Restoring confidence in banks. Keynote address by Mr Stefan Ingves, Chairman of the Basel Committee on Banking Supervision and Governor of Sveriges Riksbank, to the 15th Annual Convention of the Global Association of Risk Professionals, New York, 4 March 2014.
“The financial crisis, which began seven years ago, was in essence a collapse in confidence. It stress-tested regulation just as much as it did banks. Both were found wanting. Bank risk managers severely underestimated the risk that such a widespread loss of confidence in the banking system could occur. The regulatory framework was inadequate to protect against such a crisis of confidence when it did. The result was a crisis that continues to impose substantial costs on society. This crisis of confidence – which is what underlies a liquidity crunch – reflected uncertainty. Everyone knew that banks had taken hits from the subprime fallout. But in which banks were those losses hiding, and how large were they? Was the capital that banks reported really present and ready to absorb these losses as intended? The shortcomings in risk management and regulatory settings exposed by the crisis make for a long litany. Today, I will focus on just three issues – ones that directly relate to confidence in the underlying soundness of banks. First, in some jurisdictions the existing regulatory framework allowed equity capital – the main shock-absorber for losses – to be run down as low as 2% of risk-weighted assets. And it was not just the amount of capital that was deficient: so was the quality. Notably, banks could stock the remaining 6% of required capital with cheaper, debt-like instruments that, as soon became clear, could only be used to cover losses after a bank had failed. Second, the prudential framework filtered out – that is, ignored – some mark-to-market losses on holdings of securities. But investors weren’t willing to overlook such losses – on the contrary, they were extremely concerned about them, and they started to reassess bank capital ratios in that light. The focus on simpler measures – such as a leverage ratio based on tangible common equity – became stronger as a result.”
Third, under existing accounting standards, bank provisioning for credit losses on their loan books was backward-looking. The incurred loss model that underpinned IFRS and US GAAP prevented banks from making forward-looking assessments of likely losses. So provisions had not been adequately built up in good times, and there was considerable uncertainty about what additional provisioning might be needed.