Felix Hufeld: Regulation as Science and Art

2017-04-21 IMI

This is an abridged version of an OMFIF City Lecture on 1 February 2017 in London. The Official Monetary and Financial Institutions Forum (OMFIF) is a global financial think tank headquartered in London. Felix Hufeld, Federal Financial Supervisory Authority of Germany, President of BaFin, Germany’s Federal Financial Supervisory Authority. Markets should be given room for innovation and failure Financial regulation, like investing in the stock market, is as much an art as a science. No one doubts that regulation requires quantitative analysis, but there are questions that rely on human judgement. The answers to these will not come from algorithms. Financial markets cannot be viewed in isolation from their often volatile political and social environment. In unusual conditions, regulators must find similarly unusual solutions. While showing steadfastness and continuity in their principles, regulators must be pragmatic and flexible on individual issues. It is neither desirable nor possible for the regulator to exclude every risk and any conceivable uncertainty. On the contrary, it is part of the regulatory mandate to give financial markets the necessary freedom for innovation and, indeed, failure. That is why it is important to seek the best possible balance between responsibility and liability, which are inseparable. Liability and the prospect of a bail-in should be the best friend of financial supervision. Banks and their customers are likewise entitled to expect dependability from regulators. Nuance on risk sensitivity On the relationship between financial stability and profitability, one issue is the extent to which banks must be curbed by capital, liquidity, and other requirements. Opposed to this, there is the financial institution’s need to generate profit and offer investors appropriate returns on the risk capital they provide. Experience has shown that when this pressure becomes strong, banks seek to improve or maximise their business model. This is neither illegal nor illegitimate. It even contributes to some extent to making banking more profitable, and possibly, resilient. But there is a limit. Some politicians might say that this limit is reached at the point where profit is distributed to shareholders but heavy losses have to be borne partially or completely by taxpayers. This would disrupt the unity of responsibility and liability. Regulation should ensure that taxpayers’ money is not used, or that it used only in limited and extraordinary circumstances. Some may ask why proceedings must be so complicated, when it would be possible to make banks just as resilient by introducing a much higher leverage ratio or comparable tools. The premise for such a question is flawed. Experience shows that a crude capital approach kills all risk sensitivity. Additionally if institutions have to protect their banking and trading books with flat-rate capital requirements, they are left with no alternative but to take on maximum risk in order to recoup high capital costs. I am convinced that, rather than guiding credit institutions towards a less risky way of doing business, a leverage ratio of 10% or beyond would make many financial institutions act in a riskier way. Mitigating procyclical effects There is a conflict between the objectives of risk sensitivity and procyclicality. In recent years, the greater market orientation of the valuation of assets and liabilities has made the risk situation of financial actors and markets more transparent. In banking regulation, this has happened gradually with the transitions from Basel I to Basel III, while in the insurance sector the launch of Solvency II was a milestone. The market-value orientation is intended to reduce companies’ assumption of risks and strengthen their solvency, among other things. In addition, the loss-absorbing capacity is supposed to be increased. Risk sensitivity, if not appropriately limited, can turn long-term movements into excessive short-term volatility. It can promote the tendency towards too much credit expansion in boom phases and more restricted lending in recession phases – with potential repercussions for the real economy. Much has been done to mitigate procyclical effects. In banking regulation, the countercyclical capital buffer was designed so that institutions should accumulate an additional capital cushion during periods of excessive credit growth. However, ultimately it will not be possible to avoid the regulatory linking of capital and risk with market valuation to go along with some degree of procyclicality. A balance must be struck between market-value orientation and prudence which enables a risk-based regulation with the least possible procyclical effect. The dynamic nature of the markets can only be kept on track when regulation does not spell out everything to the last detail. Regulation ought to restrict itself to forming a framework of principles within which some leeway and freedom from day-to-day supervision is granted. Crises breed demand for regulation Working according to principles demands a close relationship between companies and supervisors. It is important that supervisory authorities can get a full picture of whether an institution has appropriately established its risk management system. Institutions, for their part, have a right to supervision which is fair and comparable, and yet essentially individual. Calls for greater rules-based regulation become louder if something goes fundamentally wrong: real estate crises, sovereign debt crises, and mis-selling scandals are pertinent examples. An abundance of rigid rules cannot do justice to dynamic financial markets and individual risk profiles. Too much principles based regulation, on the other hand, reduces predictability and the harmonisation of the legal application of supervisory measures across individual institutions and countries. It is the mix of both – a principles and a rules based approach – which ultimately makes for robust regulation. Models and statistics alone cannot live up to the reality of financial markets, which are inconceivable without risk. Good regulators are characterised by their ability to balance differing policy and economic goals, even in situations of extreme crisis. Even regulation itself is exposed to volatility. Proportionality, differentiation, and lessons learned are always important and welcome; full-fledged deregulation should be avoided.

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Felix Hufeld: Regulation as Science and Art

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