For the past 8 years banks have had it rough. Partly they had themselves to blame, partly this is the result of lax (or light touch, or ‘growth oriented’ stimulative) government legislation and action. Anti-banking public opinion and the subsequent more stringent state aid rules and bail in requirements are currently preventing public sector measures that are needed to create short-term financial stability. Now in the news are Monte dei Paschi di Siena and Deutsche Bank, but similar stories have been available in the past across the EU, and at certain times in e.g. the USA and China. For troubled banks there do not appear to be voluntary private sector interventions, and forcefully ‘inviting’ stronger banks to buy their weaker brethren does not work because either the stronger banks are too strong relative to their supervisor, or too weak to bear the cross alone, or are themselves part of the weaker side of the system. Normally the state balance sheet would now be used to prop up the relevant bits of the financial infrastructure. Examples of such traditional public sector solutions for banks overwhelmed by non performing loans, sovereign/bank cross infection (now more often in the modus that new or old bad fiscal decisions and doubts about sovereign debts are infecting their banks in e.g. the UK, Italy and in Greece) would be e.g. nationalisation or a state aid loan at non-market rates or conditions. Even though such measures are often financially beneficial to the investing state in the long term, the potential for high-risk and especially the sheer amount of money needed for the initial public investment has influenced the introduction of barriers to public sector intervention. More specifically, any use of public funds now needs to be preceded by the bail-in of shareholders, junior bondholders and then senior creditors, such as current account holders above 100.000 euro. Creatively, Italy has introduced its Atlante/Atlas fund as a private sector alternative to state aid, but there are continuing doubts whether the Italian financial sector, based in an over-indebted country, is sturdy enough as a whole for the least weak institutions to help out their weakest colleagues.
Even though at least three of the legs of a banking union (EBA in the whole of the EU, and SRM and SSM in the Eurozone) are now in their operational phase, the responsibility for coming up with the funding for solutions appears to continue to be territorial. The SRM is still building up its funding, and it is no doubt difficult to determine when it should grasp the reins from the SSM and take control and responsibility for a concrete solution. In the mean time, local funds and savings account holders tend to be the biggest category of bail-inable creditors, once the more sophisticated financial sector investors have decided not to invest in shares or coco’s of a troubled bank, or are dumping such shares or bail-inable bonds at the first hint of trouble. In the case of amongst others Italy, this is a political issue as a recent bail-in showed that many of the bail-inable creditors are consumers and small and medium sized enterprises. Agreeing that the Single Resolution Board of the SRM takes charge, means accepting that these voters will suffer. These are the same taxpayers who were supposed to benefit from the fact that ‘taxpayer money’ should only be in play after bail-in had taken place (but instead suffer most). The least sophisticated players are the most likely investors in the bail-inable unsecured bank bonds that at the moment do not pay a credible risk premium in the central bank stimulated low interest environment. A territorial approach does not work in a rich but stretched country such as Italy, however, nor is the health of Italian banks of interest only to other Italian banks, the health of Deutsche or the smaller community banks only of interest to Germany, or the health of the UK financial system upon Brexit only of interest to other UK banks. The reputation and financial health of all banks in the Eurozone, in the EU, and perhaps even in the world are now soundly linked in our open financial system, with information, distrust and fear propagating quickly on the internet. This should make it in the joint interest of the member states and governments of other financial centres to stand together, but the aforementioned public opinion and a sovereign tradition of not helping each other across borders when there are solvency issues at banking groups of which the top holding is licensed elsewhere, are preventing this.
Nothing is, however, preventing banks and other key bits of the international financial infrastructure such as CCP’s to step up themselves. Regardless of whether Atlante/Atlas was voluntary or set up under political pressure, it would appear in the calculated self-interest of such institutions to create – as they did some decades or in some cases such as the UK centuries ago – a new central bank from their midst, to deal with this issue that no bank or member state can deal with unilaterally. Strong appearing financial groups can become weak almost overnight if the banking system is distrusted or an incident in one of their subsidiaries occurs (AIG, Citi, Deutsche, Unicredit, RBS, Fortis are examples that come to mind), so it would be in wise for both currently high ranking and for currently low ranking banks to participate in a new private sector bail-out structure that would be able, allowed and willing to act. And no doubt such a EU or worldwide private sector bail-out fund could count on a high rating, and a low tax environment, especially if it is set up as a charity instead of as a profit centre (perhaps with any profits allocated to help out bail-in victims, or to sponsor financial education of consumers and small enterprises). Taking action themselves, jointly, in the common interest but by voluntarily putting up their own money would not least also give a valid emotional argument for allowing them to set their own course again, instead of being regulated to the max as is the current regulatory trajectory for the still nominally ‘private’ sector activity of banking, and thus take control of their own destiny again by also picking up the tab if things go wrong.
