Is more supervision by defintion good for stability? Amsterdam, April 28th, 2011 Wim Boonstra Chief Economist Rabobank Nederland

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1 The costs of banking regulation Is more supervision by defintion good for stability? Amsterdam, April 28th, 2011 Wim Boonstra Chief Economist Rabobank Nederland

2 Content The risky character of banking Why banking regulation? What went wrong with supervision? Positive aspects of effective banking regulation The costs of banking supervision Finding the right balance Conclusions

3 The risky nature of banking Many banking risks are the direct result of the intermediation function of banks Credit risk (banks take this risk over from surplus households) Liquidity risk (direct result of maturity transformation) Risk management is the core of banking Retail banking is less risky than investment banking, but risk-free banking does not exist

4 Why banking regulation? Banking is a risky business Financial Stability is a public good Banking failures cause a lot of damage and systemic crisis can lead to deep recessions Supervision aims to protect: Stability of financial institutions and the financial system as a whole Confidence in the financial system (precondition for stability) The banks clients Competition authorities Behavioural supervision

5 What went wrong with supervision? Risks disappeared from the radar screen of supervisors RWA based ratios masked increased leverage of banks Securitization Importance of perverse incentives in the system was underestimated Deposit Guarantee Schemes Benefit structures (Bonus Schemes) Banks were nt the only ones to fail: some supervisors failed as well Mainly in the US In NL: Icesave, DSB, AA/Fortis Lack of coherence in supervision Financial stability Consumer protection not by definition aligned Competition

6 Positive aspects of effective banking regulation Stronger financial institutions Larger systemic financial stability Consumer protection

7 The costs of banking regulation Compliance costs (small compared with potential benefits) Impact on economic performance Destabilizing incentives Increased opacity

8 The impact of BIS 3: lower economic growth and more expensive banking?? Bis 3 in short: Higher solvency requirements (RWA ratios) Introduction of straigthforward leverage ratio Introduction of Net Stable Funding Ratio (NSFR) Impact of solvency requirements: Banks need to attract much additional capital (by retaining profits and/or the issuance of new shares) This requires an adequate rate of return on capital Impact of NSFR: Reduction of maturity transformation Less short term funding; more long term funding More liquid assets This will put banking profitability under pressure The banks reaction: shorter balance sheets, higher margins

9 The impact of a deposit guarantee scheme The aim: protect the consumer The positive effect: Protection of the saver s money Strengthening the competitive position of non-systemic banks The negative result: Protects the reckless saver, punishes the prudent client Disappearing market discipline form savers Gives prudent savers a motive to become reckless Attract adventurous banks The net effect: Increase of financial instability Larger probability of financial crises The higher the guarantee, the larger the negative effects

10 The dangers of intransparency Shifted risks can give the impression that risks have disappeared Risks can be shifted, but will not disappear from the system Invisible risks will not be managed and occasionally pop-up as an accident i.e. government guarantees i.e. shadow banking The probability that things go wrong becomes larger as the Guarantor does not realize which risks he has taken on i.e. government guarantees DGS (does the tax payer know?)

11 Finding the right balance (1) It s the incentive structure, stupid. Strong supervision is essential welcome BIS 3 But financial crises (and recessions) are a central part of market economies we have to learn to live with it and minimize the potential damage Incentives are key: Given the importance of the financial sector for the economy and the potential huge costs of bail outs everything should aim at risk-avoiding behaviour within retail banks As little moral hazard as possible a (much) smaller deposit guarantee A bail out should be an extremely unattractive option for bankers: buying out the banks, but not the bankers

12 Finding the right balance (2) A coherent view on banking is essential Solving the intrinsic tensions: Competition Stability Consumer protection Financial Strenght A large and open economy needs large in internationally oriented banks View of supervision against the macroeconomic context: simple banking (lending based on savings deposits) is not possible due to a shortage of free savings. Dutch banks need global financial markets for funding of their lending (incl. retail) a certain degree of investment banking activities is essential But above all: don t take contradictionary measures!

13 Conclusions Strong and effective banking supervision is essential More is not always better if the wrong incentives are introduced into the system Supervisory measures can undermine financial stability Transparency is essential: the most dangerous risks are those that catch you unprepared Supervison can result in complacency A coherent view on banking is essential for good banking regulation and supervision

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