Confidence through regulation Speech on the occasion of the 9th East German Savings Bank Conference
Dear Dr Ermrich,
dear Minister President,
dear Professor Spitzer,
dear Mr Fahrenschon,
ladies and gentlemen,
You may well be wondering at this moment if the topic "Confidence through regulation" is a fitting one for this occasion. Would it not be more appropriate, at the conference of your association, to talk about the "burden of regulation"? Although in that case, we would need to discuss whether regulation is actually – or in some cases, is perceived to be – a burden ...
Given the massive challenges facing you and your institutions as well as the fact that I – in my three functions as banking supervisor, regulator and central bank representative – make demands of you, I could understand your showing a certain degree of scepticism towards me. Recently, some have even gone as far as to condemn central banks and supervisory authorities as a club of out-of-touch technocrats who believe themselves to be the "good guys" but are actually causing an increasing amount of harm.
As I hope you will appreciate, this is not a view I share. Saying that, I can well understand your position, because you do indeed face huge challenges.
It was only recently, in February in fact, that Dr Ermrich informed the press that east German savings banks were now charging negative interest on large customers' deposits. This news shows that you feel compelled in the current environment to take steps which would previously have been inconceivable. The competitive environment is undoubtedly growing tougher, and I can of course understand it when small banks in particular complain that they are increasingly feeling the squeeze. Because on the one hand, they have to appease regulators who – to put it crudely – keep concocting new and onerous requirements, while on the other hand, banking supervisors are demanding ever greater profitability to boost the capital base in the medium and long term in order to strengthen resilience.
But given this set of circumstances, it is especially important to talk about the topic "Confidence through regulation". The purpose of my talk today is not to sell you the idea of regulation, whatever form it may take, although I am anxious to prevent people from subscribing to simplistic sweeping criticism of the regulatory work that has followed the financial crisis. This is because the value of good regulation is often not fully appreciated until we notice we don't have it.
I will approach the topic "Confidence through regulation" from three angles.
To begin with, I would like to bring to mind the meaning of and the prerequisites for confidence in banks and savings banks.
I will then look at whether markets can create confidence or whether it has to be generated by regulation.
Third, insofar as regulation plays an important role in this context, I will consider the question: When should we say of regulation and supervision that enough is enough?
2 From hormones to governance: credit institutions and confidence
Ladies and gentlemen, a bank and savings bank landscape needs confidence, needs trust. This remark requires no further explanation. Customers have to have confidence in you in questions such as: Will I get my deposits back at any time? Can I trust my investment advisor? And you, the bankers, have to be able to trust one another, too, in questions like: Will the institution I do business with and which is solvent today still be solvent tomorrow?
Confidence, then, is the very cornerstone of all corporate success. You therefore have an inherent interest in creating confidence. This of course raises the strategic question of what exactly an institution can do to help build confidence.
Confidence is not an illusion; it can be influenced. Professor Spitzer, I read one of your articles on confidence with great interest. In it, you point out that people's tendency to trust others can be heightened by the hormone oxytocin. And of course, I was particularly intrigued by your closing question: "Should savings banks or people's banks spray oxytocin through their air conditioning systems in order to boost profits?" In case you are planning to conduct field tests any time soon, I would ask you to bear in mind that the agent in question is also known – not without reason – as the "cuddle hormone".
Of course, speaking as a banking supervisor, I am not interested in biological processes but in the structural environment of confidence. And I consider that to be crucial in a profession in which it's not just a few euros at stake – as is commonly the case with scientific experiments about trust – but much more, for instance a customer's provisioning for old age or the economic existence of companies and other market players.
Because one thing is for sure: first and foremost, banks and savings banks are themselves responsible for the confidence their customers place in them. The key word here is "reputation". If you've been trustworthy in the past, it can be assumed that you'll be deserving of trust in the future. But in the financial world – and I expressly exclude everyone here today – we have unfortunately often seen trust abused. For instance, snowball systems were particularly damaging. Social proximity played a disastrous part in them, and they sent out wrong signals.
It's schemes like those that shatter confidence. As Ernst Fendl once put it: "There is no lost and found for lost confidence." And reputation doesn't grow back all by itself. I would hazard a guess that not even an extra dose of oxytocin would tempt anyone with a healthy sense of doubt to blindly trust anyone with his hard-earned savings.
