A blueprint for finishing the job on financial regulation

The financial crisis highlighted a gap in the authorities’ toolkit. There is a pressing need for countries to have what is now known as a macro-prudential policy framework to take on the task of maintaining financial stability. Though central banks delivered a backdrop of price stability in the run up to the crisis, that was not enough. The financial system expanded rapidly and without check. In many countries, households and companies accumulated debt, and the financial system became entangled in chains of risk and leverage. The consequences have been dreadful.

Institutionally, our countries have embarked on different institutional structures to achieve a more stable financial system: in the UK, the Financial Policy Committee - the main body for financial stability - is being created within the Bank of England, while Germany is heading for a close collaboration of separate institutions in the Financial Stability Committee. However, we share common thinking on the macro-prudential framework. We believe it needs the following features. First, the framework must be flexible and allow for early and effective intervention. A lot of good work is being done to strengthen the microregulatory regime, globally and in the EU – in this regard we believe full implementation of Basel 3 to be essential. Negotiations within Europe are ongoing, with the ‘trilogue’ of the Council, Parliament and Commission seeking to secure agreement on EU implementation over the coming month or so. But any set of reforms will eventually be overtaken by the evolution of the structure of the financial system or by temporary bursts of misplaced exuberance. The seeds of the next financial crisis are unlikely to be sown in the same way as this one. Policymakers need to have the flexibility to act to head off, or choke off, systemic risk in time to avert disaster.

Second, each jurisdiction needs to be sure that it has a macro-prudential authority. This might be a single body or a committee bringing different bodies together. But whatever a country’s institutional architecture, it needs to be clear about mandate, responsibilities, powers and accountability.

Third, those macro-prudential regulators need a well-equipped toolbox suitable for a wide range of systemic risks. This is not a matter of identifying a single macro-prudential instrument that is analogous to the role that the central bank’s interest rate performs in monetary policy. The objective is to ensure that the financial system is resilient. That can involve acting to reduce risks from interconnectedness in the system or to lean against exuberance, across the whole of the financial system or parts of it.

Fourth, we nevertheless need to be clear about what tools should be available to macro-prudential authorities at this time. We believe they should include the following. To head off a generalised threat to the solvency of the financial system, they should have the ability temporarily to require an additional capital buffer to support risks in banks and, where relevant, other financial institutions. Just as important is releasing a buffer as exceptional threats recede. In some cases, the source of risk will be more localised. In those cases, more capital may be needed against exposures to a particular sector, for example loans against property or to other parts of the financial system. Where funding conditions look fragile, higher liquidity levels may sometimes be required. And constraints on margining practices may need to be adjusted to manage the risks involved in secured lending within the financial sector. The need for flexibility is also essential with respect to the toolbox: new threats or new insights will require new instruments.

In some cases, this means completing work on microregulatory policies. We must continue to strive towards a new international agreement on liquidity standards. Dangerously thin liquidity positions were one of the first vulnerabilities to be exposed in this crisis. Therefore, we must have a ‘Liquidity Coverage Ratio’ to ensure banks hold a buffer of liquid assets that is sufficient to cover potential cash needs during periods of stress. And we remain committed to introducing a ‘Net Stable Funding Ratio’ to ensure banks’ less liquid assets are funded safely.

Macro-prudential authorities also need to be able to set and adjust rules to contain risks to stability from interconnections in the system. For example, so-called systemically important financial institutions should face tougher capital standards to reduce their likelihood of failure. And we need to press forward with international work to put in place and operationalise resolution regimes that can credibly deliver an orderly failure for large, cross border financial groups.

Fifth, the international regime needs to cater for local circumstances. In the EU, it is important that a certain degree of national flexibility and regional differentiation is permitted. Economic differences between countries of the European Union are substantial, and the timing of credit cycles across regions is not always synchronous. National macro-prudential policies could be particularly useful within the euro area, where a single setting for monetary policy is not always guaranteed to suit financial conditions in all members. Not all parts of the euro area experienced a lending boom in the run up to this crisis.

Sixth, an EU framework for national macro-prudential policy interventions does need to be balanced with protection of the single European market. That certainly requires minimum standards. Exposures to the same types of risk need in normal conditions to be treated consistently across Member States. And we will need to be mindful of possible unintended effects on other economies or on the functioning of the single market. There needs, therefore, to be efficient exchange of information and coordination on national macro-prudential policies. Within the EU, the European Systemic Risk Board is well placed to play such a role; it is technically expert and, within its mandate, is independent from day-to-day politics. That process should not prejudice the ability of national authorities to act early and effectively head off a build up of risk. As the ESRB recommended in a recent open letter to the European Commission and Parliament, biases towards inaction must be avoided.

The good news is the European Council and the European Parliament are making progress towards incorporating a framework of this kind in the implementation of Basel 3 within the European Union. That effort remains work in progress. Jointly, we offer these six principles to guide its completion.

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