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A new post-Brexit trade arrangement between the UK and the EU will be complex to negotiate, and likely to be made more complex by rejection trauma. From the point of view of long term economic growth, stable financial markets and cross border peaceful cooperation, there does not appear to be good news. Position papers like the Japanese give strong hints on what is needed, but also emphasize that the UK needs automatic access to the single market more than the EU needs access to UK markets. Even if the overall size of the European economy might shrink if London suffers, the transfer of even only some crumbs of its current business would mean additional local jobs in Amsterdam, Frankfurt or Paris, trumping any benefits of keeping the London financial markets alive.
So, how to turn it around, and make the shortsighted Brexit vote (costing UK voters jobs, subsidies and workers protection) and a lack of decisive political action from UK and EU legislators to avoid this course of action, into something that would benefit Europe as a whole?
One route that has not yet received sufficient attention is a renegotiated EEA (European Economic Area, consisting of the EU member states plus three non-EU member states). So far, the ‘Norway-option’ or EEA has only been mentioned as a halfway house, where the UK could seek temporary refuge under the current provisions of the EEA Treaty (if the EEA member states would be willing to allow this). Such refuge would allow continued access to the EU single market, as well as possibly to a range of existing trade agreements with third countries. However, like for the current non-EU EEA countries, there is a rather high price to pay for single market access via this route. The current EEA Treaty of 1993 (between the EU member states plus Norway, Liechtenstein and Iceland) allows access to the EU for the three in exchange for abiding fully by EU single market legislation and paying into the EU budget, on both of which they have no say at all. In essence they are being taxed without being represented (in exchange for single market access). For instance new banking requirements have to be accepted by the three countries in exactly the way they are agreed by the EU member states. This was kind of ok at the time, when for instance EU banking legislation was still relatively low key and required implementation by local legislators into local law, but more intrusive EU regulations and directives have de facto increased the transfer of Norwegian, Icelandic and Liechtenstein’ sovereignty to the EU. The Swiss were key drivers behind the negotiations for the 1993 EEA Treaty, but before it entered into force they opted out in a referendum. Swiss banks and stock exchanges, and other businesses for which there are no specific arrangements to access the EU suffer as a result. Norway, Liechtenstein and Iceland have gained access for their banks, but they suffer from having no vote in the council, no vote in parliament and no vote at EBA and ESMA.
The economic and political interests of the UK on the one hand and Switzerland, Norway, Iceland and Liechtenstein may thus well be aligned for a new treaty that keeps the EEA benefits, but adds a bit of balance to the sovereignty transfer. That is, if the UK can indeed convince Norway, Liechtenstein and Iceland that it can act decisively, and in their common interest instead of only its own (of which Iceland may need some convincing). They might do so, if a revamped EEA deal could bring back some of their sovereignty on single market issues, and there is not only a fair voting arrangement with the EU member states, but also amongst the non-EU member states of the revamped EEA. Arrangements on voting on new legislation could for example be based on the Eurozone ins and outs voting arrangements at EBA, though it would thus need to be drafted to ensure that the ‘outs’ are not dominated by any single non-EU EEA member state. Adding the economic and financial services heft of the UK and Switzerland onto the existing access to the single market of the non-EU EEA states, might sway the EU member states to add such a provision to the EEA Treaty.
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It would still require some hard choices on customs, taxes, security, the EFTA trade agreements and especially on passport free travel and migration. For instance the likely limitation cross border long term migration rights only to people in jobs or after retirement from a local job is a common electoral issue for both the Swiss and the British (following referenda in both countries). To gain or regain access to the single market with such a painful sacrifice for the EU member states, would require equally hurtful sacrifices of the Swiss and UK negotiators.
Which price for instance the UK wants to offer up first to Norway, Iceland and Liechtenstein, and then to the EU member states would be up to it to consider. Any offer would need to be of the level of the level of sacrifice in internal UK politics as e.g. exchanging the pound for the euro. Schengen accession and doing its share on burden sharing in finance or refugees would be a good starting point, as it would ease existing troubles with e.g. France on the Calais encampment. A prudential regime for wholesale markets, desirable from a macro-prudential point of view, could be another offer, building on the AIFMD regime for wholesale investment funds. Regardless of the exact result of mutually beneficial EEA renegotiations, this route would provide the UK with the opportunity to show again why it used to be the most influential and effective EU member state alongside France and Italy, before this influence was sacrificed on the altar of national short term electoral considerations. Changing the subject from post Brexit trade agreements to renegotiating the EEA would also provide EU negotiators with cover for granting favours to the UK, allow Switzerland a better entrance to the single market, and right an existing wrong in the EU/EEA of taxation without representation for Norway, Iceland and Liechtenstein.

