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Symposium 2009

Proposal - Balancing risk taking and financial regulation

The Challenge

Many observers blame excessive risk taking and inadequate regulation as the core causes of the current global financial crisis that we have been witnessing.

Many observers blame excessive risk taking and inadequate regulation as the core causes of the current global financial crisis that we have been witnessing.

The root of the current global financial crisis has been excessive risk-taking. A significant underpricing of risk and rising financial leverage made the financial system vulnerable. A general loss of confidence ultimately led to its collapse. The factors that contributed to the global financial crisis are manifold, ranging from microeconomic aspects – in particular, skewed incentives, regulatory weaknesses and an underestimation of risk – to macroeconomic aspects, such as global current account imbalances and a blind belief in the persistence of the “Goldilocks economy”.

Initiating reforms now

To balance risk-taking and, thus, to enhance the financial system’s resilience it is vital to tackle all of these issues. Strengthening financial regulation will cover many of them and, consequently, is usually found at the top of the international agenda. It goes without saying that even the most cleverly designed regulation cannot prevent short spells of financial instability. In globalised financial markets, where financial innovation is, in principle, to be welcomed because it brings economic progress, occasional excesses are bound to happen. However, reforms can considerably improve the resilience of the global financial system. Such reforms have to be initiated now that awareness of the immense costs of financial instability has created a window of opportunity for a redesign of the global financial architecture. That window will not remain open for ever.

Safeguarding a level playing field

The starting point for a comprehensive financial stability framework is to safeguard a level playing field. Therefore, in April 2009, the G20 agreed to extend regulation and oversight to all systemically important financial institutions, instruments and markets. The objective must be to find and close regulatory loopholes such as those exploited by the shadow banking system. Hedge funds are a case in point. Although they have not been at the centre of the financial turmoil, they have been greatly affected by the crisis. The rapid unwinding of their highly leveraged positions tended to exacerbate the turbulence and, hence, posed an indirect risk to the financial system. Therefore, hedge funds should be registered at the international level and hedge funds whose transactions might have implications for systemic stability should, in addition, be subject to direct supervision.

Reforming banking supervision

In spite of an ongoing worldwide trend towards disintermediation, the financial crisis has also shown that banks remain the primary link between the financial system and the real economy. It is therefore essential to further improve banks’ risk management and to review their capital and liquidity requirements. Banks’ own resources have to return to being an effective first line of defence against financial pressures. Furthermore, in the course of the financial crisis, banking supervisors have been stepping up international coordination and cooperation. This is particularly true of Europe, not least owing to the ongoing integration of euro-area financial markets. Nonetheless, we have to keep in mind that supervisory competence and responsibility lie, for the time being, with the national authorities. Cross-border cooperation should evolve in line with market developments, not run ahead of it.

Strengthening market discipline

Even though it is key to reform financial regulation and make it more proactive, market discipline has to be strengthened as well. Of course, financial markets cannot be trusted to regulate themselves, but improved disclosure requirements concerning banks’ exposures, risk profiles and valuation approaches will still help to improve risk assessment among financial market participants. In the short run, this will also help to rebuild confidence. In addition, readjusting incentives for market participants, financial sector employees and credit rating agencies is vital. Above all, once the crisis is over, governments must find ways of dissuading markets from relying too strongly on banks being too big or too interconnected to fail.

Guarding against systemic risk

However important all of these measures are, supervision has to be taken one step further if we want to address fully the causes of the current financial crisis. The entire financial system is more than the sum of its parts. Therefore, it is not sufficient to safeguard the stability of each individual bank; instead, systemic risk has to be identified and guarded against. There are numerous issues to be addressed: How to restrain the build-up of risk taking during boom periods? How to reconcile the risk-sensitive approach of Basel II with the procyclicality of lending? How to prevent a renewed build-up of global current account imbalances? Central banks are at the forefront of financial stability analysis. They take a strong and natural interest in it because of the interdependence between monetary policy and the financial system. Moreover, as the majority of central banks, at least in the euro area, have supervisory responsibilities or are strongly involved in banking supervision, generating information-related synergies between supervision and monetary policy as well as deploying central banks’ technical expertise will surely contribute to promoting financial stability.

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