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Dombret urges end to zero risk weighting of government bonds

Andreas Dombret during a conversation

Dombret urges end to zero risk weighting of government bonds Interview published in Börsen-Zeitung, Title: "Almost politically naive"

27.03.2018 | Andreas Dombret

Interview with Andreas Dombret conducted by Bernd Neubacher.

Mr Dombret, when you step down from the Executive Board of the Deutsche Bundesbank at the end of April, you will have been responsible for banking supervision there for four years. A great deal has happened in this field during those four years, not least the finalisation of the Basel III regulatory package in December. Has the Basel Committee’s agenda been wrapped up?

Yes and no. The international process is over – the negotiations are completely finished. Now, though, these international minimum standards must be uniformly implemented into law in each of the member states. The Europeans pushed for the United States to commit implementing the whole Basel regulatory package, including the Fundamental review of the trading book – in other words, including the rules for the capital backing of market risks. Now, of course, the EU must in turn implement all of these measures. 

According to the Bundesbank, Europe and the rest of the world are implementing the Basel decisions on a one-to-one basis.

Indeed. But we have to make intelligent use of the degree of freedom that we have.

Doesn’t that contradict the concept of a small banking box, intended to grant relief to small and medium-sized banks, which you are championing?

No, because the Basel minimum capital requirements are first and foremost aimed at large, interconnected and internationally active banks. The United States has implemented the requirements accordingly, but in Europe they have been introduced for all banks to the same extent. Striving now for administrative relief for small and medium-sized banks is entirely within the spirit and the context of the Basel framework.

Europe was always accusing America of not having implemented Basel II at all.

Of course the Americans implemented Basel II, but only for systemically important banks. In fact, it was we Europeans who were guilty of not fully implementing Basel II. Even the Basel Committee’s reports continue to identify the EU as a geographical area which has deviated from the rules in its implementation of the Basel framework. In particular, we implemented a toned-down version of the 80% floor from Basel I, which has been phased out in the meantime, and performed a parallel calculation instead.

With the result that the banks report a more favourable capital ratio than if the floor had been applied.

You could say that. That’s why an output floor of 72.5%, which was agreed upon in December, is such a great leap for our banks.

In the United States, the Federal Reserve’s Collins Amendment applies, which basically works the other way round to the Bundesbank’s concession with regard to the output floor: although banks are permitted to apply internal models, they are not allowed to use them to reduce the supervisory capital ratio. 

That is correct, and it means that the Americans have a 100% floor, in principle. Essentially, the calculations of capital performed using the standardised approach are authoritative here.

Is there any indication that the United States is going to lower this floor?

No. I get the impression that the regulations will stay as they are in the United States, and that the latest Basel decisions will be implemented there.

You said that everything had been agreed by the Basel Committee, but that isn’t actually true. A risk weighting of government bonds is yet to materialise.

Unfortunately, the Committee was unable to come to an agreement on this highly important package of reforms. In my view, this is an obvious regulatory gap which I believe we should close, at least in the EU. If we could establish regulations in Europe, we’d be a big step further on.

You are advocating that Europe acts alone on an issue on which a global consensus is not achievable.

That’s right. It’s a global problem, but it really does have particular significance for us in Europe. That’s why I strongly recommend that abolishing preferential treatment of government bonds remains a fundamental prerequisite for further progress towards banking union; with regard to a common deposit guarantee scheme, for instance. Only by taking due account of government bond risks will we be able to loosen the close links between sovereign and bank risk. 

Some people see it the other way round. A study carried out for the European Parliament’s Committee on Economic and Monetary Affairs has revealed that fiscal union is the only way to resolve the problem of close ties between governments and banks, as other approaches are either procyclical or would increase the threat of risks spilling over.

There was the same debate back when the euro was being introduced. At that time, an agreement could not be reached on political union, but only on monetary union. In my estimation, political union has become more difficult rather than easier in the last few years, as the differences in risk premiums would indicate, for instance. Claiming at the present juncture that we could achieve full fiscal union, considering that we didn’t manage to do so in 1999, seems almost politically naive to me.

Is it not also politically naive to believe that a political majority could be mobilised at the European level to end the preferential treatment of government bonds among countries which actually profit most from zero weighting? That’s why the Basel Committee, too, put the issue on the back burner to start with.

