Key-note speech Frank Elderson for the Conference
Hazelhoff Centre for Financial Law, 11 May 2017
Ladies and gentlemen,
I feel honored to speak here today at the first Lustrum
Conference of the Hazelhoff Centre of Financial Law. The
centre’s education and research programs have made an
important contribution to academic debate and knowledge.
Financial law is important to De Nederlandsche Bank,
because it is the very foundation of or our work as supervisor
and central bank. And personally I am an academic and
lawyer at heart, so I feel at home here.
Since we are celebrating an anniversary, I thought it would be
fitting to come bearing gifts. Without revealing too much up
front, I would like to offer you a basket full of questions and a
small message. I hope you like it.
It is often said that financial regulation moves like a
pendulum, swaying side to side between two opposing states.
When a crisis occurs, there is a call for tighter rules, and the
pendulum swings. Over time, as the memory of the crisis
fades, there are calls for fewer rules. Thus the pendulum
swings back, laying the foundation for the next crisis. Today,
1/14
the pendulum is just about to change direction, or so the story
goes.
The analogy of a pendulum is appealing but simplistic. It
suggests an inevitability that may serve those who favor an
easing of regulation. I believe such an easing would be
unwise and I will tell you why. I will also argue in favor of a
more nuanced view of financial regulation that better fits the
complex reality. I hope that, being researchers and experts,
you’ll share my preference for sound analysis over poetic
frames.
Let us begin with a rather obvious question: why do we need
rules for the financial sector at all? In a recent speech, my
ECB colleague Sabine Lautenschläger gave a simple answer:
to make our lives safer. Financial institutions like banks,
insurers and pension funds provide crucial services to the
economy, such as deposit taking, lending, payment services,
and risk sharing. They take risks doing this, and at times they
will underestimate these risks and overestimate their profits.
This can lead to huge losses for the financial institutions and
their investors, as well as for the economy and society as a
whole.
2/14
Of course, rules put a burden on financial institutions, but they
also offer them benefits. Financial firms thrive in a stable,
well-functioning market that is trusted. That trust is
paramount. Just ask yourself: would you do business with a
bank that is not regulated?
Almost ten years ago, the financial crisis uncovered serious
holes in our regulatory house. Since then, we have been
renovating. We raised the requirements for bank capital and
liquidity. Stricter rules were introduced in areas such as
securitization, bonuses, and counterparty credit risk. We
broadened the roof of our house to cover hedge funds and
rating agencies. We built a resolution framework to steer
failing banks out of the market while minimizing losses to tax
payers and depositors. And we introduced macro-prudential
instruments, giving us a better grip on connections and risks
within the financial system as a whole.
That was not all we did. We also strengthened regulation to
combat various forms of misconduct and the involvement of
financial institutions in money laundering and terrorism
financing. We modernized European rules for insurance
companies, making them more market-based and risksensitive, and thus more effective. In Europe, apart from
strengthening regulation, we also reshaped our institutions,
3/14
culminating in the establishment of the European Banking
Union. Under the Banking Union, responsibility for supervision
and resolution of European banks, and in the future also
deposit guarantee systems, is transferred to the European
level. What all these projects have in common is that they
have been necessary to repair the regulatory house, to fix the
holes. By implication, we cannot simply undo this work at our
leisure without undermining the very construction that was
built to protect us. Luckily, no one is debating the necessity of
any of these projects, and no one is questioning the
objectives that they are meant to accomplish.
Looking at financial regulation today, and contrary to what the
pendulum story might suggest, we see that work still
continues. In fact, it is far from finished. In the Basel
Committee on Banking Supervision, final issues concerning
the so-called Basel 3.5 package still need to be worked out,
but may very well result in a substantial further increase in
capital requirements for banks. Similarly, negotiations about
the establishment of a European Deposit Insurance Scheme
are under way. And in some areas we are currently
investigating whether regulation would be necessary. An
example of this is a European framework for the resolution of
insurance companies, of which I would be very much in favor.
4/14
So work on our house is continuing and new repairs and
additions are being made. Having said so, it is time for a
critical review of the work accomplished so far, to ensure the
new rules have no unintended consequences. This year, the
European Commission is reviewing major parts of the
European banking rulebook (CRDIV) and next year we will
review the new European rules for insurance companies.
Financial regulation is not set in stone. Instead, regulators
constantly try to adapt the rules to new developments and
learn from mistakes.
Thinking about the future of financial regulation, I see some
important questions that can be grouped along three
dimensions. Perhaps they can be viewed as the three
dimensions of our regulatory house. The first dimension is
national versus international. Today, with some notable
exceptions, almost all financial regulation is European.
Indeed, important rules and standards are drafted globally,
such as in the Basel Committee on Banking Supervision.
This makes sense. The financial system has no borders and
for regulation to be effective it must be international. This is
why in Europe, supervisory and resolution tasks have been
transferred to the supra-national level. The fact that this is not
controversial even in today’s euro-sceptical climate, shows
that this has become common wisdom. But it does raise the
5/14
question: should international rules be executed by national
or international institutions?