That's why, in the financial world, reputation primarily has to be credible. This means that all the incentive conditions have to be in place. They make trustworthy behaviour credible. And incentives can be given through two very fundamental systems: the market and the state. Which of the two, then, creates the basis for confidence?
3 Market versus regulation: what makes confidence credible?
Markets are one way of providing incentives for people to build up and keep confidence in one another. Think, for example, of the online marketplaces. As a customer, you have to have confidence in the dealers. In this case, the marketplaces clearly function without social proximity or blind faith. This is no doubt partly attributable to the fact that all the parties concerned – the seller, other customers, the platform operator – contribute to confidence in the marketplace on their own initiative, for instance through seller evaluations.
This structure can foster confidence in the bank and savings bank sector, too. Banks and savings banks have a vested interest in confidence, reputation and the potential, lasting income associated with them. This applies in particular to the management and their supervisory bodies, whose objective must be to not compromise confidence and to proactively strengthen their lines of defence against undesired incidents. And finally, the markets can support enterprises that function well and punish those that are at risk. The magic word this time is "self-policing". The market rules sustain themselves, but only if the conditions are right.
When, on 5 October 2008, Federal Chancellor Merkel and Federal Finance Minister Steinbrück issued a guarantee for savers' deposits in Germany, the market's forces of self-policing, of self-organisation, had failed. The regulation that existed at that time was clearly not enough.
This effectively brought the interbank market to a standstill. Banks ceased to have any confidence in one another. The confidence of many customers was also shaken. I will return later to the fact that the misconduct of a relatively small number of financial players caused industry-wide reputational damage.
I could cite other examples, but I think you get the gist of what I'm trying to say. The functioning of the markets is one thing. The empirics of the financial crisis is another. Simply put, the financial markets were not up to the task of fully restoring confidence in this way, without external assistance. It became clear that a regulation that is rigorous enough to serve as a credible basis for confidence was needed.
Before I talk about how regulation can instil more confidence, I would like to correct a common misconception. The regulatory work that has been undertaken since the outbreak of the financial crisis is often regarded as a counter-ideology to a market economy-based financial system. In my opinion, this is a misinterpretation which unnecessarily pitches ideologies against each other. The idea behind the new financial market architecture, which had its beginnings in the 2009 G20 meeting, was not to reject market economy principles, but to rescue them.
For example, current regulation tackles the lack of market discipline with regard to the institutions deemed too big to fail by way of a new crisis management mechanism that is designed to make interconnected institutions resolvable. Moreover, regulation in the area of compensation structures addresses the short-termism of banks' decision-makers – another restriction of the market economy-based self-organisation.
So, the notion that you can't prescribe confidence can be countered by the following idea. Confidence can never be controlled directly, but we can prepare the ground that confidence will grow on by applying regulation and supervision. Although it is not the purpose of supervision to give an independent endorsement of a bank's state of health, the robust governance of the banking sector can help to restore market forces and so play a vital role in fostering the structural conditions for confidence.
4 Confidence through regulation: when is it time to say enough is enough?
The vast majority of institutions and their associations do realise this, and yet regulation has become a lightning rod for criticism which I would interpret along the lines of a "yes, but ...". This is because two contrary messages are being sent at the same time: on the one hand broad agreement with the reforms following the financial crisis, which were considered necessary and appropriate, but on the other hand a deep-seated suspicion of a seemingly overpowering regulation. Doesn't the fundamental need for regulation leave the door wide open for an ever-larger "web" of regulation? Is there still a clearly defined sphere for entrepreneurial responsibility and creativity? How much regulation do banks and savings banks need, and when does it become too much?
Let me state quite clearly: I believe the debate to be important and warranted. In particular, it is your objective criticism that we are willing to consider. However, what I find less relevant is the general outpouring of indignation at regulation, which calls into question the overall success achieved thus far and calls somewhat impulsively rather than rationally for the clock to be turned back on regulation. For this reason, I would like in the following to try to steer the debate in a direction I believe to be both objective and focused on fact.
First of all, we have to examine this feeling that regulatory requirements are "excessive". There is no doubt that considerable efforts have been demanded of credit institutions in Germany in the last few years. We see this in connection with capital in particular. Our last Basel III implementation monitoring, the sample-based analysis of the impact of the regulatory work done so far, shows for instance that the large German institutions have more than doubled their tier 1 capital ratio, from 5.4% in 2011 to 12.1% in mid-2016.
