As highlighted in Chapter 4, the current reform agenda has been designed to address many of the problems highlighted above. The Basel III (CRDIV/CRR) reforms to strengthen capital and liquidity requirements improve risk-based capital adequacy and quality, and curb excessive maturity transformation and lack of liquidity buffers. In the EU, the proposals to strengthen common supervisory structures and to establish effective bank resolution tools are very important steps towards establishing effective early intervention mechanisms. The current reform agenda accordingly overlaps with the objectives set by the Group's mandate. Even so, while sharing the same end-objectives, the current reforms do not necessarily address all the underlying problems in the EU banking sector as identified by the Group (see annex 6 for our full assessment). More specifically:
55 There are a number of other structural and behavioural features of the market, in particular in retail banking, which give rise to competition concerns and deserve further analysis. Moreover, scandals such as the recent LIBOR rate-rigging case revealed the limits of self-regulation and scope for a few banks to manipulate prices.
Capital: Basel III/CRDIV will strengthen banks' capital base, thus reducing the probability of failure by tightening and improving the quality of the risk-weighted capital requirements.
However, the crisis has illustrated the problems associated with risk-based capital requirements if certain risks are not reflected adequately (or at all). Market (especially tail- risks) and operational risks arising from complex market activities may not be covered fully by the model-based capital requirements; nor may systemic risks arising from major trading operations. The increase in capital requirements has taken bank business models as a given and does not aim to address complexity in the banking system. It also does not address transparency and understanding of risk for key stakeholders, including bank management boards, regulators and investors. Although the aim for example of the Basel 2.5 reform – which addressed loopholes in trading book requirements – and the ongoing review of the trading book capital requirements by the Basel Committee is to reduce incentives to capital arbitrage via off-balance sheet arrangements, thus reducing complexity and incentives for intra-group subsidies, additional measures might be needed. In addition, capital requirements will address the risks linked to real estate lending only to the extent that competent authorities make proactive use of the possibility to modify real estate risk weights based on the economic cycle;
Liquidity: Following Basel III, liquidity requirements are, for the first time, to be imposed on banks. This will strengthen their ability to withstand stress periods with no access to market funding (LCR) and to avoid excessive reliance on short-term market funding (NSFR). Given the importance of liquidity and proper asset-liability management of banks, principles of good liquidity management should therefore be implemented in the EU. However, the definition and calibration of these global standards remains under review. It is important to get them right so as to not either impair monetary policy or the economic recovery;
Leverage ratio: The leverage ratio is an important backstop to the risk-weighted capital requirements. By making individual banks less levered, an appropriately calibrated leverage ratio could effectively increase loss absorbency, thus reducing the probability of failure, assuming the same level of risk-weighted assets;
Market infrastructures: the gradual transfer of OTC derivatives to CCPs will significantly reduce interconnectedness between banks, thus reducing the impact of failure, provided that the CCPs are well-regulated and supervised. Moreover, increased margin/collateral obligations will ensure the price of OTC derivatives better reflects the associated risk and thus reduce excessive risk-taking. The associated capital requirements on non-CCP cleared derivatives should also contribute to an increase in the use of more transparent standardised OTC derivatives, which will help reducing complexity of that particular market place and the relevant contracts. However, as it is narrow in focus, the recent EMIR reform does not address other problems identified.
Resolution: the powers and tools contained in the Commission's recent proposal for a Bank Recovery and Resolution Directive (BRR) will contribute to ensuring that banks can be wound down in an orderly fashion, thus reducing the impact of failure. Holders of bail-inable debt will have the incentive to monitor banks more closely, which contributes to reining in excessive risk-taking provided that (i) national authorities take the necessary action when needed, and (ii) investors are actually able to scrutinise banks. In this respect, recovery and resolution planning may contribute to reducing complexity of banks, depending on the actions undertaken by banks and national authorities. However, the resolution powers will not in themselves make banks more resolvable. As noted in the Financial Stability Board
(201156), "the complexity and integrated nature of many firms' group structures and operations … make rapid and orderly resolutions of these institutions under current regimes virtually impossible." In addition, further practical experience will have to be gathered, also as regards the dynamic effects on the market place of devolved decision-making to national authorities;
Supervision: supervision has the potential to rein in excessive risk-taking, thus reducing the probability of failure. Stronger supervision would therefore contribute to restricting activities that relate particularly to interconnectedness, thus further reducing impact of failure. So far supervisors have had limited scope to address complexity outright, but the mandate is expanding. This is particularly the case with the recovery and resolution planning process, which enables supervisors to require structural changes based on the resolvability assessment. In addition, supervisors need to be involved on a timely and continuous basis.
