This column is a lead commentary in the VoxEU Debate "Banking reform: Do we know what has to be done?"
The Global Crisis that started in 2008 and the more recent Eurozone Crisis have made one thing abundantly clear. The ‘business as usual’ approach to banking regulation is not good enough. The traditional approach focused exclusively on ‘microprudential’ policy – i.e. bank-specific risks such as bad loans, illiquidity, etc. What we learned in the crisis is that ‘macroprudential’ policy is also necessary. As it turns out, banks face risk stemming from correlation of failures across banks that comes from several sources including ‘funding risk’, where banks simultaneously find it hard to borrow. Thus regulators must learn to calibrate microprudential policy by creating an adequate macroprudential oversight framework to complement it.
The goal of the banking union is to re-establish confidence in integrated banking markets in the Eurozone. An essential condition for success is to achieve the right governance and expertise to ensure a more forward-looking, risk-preventive approach, unhindered by national interests.
Institutions of the banking union
The banking union will assign the mandate for coordinated oversight on bank stability to a Single Supervisory Mechanism. Its governing board will involve the top microprudential supervisors from the member countries.
What remains unresolved is the assignment of responsibility for macroprudential tasks. The required expertise calls for attention to aggregate trends and interaction effects. As this requires a much broader perspective that has traditionally been taken by bank regulators, this task should not be delegated to micro supervisors. Direct evidence is that the composition of recently formed EU macroprudential councils draws from central banks and external experts in addition to national supervisory authorities.
A proposal: Delegate macroprudential to an independent board
A better solution would be that macroprudential coordination be delegated, within the framework of the Single Supervisory Mechanism, to a distinct board. The board:
- Should advise and coordinate to preventive macroprudential policy for the Eurozone countries.
- Should include supervisors, financial stability officers from central banks and other members of national macroprudential councils (such as independent advisors or members of the advisory committee for the European Systemic Risk Board) to give it the necessary range of national and functional competence.
This would ensure coordination with the European Systemic Risk Board’s overall role of monitoring systemic risk within the EU. The presence of external experts will ensure independence from political pressures and avoid forbearance.
- National initiative should remain for all Capital Requirement Directive IV (CRD4) macroprudential tools, subject to EU approval.
- The board should have an advisory role on existing macroprudential tools, such as the systemic buffer or the countercyclical buffer.
- It should advise on the calibration of national measures and oversee any spillover effect.
As far as powers are concerned, the board should have specific directive powers for tools not yet defined but already envisioned in the medium term, such as liquidity policy. Stable funding norms envisioned in Basel III are unlikely to be introduced in the EU for many years. In this long transition phase, bank funding remains a critical feature for financial stability. Supervising bank funding is also a natural function for a liquidity-monitoring central bank such as the ECB.
Closing the gap in the transition to liquidity policy
The European Council and Commission have stated that they are committed to introducing liquidity legislation. It is universally recognized that capital regulation would be insufficient and incomplete without this. Yet this will not come soon enough to avoid problems in the medium term; 2019 is the target date for implementation of stable funding norms – and may well be postponed further1. This delay has been justified by the current unfavourable conditions on bank funding.
This opens up a perilous gap in regulation. The combination of such a long transition phase – well beyond the long-term refinancing operations program maturity – does nothing to tackle the lack of oversight on bank funding, which was, after all, the critical propagation mechanism in the Global and the Eurozone crises (Acharya et al 2011). The argument that it is impossible to establish policy tools on liquidity risk because of the postponement in introducing regulation is equivalent to hide behind one’s finger, as if a problem did not exist because no remedial legislation has been approved. A transitional prudential framework on stable bank funding in the Eurozone is clearly necessary to avoid shifting all responsibility to ex-post ECB support without introducing preventive tools.
Preventive measures may be differentiated across economies since Eurozone nations face varying degrees of tension in their banking sectors. The Single Supervisory Mechanism will provide a reassuring framework on this critical matter, ensuring the monitoring and managing of the long term transition to a common framework on stable bank funding.
A preventative approach
A preventive approach is less risky than waiting to introducing binding ratios at some distant date. Concrete transitional tools are counter-cyclical charges on unstable funding (Perotti and Suarez 2011, Shin 2010, Goodhart and Perotti 2012). These pecuniary charges would be levied on the difference between a desirable standard (to be defined by the Single Supervisory Mechanism) and the actual standing of individual banks. These tools would reduce unstable funding when circumstances allow, and be relaxed when necessary. At present, no such nudging tools exists (Goodhart and Perotti 2012, Goodhart 2012).
