Durable financial stability requires more than microprudential standards that bolster the resilience of individual firms. It also requires a macroprudential perspective, with flexibility to respond to shocks wherever they occur; with higher standards for systemically important firms; and to increase levels of resilience when risks increase.
Mark Carney, Governor of the Bank of England, Chairman of the Financial Stability Board and Vice-Chair of the European Systemic Risk Board, (ESRB) has addressed European Parliament’s ECON Committee.
The ESRB is the only hub where all the relevant authorities are present, including central banks, bank supervisors, and securities authorities. Through our regular dialogue we can establish and update best practice.
Consider residential real estate. This year ESRB’s work emphasised how these markets were influenced by structural differences, from Loan-to-Value restrictions to tax treatments, across the EU.
Its analysis identified the tools authorities may use to respond to different vulnerabilities, ranging from capital measures to restrictions on debt-to-income ratios and collateral.
Key lessons of the analysis include that:
1. flexibility is needed in both design and calibration of macroprudential tools;
2. no single tool can combat all property risks;
3. tools need to be appropriate to domestic circumstances; and
4. domestic policies are more effective for both domestic and EU financial stability if their spillovers are managed.
The ESRB has built a framework to assess and manage such spillovers, which should be agreed soon and be operationalised early next year. Its central feature is reciprocity – eliminating regulatory arbitrage to give domestic policy greater traction. It will be member led, but, importantly, backed by ESRB recommendations. Compliance will be on an “act or explain” basis but the presumption will be that many exposure-based measures (e.g. LTV, LTI and maturity) will be reciprocated.
This is significant. The ESRB has been notified of macroprudential actions 69 times this year, and 173 times since the introduction of the CRR/CRD in 2014. Although many notices are procedural, they show the direction of travel. More countries are using macroprudential tools, creating an increasing need for a “clearing house” that is both comprehensive and timely.
The ESRB will also evaluate the ways national macroprudential authorities might apply countercyclical capital buffers against financial exposures from countries outside the EEA – a tool given to the ESRB under Union law. That will further bolster collective resilience against the global financial cycle and spillovers from outside the Union.
While risks in property markets reflect national differences, other risks such as misconduct have more common determinants.
In the past five years, misconduct penalties imposed on EU banks have totalled €50bn.
Those costs have direct implications for the real economy. At 5% leverage, that capital could have supported €1 trillion of lending capacity.
More fundamentally, repeated episodes of misconduct undercut public trust in the system.
The ESRB’s work has helped catalyse sensible actions to begin the process to rebuild that trust.
First, it has proposed capturing misconduct costs in stress tests to ensure banks remain resilient even under severe outcomes.
The Bank of England has followed this approach in its most recent stress test which included and additional £40bn of misconduct costs. These costs were calibrated to have a low likelihood of being exceeded and are therefore, by design, much larger than the amounts already provided for by banks.
Second, the ESRB has also proposed tackling misconduct at source by increasing individual accountability. This can be done by reforming remuneration – using variable pay, combined with Malus and Clawback, to hard-wire stronger incentives for good behaviour within firms. The UK is committed to this approach with the toughest remuneration regime in the EU, including the longest deferrals and claw backs.
However, the effectiveness of such measures across the EU is being tempered by the bonus cap. For example, in 2013, the ratio between fixed and variable for material risk takers at major UK banks was around 1:3 – meaning three quarters of remuneration was at risk from individual misconduct. The next year, when firms first had to apply the bonus cap, that ratio had fallen to around 1:1, with the overall level of remuneration unaffected.
Prompted by the ESRB, the FSB is now examining the impact of various compensation tools on misconduct, and if appropriate, it will recommend improvements to next year’s G20 summit.
Reforms to compensation are necessary but not sufficient. ESRB reports have rightly stressed that more should be done to hold senior individuals to account.
Prompted in part by the ESRB, the FSB members will share experiences on the role of bank regulatory powers to address misconduct and on approaches to enhancing individual accountability.
In the UK, we are implementing a new regime to ensure senior managers right across the financial system are held directly accountable for failures in their areas of responsibility. That will be buttressed by clear code of conduct, designed by practitioners, to ensure high standards are understood by all.
