In the wake of the crisis, the global financial architecture is undergoing a metamor- phosis and measures are being taken to strengthen the financial system, with impor- tant steps being taken in a number of areas, including macro-prudential supervision, the configuration of the European supervisory regime and crisis management. Institutional developments
Global initiatives
International bodies such as the Financial Stability Board(FSB), the Basel Committee on Banking Supervision (BCBS) and the International Monetary Fund(IMF) are stepping up their focus. Separate subgroups are concentrating on the most urgent problems, such as improving cross-border crisis management, setting more stringent liquidity and capital requirements for banks, and limiting systemic risk emanating from systemically relevant financial institutions. Additionally, the institutional con- figuration of financial and macro-prudential supervision in Europe is being reformed and strengthened through the creation of European Supervisory Authorities (ESAs) and the European Systemic Risk Board (ESRB). The main aim of all these changes is to generate a stronger financial system with solid financial institutions, that is bet- ter able to withstand shocks and which itself generates as little instability as possible. The measures taken by the Basel Committee to strengthen the capital and liquidity of banks play a key role here. Another aim is to create more effective policy and supervision and enhanced collaboration, both between the different authorities and across national borders.
US President Barack Obama set out the main outlines of a reform of the American financial sector on 21 January 2010. Advised by the former central banker Paul Volcker, Obama proposed that constraints be imposed on banks and other finan- cial institutions concerning both their scope (nature of their activities) and size. Under the proposals, deposit banks or groups of which a deposit bank forms part would no longer be allowed to own or invest in hedge funds, private equity or pro- prietary trading, except on behalf of their customers; in addition, a maximum limit would be set for the size of bank liabilities.
Although the American proposals initially met with some sympathy in the rest of the world, Europe fairly quickly presented its view that it was far from certain that these proposals would make financial institutions themselves and the financial sys- tem safer. It is after all difficult to determine which activities are risky and which are safe. Moreover, there is a danger of infection between safe and less safe banks. Limiting the scope of banks’ activities could also mean that the risks end up in the unregulated part of the financial system (shadow banking) – risks which could ulti- mately be too great for regulators to ignore.
Another proposal which is being widely discussed, especially in Europe, is the option of imposing an additional tax or levy on banks or on the broader financial sector. The proceeds can be regarded as a general government revenue or could be used or to meet the costs of a subsequent crisis in the future (resolution fund).
Several initiatives to strengthen system
Ensuring alignment with the broad raft of international measures and initiatives to address the problem of banks being ‘too important to fail’ is very important here, as is ensuring a level playing field. The consistency of such a levy, for example as regards the basis on which it is levied, is also essential. Key questions here relate to the strategy used for such a levy and the way in which activities in other countries are taxed.
The timing of a levy would also be crucial: many banks are still in the recovery phase. Ultimately, questions can be asked whether a bank levy is actually the most effective method of curbing systemic risk. For example, the high leverage of banks would change little if uninsured debt is exchanged for insured debt (substitution to deposits). Moreover, alternative sources of finance (e.g. securitisation) would be unaffected, whereas these played an important role in the recent crisis. Clarity is also needed about the impact of a tax at macro-level, for example the consequences for lending.
DNB sees the value of the above proposals, but does believe that it is important not to lose sight of the bigger picture. Initiatives such as the plans of President Obama or the introduction of a bank levy must not divert attention from the need for a fundamental strengthening of the financial system in relation to capital and liquid- ity requirements, risk management and macro-prudential supervision. However understandable some plans may be, it is crucial that these measures are not prepared through separate channels. Proposals to constrain the activities and size of banks and plans for a bank levy broadly have the same intent as the modifications on which the Basel Committee is currently working. It is important that the momen- tum for tightening up the Basel norms is maintained.
Crisis management and crisis management system
Discussion is currently going on at European level on strengthening the crisis man- agement framework for cross-border banking groups. Attention is also focused on the scope for introducing ‘living wills’ and compulsory convertible bonds. Further research is needed on the practical benefits and drawbacks of such schemes. Moreover, their introduction would require international coordination in order to ensure that the level playing field between institutions is not disrupted.
Strengthening the Dutch crisis management system is also a high priority. The expe- riences of the financial crisis show the need for an improved system. Some countries have already taken steps to enable more rapid intervention where there is a threat to financial stability, such as granting authorities the power for expropriation and transfer of the shares and/or assets and liabilities of troubled banks. In the light of this, DNB is working in partnership with the Dutch Ministry of Finance on an eval- uation and review of the crisis management system in the Netherlands. Naturally, the financial sector will also be consulted once the relevant legislative proposals are ready.
Developments in the financial infrastructure
The market for over-the-counter (OTC) derivatives has grown massively in recent years; in June 2009 the total notional value of all outstanding derivatives contracts exceeded 600 trillion US dollars (that is, 600,000,000 million; IMF, 20104). The
financial crisis demonstrated that the trade in OTC derivatives can contain consid- erable systemic risks due to a lack of uniform standards for risk management. Lack of transparency in the market also contributed to the systemic risk. There is accord-
4 International Monetary Fund (2010), Global Financial Stability Report.
Proposed bank tax
Progress on Basel proposals crucial
Reforms in OTC derivatives market
ingly a consensus among policymakers that the OTC derivatives trade must be made safer and more transparent. In September 2009, the G20 group of countries formulated reform proposals, and international supervisory authorities are looking at proposals for new regulations. A key component of these proposals is the stand- ardisation of derivatives contracts. This will promote clearing via central counter- parties (CCPs), which is desirable under certain conditions (figure 1).5 A CCP that
is properly managed, adequately capitalised and earns a sufficient margin can miti- gate systemic risk by i) netting positions, ii) absorbing the failure of a clearing mem- ber, and iii) imposing high risk management standards on dealers. Moreover, the use of CCPs fosters transparency. The case of Lehman illustrates the potential ben- efits of central clearing; both the securities and derivatives position that Lehman held with CCPs at the time of its failure were subsequently settled with virtually no problems. Counterparties were not affected because the CCPs had assumed the counterparty risk. The collateral that Lehman had placed with these counterparties to hedge its positions proved sufficiently valuable to compensate for the losses suf- fered.
