Deposit insurance core principles
Keynote address by Mr Jaime Caruana, General Manager of the BIS, at the Conference on the "Core Principles for Effective Deposit Insurance Systems", Basel, 23-24 September 2009.
The crisis has shown that deposit insurance issues matter a lot for financial stability. It is essential to have properly functioning deposit insurance schemes in place when financial stress emerges. And it is essential that these robust insurance frameworks are built sufficiently in advance in good times, given that it is often too late to improvise once the problems occur. From this perspective, the recent completion of deposit insurance core principles is welcome and represents a great achievement on the part of the International Association of Deposit Insurers and the Basel Committee on Banking Supervision. It is one key element of the massive and broad work programme undertaken by the official sector in response to the crisis. But implementation is crucial: the development of prudent, well informed standards and supervisory guidance is only the first step in a two-step process. The second critical step is for these standards and guidance to be implemented in an internationally coordinated and consistent manner. This puts a premium on cooperation and information sharing among supervisors.
Good morning. It is a great pleasure for me to participate in this conference on the Core Principles For Effective Deposit Insurance Systems. It is also a great pleasure to have all of you here at the BIS - I hope that you really feel at home.
1. The recent financial crisis - a real test
Three years ago, when I was at the IMF, you invited me for the first time to one of your events, the Fifth Annual International Association of Deposit Insurers (IADI) Conference in Rio de Janeiro (16 November 2006). I have just checked to see what I said in my dinner speech on that occasion. I must say that looking back over what you said before a crisis is a humbling exercise.
I argued then that there were two significant changes in global financial markets which were supportive of financial stability. First, I felt that progress in risk management practices in financial institutions was enhancing the resilience of financial markets. My second example - very different - was debt management improvement in many emerging market countries, with respect to both the structure of their sovereign debt and the functioning of their domestic capital markets.
What a difference a few years can make! Certainly, I was proved right with my second comment: stronger emerging financial markets have been a stabilising factor in the current crisis. But I was less right on the first point. The resilience of mature financial markets proved to be much weaker than we thought. Risk management frameworks, from governance arrangements to models, were unable to cope with incentive structures that led to excessive leverage and risk-taking. Neither supervisory arrangements nor market discipline were able to prevent the crisis, and markets proved to be less efficient and less self-stabilising than we thought.
What went wrong? I would argue that the case made against the models in financial institutions should not be exaggerated. To be sure, some models have proved to be erroneous, and there are a number of areas where significant progress is required. Rating agencies' models were not able to capture some of the complexities of structured products; valuation techniques did not take sufficient account of liquidity risk; etc. But a significant part of the problem was a governance and management failure: indeed, different financial institutions with similar models took different decisions. Another key challenge highlighted by the crisis is the limitations of the existing toolkit for dealing with unexpected events, particularly those that are infrequent and therefore unlikely. It turned out that we knew much less than we thought we did. Perhaps it is true that "we know accurately only when we know little; with knowledge, doubt increases". But the question is how regulation can better deal with uncertainty and compensate for these shortcomings.
What, then, should be the lessons for us going forward? They say that experience is the toughest teacher because it gives the test first, and the lesson afterwards. We have just had that very difficult and painful test, and now we need to draw the right lessons.
2. Deposit insurance and financial stability
Of course, a key lesson of interest for all of us today relates to deposit insurance. The crisis has shown that deposit insurance issues matter a lot for financial stability. It is essential to have properly functioning deposit insurance schemes in place when financial stress emerges. This can help support confidence, limit panic reactions, and avoid economic agents becoming too risk-averse. And it is essential that these robust insurance frameworks are built sufficiently in advance in good times, given that it is often too late to improvise once the problems occur. Indeed, the recent crisis has required exceptional measures beyond the comfort zone of all policymakers. Many countries around the world had to expand deposit insurance coverage across the board in a precipitous and uncoordinated way. This highlighted the importance of international cooperation in a global crisis.
From this perspective, the recent completion of deposit insurance core principles is welcome and represents a great achievement on the part of IADI. It is testament to the fact that the official sector can collectively deliver high-quality, well considered and highly relevant work. It is also a good example of cooperation among standard setters, namely IADI and the Basel Committee on Banking Supervision.
