and gentlemen? Very, to some extent, or not at all? It is a well-known fact that, given three possible answers, people tend to choose the middle option. In this case, that wouldn’t be far wrong.
Crises are like divas. They are somewhat temperamental and are generally not helpful enough to turn up in the same place as they did the previous time. Neither do they erupt in exactly the same way as we imagine they will. This makes the whole thing rather complicated, which is why we, BaFin’s board of directors, have decided that there will not be any crises from now on.

But in all seriousness: even I, the president of a governmental financial supervisory authority, know, of course, that we cannot prevent crises completely. But what we certainly can do is make crises less likely and reduce their destructiveness. Good, appropriate regulation provides the key tools for this. That is the only way we can be successful in protecting the public good of financial stability.

The regulation of the decade before the 2007/2008 crisis did not meet these quality standards. That much we know. This was why, a few weeks after the Lehman collapse, the heads of state and government of the G20 countries at their landmark summit in Washington made a far-reaching commitment, which I quote time and again because it is a succinct summary of what is important:

“We pledge to strengthen our regulatory regimes, prudential oversight, and risk management, and ensure that all financial markets, products and participants are regulated or subject to oversight as appropriate to their circumstances”¹

We have come a long way along that path: many of the failures and false incentives of the pre-crisis decade have been rectified, both in accounting law and in financial regulation. This has at least made banks and the financial markets as a whole more resilient, even if not bulletproof. I will now give you just four examples to illustrate this point:

1. The capital requirements we place on banks today are more demanding, both quantitatively and qualitatively.
2. We force institutions to maintain sufficient liquidity.
3. We have created rules and mechanisms to allow us to resolve banking giants when they are faltering.
4. And we have established a new subdiscipline in regulation which focuses on protecting financial stability as a stand-alone systemic field: macro-prudential supervision.

We have now reached the phase for implementation, initial practical experiences and fine-tuning. Does this bring a regulatory pause? No – not in the long run, at least. While the majority of post-crisis reforms may have been completed, regulation in itself is never finished.

I have claimed many a time that the art of regulation lies in being able not only to resolve known problems, but also to mentally anticipate and forestall future turbulence. However, that is and will continue to be an ambitious goal.
A single reform that covers all known and unknown risks for the rest of time just does not exist.

No, there is simply no way around it: if we want to be prepared for crises, we have to remain on high alert. We have three starting points:

1. We need to thoroughly investigate all conceivable threats and risks that could provide fertile ground for the next crisis – firstly so that we, as supervisors, are able to act, but also to enable us to detect if any new regulatory gaps are developing.We are devoting a great deal of attention to these issues, both within BaFin and in cooperation with supervisors from other countries and with our central bank colleagues, who have particular experience with macro-prudential supervision.

   As a result of one of the lessons learned from the great crisis of 2007/2008, various bodies were formed that scan the markets constantly for new risks.

   The Financial Stability Board (FSB), for example, which the G20 created not just as the coordinator of post-crisis regulation but also as an independent global guardian against risks.

   After the crisis broke out, the European Union brought the European Systemic Risk Board into being, and based on this model Germany created the German Financial Stability Committee, which forms an institutional framework for the three-way dialogue between supervisors, the central bank and politicians.

   Of course, even these bodies will not enable us to anticipate and forestall crises precisely. But only if we devote our time to studying the possible scenarios do we have the chance to deal with the next crisis in the right way, or even avert a crisis altogether. Forewarned is forearmed.

2. The second starting point is the individual risks that are well-known from past experience and are easy to detect from a regulatory point of view – including some that we know come up again and again.A prime example is credit risk, one of the areas of focus for the tightening of micro-prudential measures to date and a key priority in supervisory activities.

   We now have an additional tool to help us keep the cyclical nature of this risk under control at a macro-prudential level, too: the countercyclical capital buffer.

   The idea is that in times of excess credit growth, banks should build up an additional capital buffer, thereby increasing their resilience. This buffer acts as a cushion in more difficult times and prevents institutions from needing to reduce the size of their loan portfolios too much.

   The intention is that this should prevent procyclicality, and thus the dreaded credit squeeze. BaFin sets the buffer rate on a quarterly basis – so far it has always been set at zero.

   Using the tools of financial regulation to mitigate cyclical risks, too, is another important lesson from the 2007/2008 financial crisis. Implementing this lesson in practice, however, is a challenge, as is evident from a number of European countries.

   A multitude of different political interests have to be balanced in order to achieve sensible solutions.

3. The third starting point is the risks that are less easy to detect but that are – theoretically – quite conceivable.Examples include the cumulation of political risks and cyclical disruptions at a global level, as well as large-scale disruptions resulting from cyber risks.

   In order to be appropriately prepared for these known unknowns, we need to increase the resilience of individual institutions and of the financial system as a whole.

   Banks need to be able to weather times of stress without being thrown off-balance straight away and putting the financial market’s ability to function on the line – and this applies regardless of where the stress comes from.

   For this reason, we require all banks to have a capital conservation buffer in addition to the Pillar I and Pillar II capital requirements.

   We also require an additional buffer for global systemically important institutions (G-SII buffer) and for other systemically important institutions (O-SII buffer). Both of these are currently being built up step by step.

   Furthermore, for systemic risks we have the option of ordering capital buffers for certain exposures in order to mitigate long-term non-cyclical risks resulting from structural developments. This, too, is appropriate, proportional regulation

Ladies and Gentlemen,

Yes, in order to avoid the next crisis catching us by surprise, we need good, appropriate regulation – including for new risks. But we also have to be vigilant and – when necessary – rigorous when applying the regulation in practice.

What we do not need is to relapse once more into deregulation and “light touch” supervision. Anyone wishing to follow that path will make the next crisis very predictable indeed, but not in the way we would hope for: it would not leave us waiting.