Within the Committee, we tried to come to an agreement, and unfortunately, we failed. It was an extremely arduous process, at the end of which was printed in black and white that we couldn’t agree. The resultant paper was not published for consultation, but only for discussion. You wouldn’t believe how long we debated whether it was a consultation papier or a discussion paper. In the end, it became a discussion paper with questions addressed to the public. We were able to agree on the questions, at any rate. In the meantime, we have carried out a market survey and received a multitude of answers. I am curious to see what they are.

There was even opposition to publishing anything at all.

Yes, immense opposition.

Against such a backdrop, you could probably expect the river Main to run dry before an agreement on putting an end to zero weighting was reached. 

I’m afraid you may be right. Nevertheless, we won’t give up, and we are not alone in our efforts.

A global-scale agreement is unrealistic as there are highly indebted countries, like Japan, which will not agree to an end of zero weighting because they want to retain a favourable sales channel for their government bonds. The situation doesn’t appear to be much different at the European level, though, looking at Greece or Italy. How can a political majority be mobilised in the EU to support the abolition of zero weighting?

By making it a vital prerequisite for the further development of banking union.

Would you care to predict when a breakthrough might be expected here? 

I do in fact expect this to happen during my successor’s term of office, albeit more towards the end. The risks in our monetary union must be brought into line, starting with non-performing loans and continuing with the concentration and capital backing of government bonds on banks’ balance sheets. The debate on the bundling of core countries’ government bonds into sovereign bond-backed securities, or SBBS, also indicates that many people are thinking about how this risk diversification can be achieved. SBBS are a difficult topic in this context. 

Why?

At present, zero weighting applies to capital when a bank holds a government bond or another public sector bond. It would only make sense to purchase SBBS if these were zero-weighted, too. If we were to allow that, however, we’d be extending zero weighting even further – to structurised securitisation, even. That would be the exact opposite of what we want to achieve.

Another of your demands, namely regulatory relief for smaller institutions, stands a better chance of becoming a reality in the foreseeable future.

The relief proposed in the European Parliament by Socialist and Democrat rapporteur Peter Simon comes very close to our ideas in many respects. Almost 100% of the smaller and medium-sized banks and savings banks already more than meet the requirements for capital and liquidity. The problem, however, is that these institutions are groaning under the complexity of the reporting – and with good reason, in my opinion. As I already mentioned, this is because the regulatory framework was developed for large, interlinked and high-risk banks. It is only natural to start regulating where the risk is highest and not where it is lowest. With that arose a body of regulation that is administrative overkill for small and medium-sized institutions. 

The idea of relief also has its opponents. For example, Sabine Lautenschläger, the Vice-Chair of the ECB’s Supervisory Board, who fears treating unequally what is essentially the same when, for instance, in future a small bank and a big bank compete with each other in the same market for the same customers but with different regulatory requirements.

I have great respect for Sabine Lautenschläger, but on this point I disagree with her. We need to strike a balance: this is the issue that Sabine Lautenschläger has also been addressing constantly, namely how complex regulation has actually become, and on the other hand, whether an unnecessary level of pressure to consolidate is being generated as a result. I have nothing against mergers if they follow some kind of business logic. If, however, small banks are giving up because regulation has become so complex that the banks are no longer able to cover the degression of fixed costs, then I have to ask myself whether something is wrong here. I believe that it is not for us, the supervisors, but for the market to decide whether we should have 1,700, 4,500 or 200 banks here in Germany. 82% of German banks and savings banks have total assets below €3 million, while only constituting 14% of aggregate total assets. In supervision, then, should we focus on completeness and treat every institution absolutely equally, or shouldn’t we instead supervise based on the level of risk? In any case, when it comes to capital and liquidity requirements, we don’t want to treat anyone unequally. But in terms of what needs to be reported and how often, I’m in favour of some kind of relief.

Such as?

For example, the issue of whether the net stable funding ratio can be calculated based on fewer granular data. I fail to understand why a savings bank or small bank has to fill in a form about income millionaires at the bank and has to report that they have none, and then the Bundesbank has to check whether the bank has scored everything out.

The ECB’s Supervisory Board is also looking to extend the Supervisory Review and Evaluation Process (SREP) successively from just the big banks that it supervises directly to the other institutions in the euro area. Doesn’t this contradict efforts to reduce costs for smaller institutions? 