The design of explicit and internationally coordinated deposit guarantees will instil public confidence. Having proper mechanisms in place in a pre-emptive way should a new episode of financial stress emerge will provide clarity and certainty. The new principles will also contribute to financial stability by minimising systemic risk, protecting consumers, limiting moral hazard and promoting market efficiency. This in turn will help to limit the severity and probability of future crises.
It will also contribute to addressing the new challenges posed by the crisis in this area of deposit insurance, for instance: the strategies for exiting from government explicit and implicit guarantees; and the "too big to fail" problem and the necessary resolution frameworks, particularly for cross-border bank resolution. In particular, the recent turmoil in Iceland has underlined the importance of cross-border coverage of deposit insurance. Indeed, the recent report prepared by the Cross-border Bank Resolution Group of the Basel Committee sets out 10 key recommendations that reflect the lessons from the recent financial crisis and seek to improve the resolution of a failing financial institution that has cross-border activities. In this context, having adequate special resolution regimes in place to deal with failing financial institutions will ensure the prompt payment of insured cross-border deposits. They can help to reduce the moral hazard problem.
The various standard setters such as IADI and the Basel Committee as well as the BIS - in particular through its Financial Stability Institute (FSI) - are continuing to work on many other issues related to deposit insurance. Some of these efforts seek to improve firm-specific risk management inadequacies, supervisory standards and oversight. Other important tasks are more macroprudential: for example, the accurate assessment of the interlinkages between the performance of systemically important banks, financial stability and the real economy; or the introduction of countercyclical elements in prudential regulation. I will not be reviewing these specific issues in detail today. But it is essential that this ongoing work is continued apace and with the full support of the international community.
3. Maintaining the impetus for reform
Maintaining the impetus for reform is key not only for deposit insurance but also for financial regulation and supervision more generally. Reforms need to be pursued in order to: first, address weaknesses in regulatory and supervisory frameworks; and second, find ways to ensure that markets correctly internalise system-wide risks. Let me expand a bit on the various efforts that are currently under way and that aim at better financial regulation. This is at the heart of the work of the BIS and the various committees and groupings hosted by the BIS.
A core of these Basel-based activities has traditionally focused on banking supervision, and a lot of progress has already been achieved on this front. Weaknesses that were exposed by the crisis have been quickly addressed - let me just mention the regulatory treatment of banks' trading books. Moreover, fundamental changes are being implemented. Early this month, the supervisors and central bank Governors of 27 major industrial and emerging economies met in Basel. They adopted a comprehensive set of measures to strengthen regulation and supervision of, and risk management in, the banking sector. Six particular objectives are worth highlighting:
- to raise both the level and the quality of banks' capital, including the phasing-in of a Pillar 1 leverage ratio as a supplement to the risk-based requirement;
- to adopt global liquidity standards for funding operations;
- to implement countercyclical capital buffers, with a focus on capital conservation;
- to better address the contribution of individual institutions to system-wide risk;
- to ensure a thorough and comprehensive calibration of all these elements in terms of the overall capital requirement; and
- to allow significant time for ensuring the transition so as not to impede the current recovery.
Financial regulation is also making progress outside the banking sector. A few days ago, the Financial Stability Board met in Paris. It reviewed the implementation of the plans set out by the international community to strengthen regulation in the wake of the crisis. The outcome of this meeting is easy to summarise: progress is being made rapidly on a variety of fronts. Let me give just a few examples. Steps are being taken to address moral hazard issues related to "too big to fail" institutions. Derivatives infrastructure and securitisation are being strengthened. Cross-border cooperation is being enhanced. Various international standards and accounting rules are being revamped. This is precisely what the work of IADI and other standard setters hosted by the BIS is all about.
These reforms will bring two benefits that are crucial in present circumstances. The first is to reduce uncertainty. By clarifying today the features of financial regulation in the future, we can contribute to increasing confidence and help economic agents make better decisions today. The second and particularly obvious benefit is to repair and strengthen the financial system.