Initially, charges would be country-specific. This would bring a return to flexibility in a rigid monetary context, and would, de facto, enable lower marginal rates in Spain than in Germany, even with a single currency.
Setting charges may be ultimately assigned to the Single Supervisory Mechanism along the transition. Transferring this mandate to the Single Supervisory Mechanism will ensure a rapid and coordinated response to emerging risks in Eurozone financial markets.
While moderate fees may be charged by the ECB to ensure the funding of supervision, these may be insufficient to ensure a full shift in funding incentives. Furthermore, accumulating surcharge revenues would also involve the ECB in political conflicts. Accordingly, revenues from prudential surcharges should be directed to financial stability funds held outside the ECB/Single Supervisory Mechanism and under the discretion of deposit insurance or resolution funds.
Comparing liquidity coverage ratios and net stable funding ratios
Liquidity coverage ratios are stress test estimates of the liquid buffers banks have for self-insurance on temporary runs of unstable funding. Targeting such a goal as liquidity coverage ratios is now widely seen as excessive and probably counterproductive. It is excessive and unrealistic to demand liquidity self-insurance that would work in the case of major bank runs. Buffers are quite costly, and are thus likely to be diluted. Indeed, they will most likely be ‘gamed’, as buffers will be largely borrowed on the cheapest and thus least stable form (for instance, via. collateral swaps). It is counterproductive because liquidity coverage ratios penalise funding channels that are necessary for flexibility and interbank fund circulation. Finally, liquidity coverage ratios, even as implicit charges, are very procyclical2.
Preventing the fire spreading
Systemic risk management is akin to regulation that controls fires. Indeed, an historical analogy to a systemic liquidity run would be a medieval city in which fire spreads quickly among the wooden houses. Liquidity buffers are like mandatory water buckets in each house, while stable funding ratios is akin to requiring that people build one brick houses. The solution to city fires came from establishing construction standards (Goodhart and Perotti, 2012) not from mandatory water buckets.
Liquidity coverage ratios should not be the main target of liquidity policy, as they do not help to contain aggregate liquidity risk. In contrast, stable funding ratios (related to Basel III’s NSFRs, or core funding ratios elsewhere, such as in Korea) represent a direct and robust constraint on micro and aggregate funding risk. As a structural change, they will need to be built over time. Charges can help with this transition.
In the last two years the need for internal Eurozone instruments for bank funding risks has become evident, yet the prudential tools have been postponed. These diverging time scales are becoming a problem. The Eurozone needs a common liquidity policy to overcome this gap in the management of bank funding stability, both at the microprudential and macroprudential level. Leaving this responsibility entirely to national policymakers implies that under a banking union, the need for ultimate ECB support in the form of bank funding will persist without the Single Supervisory Mechanism having adequate interim controls.
Acharya, Viral, Arvind Khrishamurti and Enrico Perotti (2011), “A Consensus View on Liquidity Risk”, VoxEU.org, 14 September.
Brunnermeier, Markus, Gary Gorton and Arvind Khrishamurti (2011), “Risk Topography”, NBER Macroeconomics Annual 2011, 26.
Goodhart, Charles (2012), “Ratio Controls need Reconsideration”, LSE working paper.
Goodhart, Charles and Enrico Perotti (2012), “ HYPERLINK "http://livepage.apple.com/" Preventive Macroprudential Policy", VoxEU.org, 29 February.
Shin, Hyun Song (2010), “Macroprudential Policies Beyond Basel III”, Policy memo.
Perotti, Enrico and Javier Suarez (2011), “A Pigovian Approach to Liquidity Regulation”, International Journal of Central Banking, December.
Perotti, Enrico (2012), “ HYPERLINK "http://www.ft.com/cms/s/0/258f84fe-36c7-11e1-b741-00144feabdc0.html" How to stop the fire spreading in Europe’s banks”, Financial Times, 4 January.
1 Liquidity Coverage Ratios (LCRs) may be operational by 2016. We argue later why these are less useful instruments (see also Goodhart and Perotti, 2012).
2 This is because their marginal cost equals the (fractional reserve) ratio times a market spread of bank funding costs minus liquid asset yield, which is highly procyclical (Perotti and Suarez, 2011). Note the spread and thus the indirect tax would have been essentially zero in 2005-2007.