There is the risk of that. Currently, the ECB is working on some kind of harmonisation when supervising small banks. The requirements for the SREP that we have now are still sufficiently flexible that we can still use our system, as we calculate the respective add-on to the capital ratio according to Pillar II of the Basel Capital Accord.

The emphasis is on "still"? The SREP will be introduced for smaller institutions over a number of years and the associated costs won’t get any smaller.

This is true, and that is my concern. We will need to keep working on that from a German perspective. 

Officially, the ECB is of course the boss.

No question about it. It can set requirements for the supervision of small institutions. Yet on the other hand, the ECB has a great many other fish to fry, and perhaps other matters are more important than the introduction of the SREP for smaller banks...   

Are we now transitioning to the topic of non-performing loans? 

That would be one example. The ECB’s priorities are absolutely correct, and ground-breaking in many cases. When the ECB asked us to screen business models now, at first there were long faces at the Bundesbank. We now believe that this is important and it was a process of getting used to the idea.

What happens next at the ECB’s Supervisory Board? As an outsider, you get the impression that, after it had been collecting data and screening banks since its introduction at the end of 2014, it is now proceeding to use resources in a more targeted manner, namely leaving good banks to keep ticking over in order to focus more keenly on more unstable ones.

Nor is that a bad thing. We are now past the honeymoon period.

Were the last four years a honeymoon period?

Not the whole time, but supervisors were very polite to each other during the first two years. There was a phase during which we got used to each other and were more tolerant of one another. This period has now come to an end, at least for yours truly.

What does that mean? 

For instance, during the last visit by Danièle Nouy, who visits each national supervisory authority once a year as the Chair of the ECB Supervisory Board, I found some balanced critical words.

In what way?

I only told them to her. We are now in the next phase, in which particular attention is directed towards us as representatives of the largest economy in the Eurosystem. We must also fulfil this responsibility. 

Last year, there was a wave of ad hoc inspections regarding banks’ IT systems. Have they improved since then? 

We definitely get the impression that by focusing on this topic over the last 18 months, banks and savings banks now understand that continuing to develop their IT is in their very best interest. We are still far from satisfied, but we keep focusing on the matter. We will therefore take even greater consideration of IT security in supervisory reviews and evaluations, too.

How often have banks been attacked successfully? 

What does successfully mean?

That hackers infiltrated a bank.

I can neither confirm nor deny that.

Can you give details about that in another way?

No, we can’t give any details about that, and we also have to create a protected space where banks can exchange experiences in order to learn from these attacks without falling into a competitive situation in the process.

It is not just banks’ IT that entails risk, but also cryptocurrencies such as Bitcoin. Auditors have been heard to say that they wouldn’t know how to account for Bitcoin in balance sheets. What does a supervisor do?

I think it is really rather simple. Prudential regulations require institutions to ensure that a sufficient amount of capital is held against all types of risk. These tokens’ high volatility naturally calls for a correspondingly high level of capital backing in order to cover the risk.

But they do need a line to know how high the capital requirements are. 

We have to counter the idea that crypto-tokens such as Bitcoin should be treated equally and reported in the balance sheet the same way in every single case. Because this is not true. Banks must define it in each specific instance. But the banks we have spoken to so far do not want these kinds of assets. If that should change, we would already know to what extent we would want this risk to be covered. For positions where there is a risk of total loss, a significant capital deduction would definitely be appropriate. 

Recently, the international Financial Stability Board published a report which stated that the shadow banking industry grew once again in 2017. Is it enough to just write reports, or should there be stronger regulation?

I think the subject of shadow banks is currently rather overstated. It isn’t as noticeable as I thought at the beginning of my term of office – they’re growing quite moderately.

They still grew by 7% around the globe.

Only by 4% in Germany. It is actually a phenomenon that’s growing at a manageable pace. 

What will you do once your term of office at the Bundesbank expires at the end of April? 

I have decided not to extend my term because I have other private plans. With regard to financial industry activities, I have to "cool off" for twelve months, also because of my work in European banking supervision. I’m actually really looking forward to this slower-paced period.

And afterwards, will we see you again in the financial sector?

I certainly won’t be retiring.

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