But ongoing reforms are far from being fully implemented, and we should avoid complacency. There are signs that the global economy is currently improving thanks to unprecedented policy actions. The main risks we were facing only a few months ago have to some extent dissipated. Yet a new risk has emerged: that the ongoing rebound in financial markets could reduce the impetus for the reforms that are urgently needed.
To fail to maintain that impetus would be a clear mistake. The profile of the recovery is still unclear, and it is too early to think that we are out of the woods. Moreover, the financial system is still in intensive care. It needs to become more resilient and less prone to the kind of financial stress that we have just experienced - the exceptional combination of a severe economic recession, a financial crisis and asset deflation. We must be aware that coping with this sort of stress is a very difficult and lengthy process, as it involves many fixes: repairing balance sheets, restructuring financial institutions, revamping business models, etc. And it also requires substantial adjustments on the other side of the coin - the real economy - to absorb past excesses in terms of leverage and overcapacity in a number of sectors.
History tells us that, first, such an adjustment process requires time and policy determination in order to be completed and that, second, the transition period can be very challenging: both the financial system and the real economy remain exposed to idiosyncratic shock and risks of reversals. Perception of policy mistakes can easily arise, especially if exit strategies are not well planned and communicated. These considerations are particularly relevant today, and there is a major risk of misreading the recent rebound in financial markets.
4. Regulation alone will not be sufficient
Improving financial regulation is important, and ongoing reforms must be pursued. But better regulation alone will not be sufficient. Indeed, the recent global crisis produced quite different results across countries despite similar capital regulation. Some financial systems were left broadly unscathed, while others almost collapsed.
One of the reasons behind this variety of outcomes is that regulatory enforcement differed substantially among countries. For example, supervisory authorities responded in a different way to the relaxation of underwriting standards and the growth of banks' off-balance sheet positions in the run-up to the crisis. This suggests that setting adequate regulation is not enough if not proactively implemented and properly enforced. The rules of the game do not matter without the ability and/or willingness to fully apply them. Good regulation has to be supported by equally good supervision, which must be able to act in a timely and credible fashion. To be sure, supervisors will have to have the necessary legal capacity to enforce rules and the adequate means to do it properly.
Needless to say, regulation must also be complemented by better macroeconomic policies. These policies must play a more active role in mitigating excessive leverage and asset bubbles in the upturn of the cycle. Relying only on regulation would not only be likely to overburden it, at the risk of impeding innovation, but it would also be self-defeating.
To that end, macroeconomic policy frameworks should be better designed so as to contribute to leaning against the build-up of financial excesses at the first stage. This is a key element in mitigating the succession of serial boom-bust cycles. For instance, in some cases, monetary policy could seek to counteract excessive credit expansion and asset price booms even if price stability is achieved. Similarly, we must achieve greater fiscal restraint in good times. First, this will help moderate booms. Second, lower public debt in good times would provide room for manoeuvre to activate financial stabilisation measures in times of stress - we should never forget how costly repairing financial institutions can be.
Although we should avoid creating headwinds for the recovery, we need to embed current exceptional policies in a credible longer-term perspective. And we should plan sufficiently in advance how to unwind these policies. This is the well known exit strategy issue.
This normalisation question is also relevant for deposit insurance. In response to the crisis, many exceptions to previous deposit guarantee arrangements were introduced at the last minute and with almost no coordination across countries. These temporary measures will have to be progressively unwound, in a way that should be more coordinated than when they were set up. This does not, of course, mean that the same calendar should be applied in all countries irrespective of their domestic conditions. What is important for international coordination is that measures must be consistent and announced sufficiently in advance, in a clear and transparent way.
5. Implementation is essential
In conclusion, I believe it is important to recognise the massive work programme undertaken by the official sector in response to the crisis. Let me also stress that implementation is essential. The development of prudent, well informed standards and supervisory guidance is only the first step in a two-step process. The second critical step is for these standards and guidance to be implemented in an internationally coordinated and consistent manner.
Finally, I would be remiss if I did not emphasise the importance of cooperation and information sharing among supervisors - yet another lesson from the crisis. Conferences like this one play an important role in helping to disseminate timely information, and I once again commend the FSI, the Basel Committee and IADI for the timely organisation of this event.