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German response to weaknesses in prudential supervision: radical reform or just the first step?

 

31 March 2009

This is one in a series of articles looking at financial regulation and reform.  

During the financial crisis, prudential supervision in Germany has proved to be weak. Supervisors have not included adequate and prudential macro-supervision in day-to-day prudential micro-supervision and early warning mechanisms have proved to be ineffective.

An immediate response was required to deal with these weaknesses, even before any EU wide revisions.

Therefore, the German Ministry of Finance has introduced an act to further strengthen the powers of the German supervisors giving them comprehensive and adequate crisis prevention tools.

These tools would include extended rights to request add-ons to the capital base of regulated entities exceeding Basel II requirements. The add-ons would be triggered if, for instance, the current capital adequacy requirements did not appropriately address the exposures of a regulated entity or if the capability of the institution to absorb incurred risks were (in the opinion of the supervisor) not guaranteed.

The capital add-ons would be enforced by additional intervention rights, which could be triggered even before capital adequacy requirements are violated. Such intervention rights would include the authority to order a stay on making any dividend payments or upstream loans.

Additional information requirements vis-à-vis BaFin and Bundesbank would also apply to make the new crisis prevention tools effective. In particular, information would be required about the "leveraged ratio" of the relevant institution and the eligibility of non-executive members of any supervisory or administrative board, which would have to pass a "fit and proper" test.

From our perspective it is crystal clear that these changes would not sufficiently address all the issues and weaknesses identified so far (e.g. at EU level in the report of the High Level Group of Financial Supervision in the EU chaired by Jacques de Larosière).

However, the proposal is meant to revise some aspects of prudential regulation and supervision in Germany in order to tackle certain key weaknesses that have arisen in the context of the ongoing turmoil in the financial markets.

Therefore, the intended changes are not (and are not meant to be) a radical reform of financial market supervision and regulation. The changes can only be seen as first steps. But do these steps go in the right direction or are the intended changes described above somehow flawed?

The revision seems to follow a common understanding in the EU about what needs to be changed in prudential supervision. Requests from the German supervisor for add-ons by banks to their regulatory capital base on a broader scale and not just as ultima ratio is now more common.

At first sight, the broader scope of add-ons to the capital base is in our opinion certainly a good idea. But only the future will tell whether these "add-ons" to the capital base actually work in practice.

The difficulty for the supervisor is to determine in advance whether there is a real threat to the capital base which justifies an intervention by the German supervisor.

In other words, the challenge is to design these prevention tools in such a way that they are not just "toothless tigers", since the supervisor always needs to take into account the impact of any add-ons and the potential downsides to the relevant institution.

For instance, any additional capital may require the cessation of (some) lending business and force an institution to liquidate assets at unfavourable prices. This may result in a vicious circle, further eroding the capital base of the institution.

If the supervisor’s decision to request an add-on were regarded as unjustified, this might result in claims for damages and such a threat might prevent the supervisor from using this new crisis prevention tool.

Bearing these practical issues in mind, it would definitely be going too far to argue that widening the scope of requiring "add-ons" is inherently flawed from a risk prevention point of view.

Since the financial crisis has shown that crisis prevention needs to be more within the scope of the supervisors, there is no real alternative.

In light of the difficulties of this type of new tool, the German supervisors need to establish clear guidelines to make the application of this crisis prevention tools predictable for both the supervisors and the regulated entities. To avoid any further regulatory arbitrage and to achieve a level-playing-field, the German government needs to work closely together with other EU member states and international bodies in setting these guidance rules.

Requesting information about the "leveraged ratio" of a credit institution has now also become quite common in the EU. Unlike proposals in other jurisdictions, the German initiative merely foresees a requirement to inform the German supervisors about a change in this ratio above a certain threshold.

An obligation to comply with a certain pre-set "leveraged ratio" or to prevent such a change will not be implemented. We think that such a purely information-based leveraged ratio requirement is sufficient to ring an alarm bell for the supervisor. Any pre-determined leverage ratio set for the institutions would be going too far.

Overall, the German response is not a radical reform, since it addresses some but not all issues. However, in our view it is certainly a first step in the right direction.

The challenge for the German government is to implement a comprehensive revision to prudential micro and macro-supervision. From our perspective the following key issues still need to be addressed:

  • better combination of prudent micro and macro-supervision by strengthening the focus on the impact of systemic risks for day-to-day supervision
  • elimination of regulatory arbitrage and achieving a level playing field at least within the EU.

The German government needs to keep the balance right between more regulation and supervision and necessary freedom for the financial markets.
Therefore, a new supervisory institution at EU level is not necessary.

The reforms can be achieved based on the existing model, where responsibilities in prudent micro- and macro-supervision of credit institutions, insurers and financial services are shared between the German Bundesbank and BaFin.

However, information sharing between national supervisors is key to achieving a better interchange between micro- and macro-supervision.

Further information

View the webcast: Philip Wood on what really caused the financial crisis and what needs to happen now.

 

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