But that doesn't mean we've already crossed the finishing line. The definition of capital, the calculation methods and the individual minimum metrics that once applied are no longer consistent with our modern, present-day understanding, for which reason they can no longer serve as reference values for excessive burdens in previous years.
Yet at the same time, regulators and supervisors also have to recognise the boundaries that define their sphere of activities. The red line has to be drawn where entrepreneurial responsibility and market forces should prevail. That is the Bundesbank's understanding of regulatory work. We have no wish to, and indeed we must not, replace the market.
Nor is that what we're doing. This is clearly demonstrated, for example, by our business model analyses, which we regularly carry out at German institutions. As the name implies, we delve very deeply into the entrepreneurial operations of those banks.
Yet the purpose they serve is not to thrust upon banks a business strategy that has been developed by supervisors or is perhaps even standardised. Rather, we proceed from the question of whether a particular institution's solvency and internal capital adequacy will still be intact two or three years hence. Every institution – each in its own specific situation, its own business environment and with its own risk management – is examined and its respective planning is subjected to scrutiny. Are assumptions about how a bank's business environment will develop justified, or are they rather driven by wishful thinking? Are the strategic conclusions that have been drawn from tracking trends logical and consistent, or do they border on the contradictory and untenable? If an institution is planning to make strategic changes, is the requisite expertise being built up, and is this factored into its capital planning?
So you see, our supervisors do not walk into the banks armed with a strategic roadmap, and certainly not brandishing a strategic blueprint.
Having said all that, I would now like to conclude this line of thought by deferring somewhat to the "yes, but ..." objection. There have been and there are banks and savings banks which, thanks to their business model and corporate structure, are better able than others to put into place effective methods of self-organisation and self-control. To impose the same control requirements on all banks and savings banks gives institutions with a highly developed governance and control culture the impression that they are being made jointly liable for misconduct, market turmoil and other damage.
This takes us to the heart of the proportionality debate. In the past, supervisors in Germany were already at pains to take the differences in the bank and savings bank landscape into account. One case in point concerns the regulation that envisages not only extensive requirements but also simple counterparts like the standardised approach. Consider, for instance, the largely proportional application of the Minimum Requirements for Risk Management.
Nevertheless, we are currently seeing that smaller and medium-sized institutions are quite simply overwhelmed by the task of meeting compliance requirements in particular. After all, the regulatory framework is not wholly devoid of complexity.
It is in this context that the approach of the so-called small banking box should be seen – a rulebook for small institutions that is separate from the framework for large internationally active banks. We, the banking supervisors, are in the process of discussing such an approach with the German Banking Industry Committee.
The relevance of a rulebook of this kind can also be viewed in the context of my remarks today: the problem areas that affect complex credit institutions – those that call for disclosure requirements or compensation regulations – crop up to a far lesser extent in many small institutions, if they arise at all. Where such issues are concerned, the idea of relaxing the requirements in a separate rulebook is surely conceivable. Yet I am convinced that quantitative minimum standards should not be lowered as a result, since insolvency and illiquidity are fundamental risks that every credit institution faces.
Whether such a two-tiered system can be put into practice ultimately depends on the European legislative process. The German Banking Industry Committee, the Federal Ministry of Finance and Germany's supervisors must know exactly what it is they want. There can only be success if we all stand together and arrive at a unanimous position.
Ladies and gentlemen, regulators and supervisors don't always make your daily work easy. However, we should take care not to spread doubts about the tasks of regulation where we are essentially in agreement about them. The task of regulators and supervisors is to safeguard confidence in the bank and savings bank sector. Even in times of relative stability, we should be wary of trying to convince ourselves that – from the outset – things would have worked out even without the improved rules.
Let us keep criticism objective. As representatives of banks and banking associations, each one of you can make a valuable contribution to the debate on greater proportionality in regulation and to an appropriate reduction of burdens. If we pursue this path together, we can continue to fine-tune a system of regulation that safeguards stability on the one hand and diversity on the other.
Thank you for your attention.
- M Spitzer, Vertrauen schnuppern, Nervenheilkunde, 24(6), p 522.
Ernst Ferstl (*1955, Austrian teacher and writer).