Central banker sees little progress toward financial reform

It’s sobering to be reminded of how little we’ve accomplished toward preventing another financial crisis.

In a London speech March 10, Axel Weber, the president of German’s central bank, ticked off three areas that need to be fixed:

(1) Require banks to have more capital, or equity. Status: Some progress. Basel III has been proposed. Now it’s up to individual governments to impose it. But even Basel III is being criticized by some as weak, and the provisions aimed at preventing runs on the repo market will not be implemented until 2018 (the net stable funding ratio) and 2015 (the liquidity coverage ratio).

(2) Design regulations to handle “systemically important financial institutions,” which he describes as international banks that are so big or so interconnected that their failure might provoke a chain reaction which could eventually lead to a systemic crisis. Status: No progress.

(3) Control the systemic risks in the shadow banking sector. Status: No progress.

Notice that he does not mention predatory lending, derivatives or securitization, which have gotten the most attention in the U.S.

He also doesn’t specifically mention repos, but RepoWatch readers understand that repos are at the heart of shadown banking. Here’s what he has to say about shadow banking:

Basel III and special rules for systemically important institutions are certainly important instruments in safeguarding the stability of the financial system. However, the best dike is of little use when there is a whole ocean at your back.

This ocean is the so-called shadow banking sector: the part of the financial system that is not subject to regulation, that has been inviting regulatory arbitrage and that has been a significant amplifier of risk during the financial crisis. With stricter rules for the regular banking sector, there is a clear danger that more and more activities will flow around the newly erected dikes and add to the ocean of unregulated activity at our back, thereby increasing systemic risk.

Thus, we have to turn our heads, take a close look at the shadow banking sector, understand what is going on there and ultimately control the systemic risks that we have identified.

As a first step it is necessary to define the shadow banking sector. Here, a broad approach is
warranted for two reasons. First, the broader the regulatory view, the less room for regulatory
arbitrage remains – provided regulation is internationally coordinated. Second, only a broad
view allows the regulators to keep track of the constant evolution of the shadow banking
sector.

For the same reasons, it is imperative to define the shadow banking sector not in terms of entities but in terms of activities. The central characteristic of shadow banks is that they replicate the classic activities of banks: they conduct credit transformation, liquidity transformation and maturity transformation. Given that shadow banks pursue similar activities as regular banks, they accumulate similar risks which might easily become systemic, flooding back into the regulated part of the financial system.

Consequently, as a second step it is necessary to monitor the shadow banking sector to identify potential systemic risks – a task that requires first and foremost enhanced transparency requirements for this part of the financial system, for example with respect to trade in derivatives. As a third step we have to draw up an adequate regulatory framework.

One option would be a direct approach whereby the activities of shadow banks are regulated via instruments such as capital, liquidity or disclosure requirements. Another option would be
an indirect approach which regulates banks’ interactions with shadow banking entities.
Potential regulatory instruments could be tighter consolidation rules, higher capital requirements for exposures to the shadow banking sector or limits on the size of banks’ exposure to shadow banks.

The Financial Stability Board is currently discussing all the options regarding the definition, monitoring and regulation of the shadow banking sector. However, as this is a complex subject and a number of unresolved issues exist, it might prove to be a lengthy process.

But I am confident that eventually we will be able to adequately monitor and regulate all potential sources of systemic risk.