Johnny Åkerholm: Basel III outdated before the ink has dried

 
Johnny Åkerholm. Photo: Johannes Jansson - Norden.org

Summary of introductory remarks*

How is it possible that the largest financial problems in modern history occur only a few years after the introduction of Basel II, the most extensive regulatory framework ever? Did the implementation fail, did it not go far enough or was the framework flawed?

Following the 2008 crisis, we have a system where the collective responsibility for financial stability has become explicit rather than implicit. In these circumstances, it is logical for the collective to try to ensure that risk-taking is contained. But how can this be achieved?

The preferred framework has, no doubt, the right intentions but it does not offer the right incentives. One can hardly object to the target that more risk should be backed up by more capital. But it is the operationalisation of this target that creates the problems.

The regulatory framework assumes that we can objectively measure future risks. At best, this is true in the short term, but the further we go into the future, the less the past tells about the future. This has always been the case, but intensified globalisation has alone rendered this assumption doubtful in the last decade.

A good case in point: this framework has not been able to predict that the sovereigns would exert the most significant risk to the financial sector, as is the case today. On the contrary, financing of the sovereign has been seen as risk-free for which, in most cases, no capital coverage has been required.

In the effort to find objective measures of risk, the risk assessments have become increasingly technical. Even worse, the regulatory authorities have, in scrutinizing and finally accepting the models which are used to assess the objective risks-intentionally or unintentionally-taken responsibility for the "correctness" of the frameworks. After being accepted, the players in the financial sector have all the reasons in the world to believe that they now have a proper measure of their risks.

As a result of this, the focus in the financial sector has come to be concentrated on technicalities rather than economic fundamentals. The temptation for a banker not to use time and effort to analyse Portuguese, Italian or Greek sovereign risks, if the accepted models tell us that these investments are risk-free, is overwhelming. The result is that when the risks materialise, there will inevitably be a lack of capital in the banking sector.

To make a long story short, I doubt the wisdom of trying to regulate the financial system in such great detail. Not only will it lead to a situation where regulators solve the previous problem (like generals who fight the previous war), but it will also provide the wrong incentives to the financial sector.

In essence, the division of responsibility between regulators and tax-payers, on one side, and the financial industry, on the other, has to be redesigned; regulators and tax-payers have taken over too much responsibility.

I believe more in the traditional approach where regulators ensure that proper risk management systems are in place but do not take responsibility for all the details, and, above all, do not take responsibility for judgements. Risk-takers should take this responsibility, and face the consequences if things go wrong.

This rests basically on two things: the owners should be aware that they are the first to lose their money, and management the first to lose their jobs, if things go wrong. Owners and management must have the incentive to contain risk-taking.

For this, I see at least three requirements:

• The regulatory authorities should be equipped with the legal possibility (and requirement) to take over and install new management in financial institutions which find themselves in a distressed situation.
• The regulatory authorities should also have the legal possibility to wind down and dissolve financial institutions.
• While the compensation systems have, in many cases, contributed to excessive risk-taking, it is difficult to believe that this could be managed through detailed regulation. But the regulatory authorities should have the possibility to enforce full transparency of the compensation system and also to express a public opinion when these are deemed to stimulate unhealthy risk-taking.

Given that Europe is heading into a recession, that the sovereign sector is in deep structural and financial problems in many countries, and that the financial industry, as a result, is in a weak position, is this the right time to burden the industry with more costs? Timing is probably always bad from somebody's point of view. But it is obvious that the risk of a credit crunch is real for the time being, and this will not make the sustainability problems in the public sector any easier to solve. It is also clear that contrary to the situation in 2008-9, the possibilities for tax payers to provide support are limited, as weak public sector finances are at the root of the problem.

As a result, I am afraid that we are grossly underestimating the economic effects of increased costs on financial intermediation. After years of excesses in this sector, one is tempted to believe that one or two limitations will have a marginal impact. True, the impact of the individual measures might seem bearable, but the combined effect could be very different, and the cumulative effect will not be linear (not additive but multiplicative). In a situation where the EU-area is lacking growth and it risks falling off the global economic map, the policy efforts are concentrated on increasing the cost of capital and limiting risk-taking.

It is popular to blame the financial industry today. So much so that it is even blamed for the excess indebtedness of sovereigns. However, one should remember that while reckless risk-taking is a problem for society, a malfunctioning financial system which is not able to intermediate funds to investments at a reasonable price is a catastrophe for the economy. This is of particular concern in Europe, which is much dependent on a well-functioning banking system, as the capital market is of clearly less importance than in the US.

Therefore, my humble prediction is that in the future, which is not too far away, the revitalisation of the financial industry will be high on the economic policy agenda.

* The introductory remarks were delivered at the conference on EU regulation and supervision being held by Finland's Financial Supervision Authority.