Today, some people are saying that the storm of the financial crisis is subsiding. I am not so sure. Interbank lending rates are slowly coming down, but they are still far higher than they should be, share prices continue to be volatile and conditions in global markets remain fragile.
More worryingly, we are seeing the effects on the real economy across Europe, in the US and now further afield. GDP is contracting. Industrial production is falling at a record-high pace.
So where do we go from here? The answer is that we have to rebuild trust. That is the core challenge for Europe, the European Commission, global leaders, and the financial services industry over the next five years. It will not be easy.
We need healthy financial markets, without which we will not recover. We need to ensure transparency and adequate risk management, measures on which are part of my proposal on capital requirements. We need adequate oversight and crisis management, which is why I am submitting a paper on early intervention and was looking forward to the analysis of the High Level Group on Financial Supervision under former IMF chief Jacques de Larosiere, which was released on Wednesday.
Finally, we need international cooperation in bad and good times alike. We need reform of the international financial institutions and adequate monitoring and surveillance mechanisms.
The current European and global frameworks for accounting standards and capital requirements, for example, have exacerbated turmoil in the markets. The rules, frankly, are too pro-cyclical. When market liquidity becomes tight, as it is currently, sales decisions and valuations based on mark-to-market accounting reinforce the downward spiral by causing further forced sell-offs, which amplifies the decline in mark-to-market prices. That is why I recently proposed a measure to provide firms with more flexibility on mark-to-market requirements and to facilitate asset transfer from the trading book to the banking book.
Dynamic provisioning has benefited many banks in the past. In the current turmoil, it has served Spanish banks particularly well, and I would like to see a return to it more broadly. A system that requires banks to accumulate more substantial buffers in good times so that they can let them run down in bad times makes sense both from a micro viewpoint and from a macro viewpoint. It restrains excessive credit expansion during booms, while reducing the risk of bank failure or a much diminished capital base in recessions, thereby enabling bank lending to kick-start a sustainable recovery.
Ideally, we should get international agreement on such a revised regime, and I will be pushing for it. This issue aside, I have never been persuaded that capital requirements on trading books should be materially lower than for those on banking books.
When liquidity dries up, trading becomes impossible without a very sharp discount. To be sure, the probability of default might be lower on a trading book because of the shorter time that the assets are held. But the scale of total capital erosion in the event of default is the same, regardless of whether the asset has been held for a single day on the trading book or an entire decade on the banking book. Much tougher capital requirements for trading-book exposures are therefore needed and will be brought forward as soon as possible.
As to value-at-risk models, we now have inconvertible evidence they are very useful when they don’t matter and totally useless when they do matter. I am convinced that we need an overall cap on leverage on banks’ balance sheets, regardless of risk asset weightings or value at risk measurements. The fact that equity-to-asset ratios are currently averaging out at about 3 percent tells you everything that you need to know about the inadequacy of the current pro-cyclical capital requirement framework.
In the current climate, it is impossible to measure the valuation of many financial assets to an accuracy of 3 percent, and the excessive leverage that has been a feature of many banks’ balance sheets through this crisis needs to be put right — and kept right for the future. Again, this must be a feature of further revisions to the capital requirement framework for banks.
We need to strike a balance between regulation to correct the failings that we have witnessed and the need to preserve dynamic and innovative banks and markets. What we do not need are forests of reports going to supervisors who appear to devote ample resources to ensuring they arrive on time but fewer on interpreting their content and drawing the relevant conclusions.
Nor can we afford to become captives of those with the best-paid and most persuasive lobbyists. After all, it was many of those same lobbyists who in the past managed to convince legislators to insert clauses and provisions that contributed so much to the lax standards that created the systemic risks for which taxpayers are now being forced to pay.
Charlie McCreevy is EU commissioner for the Internal Market and Services.COPYRIGHT: PROJECT SYNDICATE
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