They must take a strategic, forward-looking view and be willing to act intrusively, timely and bold in direction. Furthermore, while the creation of the European Banking Authority (EBA) has significantly contributed to converging supervisory practices, significant differences still remain. Finally, ultimate responsibility for supervision remains at national level and the current levels of coordination and cooperation have proven insufficient to preserve the internal market throughout the crisis and effectively supervise banks active across the internal market in an identical way. That is why the recent first proposals on banking union outlining the Single Supervisory Mechanism are welcome;
Lack of a sufficient systemic (macro-prudential) focus: banking supervision and regulation did not sufficiently focus on systemic/macro-prudential risks prior to the crisis. Banks themselves do not have an incentive fully to internalize the social cost stemming from their own contribution to system-wide risks. In the absence of substantive regulatory and supervisory measures, systemic risks built up in the form of ever larger, more complex and more leveraged financial institutions. Three main weaknesses ought to be mentioned: first, the Basel minimum capital requirements were based on stand-alone risks of a bank; second, liquidity risks were not covered by the Basel rules. This was a problem because excessive short-term market funding increases interconnectedness and hence systemic risk in the financial system; and, third, the existing supervisory structures focused on risks facing individual institutions rather than the financial system as a whole;
Risk management and corporate governance: effective governance and control mechanisms within financial institutions could have helped mitigate the crisis. Accordingly, the CRDIII in 2010 introduced new rules to ensure that staff and management incentives (including remuneration policies) are aligned with a bank’s and society's long-term interests and do not encourage excessive risk taking. Moreover, in order to increase the effectiveness of risk governance in European banks, the CRDIV package proposes enhancing the existing governance framework for banks, in particular by increasing the effectiveness of risk oversight by boards; improving the status of the risk management function; and, ensuring effective monitoring by supervisors of risk governance. When implemented, these rules will contribute to restraining excessive risk-taking, shifting the focus to more long-term risk- adjusted returns and improving the risk culture of banks. Nevertheless, in the absence of representative and authoritative boards, more rigorous regulatory scrutiny of board and management appointments, more accountability and stronger sanctions and stricter measures on remuneration, these rules may not go far enough; and
56 FSB (2011), "Effective resolution of systemically important financial institutions".
Lack of focus on consumer protection in financial regulation and supervision: the financial crisis at least partly originated in irresponsible lending practices. However, the current EU- wide regulatory and supervisory framework and proposals may not sufficiently address these aspects. Several EU initiatives focus on improving transparency of financial instruments (MiFID, PRIPS, UCITS). However, they present two types of shortcomings: first, transparency alone may not be sufficient effectively to protect retail consumers (e.g. in view of complex financial products, selling techniques) and there may be a need to consider different avenues (e.g. engage into more intensive product regulation and/or regulation of marketing practices in the banking sector); and, second, there are supervisory gaps (e.g. consumer protection authorities not being competent in the financial area, and financial supervisors focusing on prudential control) leading to inconsistent implementation.
In sum, substantial steps have been taken, or are in the process of being taken, to address the problems highlighted by the crisis. Even so, the current reform agenda does not fully correct incentives for excessive risk-taking, complexity and intra-group subsidies. While banks' loss absorbency will increase, it is unclear that the new capital rules will be sufficient to limit trading risks or incentives for excessive real estate (and other) lending. Banks in trading and other investment banking activities continue to enjoy a funding subsidy by conducting these activities on the back of (explicitly) guaranteed deposits and other implicit support extended to the bank as a whole. The complexity of bank structures and activities also makes it more difficult to curb excessive risk-taking through internal control processes and external scrutiny by supervisors or market participants. While the Commission's BRR proposal puts a welcome emphasis on reducing complexity, further measures could nevertheless be considered so as to assist resolution authorities. Additional reforms are therefore warranted to complement the existing reforms in order to further address excessive risk taking incentives, complexity, intra-group subsidies, resolvability, and systemic risk.