However, not all derivatives can be cleared centrally, and efforts are therefore also under way at European level to develop regulations for OTC clearing. In order to limit risk, financial institutions will have to hold more collateral when clearing derivatives bilaterally than when making use of a CCP. This requirement also encourages the settlement of suitable contracts via a CCP. In addition, to foster transparency, OTC transactions will have to be reported to trade repositories.6
An increase in the use of CCPs – for settlement of both derivatives and securities – will however lead to a concentration of counterparty risk, so that a failure could have significant repercussions for the system as a whole. A specific factor for the trade in OTC derivatives is the usual existence of the loss-sharing agreements between the clearing members affiliated to a CCP. Failure of a large clearing mem- ber could then lead to losses for the other members. This places heavy demands on
5 Standardisation is in fact not the only condition for central settlement; the derivatives must also be suffi- ciently liquid, must not bring any additional risks that cannot be eliminated or mitigated by the CCP, and regular pricing information must be available.
6 A trade repository is an electronic storage facility where information on trades in OTC contracts is logged.
Creation of CCPs strengthens system …
… but also entails risks
A E A E CCP F B. F A. B D B D C C
Figure 1 Reduction of bilateral relationships through creation of a CCP
Note: the circles represent financial institutions which enter into mutual credit derivatives contracts. The creation of a CCP for credit derivatives increases the potential netting of contracts.
the risk and liquidity management processes of the CCP itself. The EC is currently looking to develop a supervisory framework at European level; this is a desirable move as the present fragmented supervisory system distorts the level playing field within Europe. For example, growing competition between CCPs has led not only to a significant reduction in clearing fees (chart 19), but also to competition on risk management standards, something that has a negative impact on the stability of the institutions concerned.
To guarantee adequate risk management, it is desirable to establish not just a har- monised supervisory regime, but also an independent international validation group for CCP risk models. A further issue is the extent to which interoperability – the netting of positions between CCPs – should be permitted. The fragmented playing field means that dealers may be forced to place collateral with several CCPs, potentially leading to loss of efficiency. CCPs have therefore formulated joint pro- posals on interoperability. DNB is currently studying these proposals together with its European colleagues. One of the prerequisites for approval will in any event be that clearing members will be required to hedge the inter-CCP exposures with addi- tional collateral to compensate for the implied heightened risk of interoperability for the affiliated CCPs. This could also be beneficial for financial stability because the creation of a network of CCPs would make the system less sensitive to the fail- ure of one single CCP. The benefits of interoperability, which would see the collat- eral requirements imposed on clearing members reduce, are likely to far outweigh the additional costs in the form of extra collateral to hedge the mutual exposures. A further relevant development in securities settlement systems is the imminent creation of Target2-Securities (T2S), a Eurosystem initiative for a joint platform to enable securities and central bank cash transactions to be settled across European borders at low cost. Securities custodians will then outsource their securities settle- ment activities to the Eurosystem. T2S contributes to the further standardisation and European integration of the securities settlement infrastructure; until now, cross-border processing of transactions in central bank money has not been possi- ble. In addition to fostering transparency, T2S will act as a catalyst for further har- monisation at the European level and will therefore contribute to financial stability. T2S is expected to become operational in 2014.
The trade in securities and financial instruments has evolved considerably in recent years, driven largely by computerisation. The use of new techniques such as algo- rithmic trading has for example enabled stock exchange traders to identify and exe- cute transaction opportunities without human intervention. The algorithm can also set the timing, trading platform and size of an order. Automated trading strategies
Emergence of new securities trading techniques …
Chart 19 Clearing fees In EUR 0.7 0.6 LCH.Clearnet (NL) EMCF (NL) 0.5 0.4 0.3 0.2 0.1 0.0 Jan.
05 July Jan.06 July Jan.07 July Jan.08 July Jan.09 July
such as these are based on technical analysis models, which can also be fed from news sources or detected dealing patterns by other market players. A key issue for supervisory authorities will be the degree to which these developments in trading systems introduce new risks. For example, automated trading systems can reinforce market movements and thus increase the procyclical nature of the financial system. Partly as a result of algorithmic trading, the average order size executed via trading platforms has been declining steadily in recent years. This is making it more and more difficult for market players who regularly execute large orders, such as institu- tional investors, to realise these orders with minimum price impact. As a result, larger orders are increasingly being executed via ‘dark pools’ and other alternative trading platforms where trades in financial instruments are invisible and only lim- ited market information is released after a transaction. The rise of these ‘dark pools’ can pose problems for supervisory authorities if the transparency of market move- ments is impeded. DNB believes it is desirable that there should be adequate super- vision of all new trading platforms, with concomitant requirements in respect of transparency.
… demands transparency and supervision