The second dimension of our regulatory house is private
versus public regulation, the topic of this conference. As we
know from both economic theory and history, private
regulation is not always effective in serving public interests.
Often, it’s not. Yet, where possible, it is both wise and fitting
for the public regulator to keep some distance.
Since public regulation has both direct and indirect costs, the
regulator always needs to explain why public regulation is
necessary. In some cases self-regulation works well, in other
cases a general public norm or principle is sufficient. This
encourages the financial sector to take responsibility, and can
be effective especially when rules tend to be trailing
developments in the sector. Industry associations can perform
an important guiding role in this regard. A good example is
the banker’s oath in the Netherlands, an industry initiative to
promote prudent and ethical conduct, which has been put into
legislation. The industry is granted a high degree of autonomy
in how they honor the oath, as long as they can prove that
their way leads to the desired results. This example highlights
an important question: when is private regulation effective
and when is public regulation called for?
6/14
The third and final dimension of our regulatory house is
simple versus complex rules. Over the years, the rulebook
has become more complex. Very complex, in some cases,
but to a large extent this mirrors the increased complexity of
the financial industry itself. I agree that in some cases, a
complex environment calls for simple rules. Detailed rules can
suppress a sense of responsibility and foster a culture of
‘ticking the box’. Over time, detailed rules also trigger
behavioral responses from financial institutions, making them
less effective or even counterproductive.
To be clear, simpler rules do not equal easier requirements.
The Economist recently said: “Keep capital high and rules
simple” and I agree with that statement, but would add ‘where
possible’. Simplicity is not always the answer. Sometimes we
need detailed rules. Let me give you an example. Banks
prefer to use internal models to determine how risky their
assets are and, subsequently, to calculate capital
requirements. As a supervisor I encourage this because it
stimulates banks to invest in top-notch risk management
capabilities that help them understand their risks better.
But internal models are complex and we need complex rules
to keep them in check. These rules, for example, require
banks to comply with certain conditions before they are
allowed to use their models. Without these rules we would
7/14
quickly experience a race to the bottom in capital and an
uneven playing field no one would favor.
Of course, the million euro question is: what kind of
complexity is best regulated with simple rules, and when do
we need more detail? Could we think of a set of criteria that
sheds more light on that issue? Implied in the ‘simple versus
complex’ dimension are other questions that are particularly
interesting from the perspective of financial law. One that
intrigues me is: how sustainable is principle-based
regulation? If given the choice, financial institution would
prefer principles over detailed provisions. And yet, as it turns
out, in practice many are pretty uncomfortable with general
principles. More than once I have heard them say: “please
give us guidance, tell us what we should do to be compliant!”
But once you start to fill in the principle for one institution, the
principle of equality dictates that you treat the others equally,
and before long we are back to a rules-based approach.
Also, where more detailed rules are needed, an important
question is: who should be responsible for formulating them?
Supervisors need to act quickly and flexibly, based on their
judgment and expertise. Specifying more and more regulation
at the level of the law would limit their ability to adapt to the
ever-changing financial industry. On the other hand, I
8/14
understand the reluctance of legislators to leave extensive
powers to impose rules in the hands of the supervisor.
That leaves the question: what determines the optimal
balance between supervisory effectiveness and democratic
legitimacy?
This was the present I promised at the start of my talk: a
basket full of questions. My hope is that you will feel inspired
to ponder them, to discuss them, perhaps to use them as a
starting point for your research. As a supervisor, I would be
very interested in your findings.
In physics, the fourth dimension is time, which brings me back
to the image of the pendulum swinging from left to right.
It reminds me of an old comtoise clock that I grew up with in
my parents home. From the front, you can see the pendulum
swinging to and fro…but from the side an ingenious network
of delicate cogwheels is revealed.
I will not claim that our system of financial regulation runs like
clockwork. Along the way, mistakes have been made which
need repair, and here and there rules could be made simpler,
without compromising on their objectives. In working on these
improvements, we seek consultation and dialogue with the
financial sector, because their valuable feedback makes our
9/14
rules better. To those who claim in the broadest possible
terms that the financial industry is overregulated I say: please
be specific, so that we can have an informed discussion
about the pros and cons. Because the image of the
pendulum, attractive as it may be in its simplistic inevitability
is not how it really works. It is the delicate network of
cogwheels that make the clock tick. And if we haphazardly
remove some wheels, we risk bringing the whole machinery
to a standstill. A machinery that protects us from financial
crises and ensures our economies stay strong and our
societies remain prosperous.
Thankfully we have the highly-qualified experts of the
Hazelhoff Centre of Financial Law to advise us. I am grateful
for the wonderful contribution you have made to building and
spreading knowledge of financial law and regulation. I hope
you will continue your important work for another five years
and more. And maybe my basketful of questions might
contribute…
I thank you for your attention and wish you a very fruitful
conference.
10/14