The debate on whether insurers can be systemically important has taken a strange turn. After focusing on non-traditional and non-insurance activities at large international insurance groups, the scrutiny is now on whether or not to include reinsurance groups into the set of systemically important insurers. Lobbyists are rumored to have found the weakest link at the FSB (this time the USA) to stop reinsurers from being considered as systemically important. The arguments for this remain unclear. The main reinsurers are big, their clients depend on them, and if they have to liquidate their assets to afford a timely payout this would impact on the financial markets.

In the past, arguments appeared to focus on the expectation that the problems would be dampened by the structure of the insurance market. A regular insurer stands between them and policyholders, which would continue to be liable even if the reinsurer on which it relied fails. A traditional argument is also that reinsurance is more like traditional direct insurance instead of like non-traditional insurance activities such as derivatives investing. If such reasoning would be considered valid still, that would be shortsighted, but not unexpected. Reinsurers, insurers and the IAIS have a track record of downplaying potential contagion arising in the insurance sector, including in the reinsurance sector.

Reinsurers are not client-facing, that is true. And the policies they close are not structured as formal derivatives, but as insurance policies of a direct insurer against the materialization of a risk (in their case, that policyholders make claims at the direct insurer). If a reinsurer fails, the direct insurer is indeed left holding the bag. However, that direct insurer would have a huge gap in its capital and technical provisions. A reinsurance contract counts as risk mitigation for prudential supervision purposes at the direct insurer. If the reinsurer can pay out, it does indeed mitigate that risk by offering to pay all or part of the claim that arises from a policy written by a direct insurer (in exactly the way derivatives do if the triggering event occurs). The direct insurer subsequently does not need to hold financial buffers for potential claims that are no longer expected to land on its balance sheet as it is expected to be reimbursed in full by the reinsurer. For large reinsurers this (large) gap at the direct insurer it contracts with is multiplied across all the direct insurers it accepted premiums from. If one of them makes a disproportionally large claim, the reinsurer may no longer be able to honor its commitments to other direct insurers, making reinsurers the main potential channel for contagion in the insurance sector. As e.g. mortgage loans are built on required fire insurance and long-term pension payments from life insurance policies, this would impact on the banking sector too, providing another channel for systemic risks. Even if reinsurers can delay the pay-out by denying the validity of claims, that would just speed up the problems at the direct insurers and their clients, and would not dampen market expectations of asset sales by the reinsurer for an eventual pay-out.

The limited set of large reinsurers are thus a crucial underpinning of this sector of the financial market, similar to the role of central clearing parties (CCP) in securities trading, and ECB systems in Eurozone payment systems. The argument a non-client-facing entity is not systemic has been (and should be) eradicated from public policy thinking since the AIG London branch, LTCM and the Fannie Mae/Freddy Mac bail-outs. Even shareholders of large reinsurance companies like the subsidiaries of Berkshire Hathaway should actually see the benefit of better focus on and the acknowledgement of the importance of such key service providers. For one, it makes their investment in a reinsurance company less likely to suffer catastrophic damage. And if reinsurance would get a more explicit systemic role as a stimulated safety buffer for the wider insurance sector (like CCP’s and depositaries are for the securities markets), it would actually be a business opportunity. It would strengthen their hand against competitors from the hedge fund industry or (other) derivative writers. Even so, it would be more likely that shareholders and boards of reinsurance companies would actually admit that reinsurance is systemic, if the consequences of being deemed systemic were more focused on the business at hand. This is now not the case. The FSB and the committees that work for it (such as the IAIS) appear focused on just slapping an extra percentage on a yet to be developed solvency ratio for large worldwide operating insurers, in a move copied from the banking sector. The fact that it is not yet tested there as an effective tool to avoid or even mitigate a banking crisis does not seem to dampen regulatory ardor to roll it out to non-banks, but it may dampen the ardor of shareholders and boards to subject their reinsurance companies to it.

They have a point. To me it appears strange that the systemic surcharge on top of a debatable ratio calculation is now copied in other financial sectors as if it is a wonder formula. Especially if there is little or no experience with a solvency ratio in the insurance sector in the first place (where a first solvency ratio under the EU Solvency II directive is being rolled out only now). It is not guaranteed that a higher percentage for systemic insurers based on a totally new formula for calculating a ratio would withstand (fear of) the potential waves of destruction of a next crisis, nor that it would avoid the pitfall of being calibrated to the last crisis instead of to the next.

It may be better for the FSB and the (re)insurance industry instead to come up with a more measured response, focused on what is known to work in the specific financial sector at hand. For instance, CCP’s have a similar role in the securities sector both as a core service provider, risk mitigator for client facing securities firms, and – because they are trusted to handle this – risk aggregator as reinsurers have in the insurance sector. CCP’s developed homegrown techniques to be able to bear that risk, mainly by a system of collateral (margin), guarantee funds and novation and netting through which risk is minimized and spread. If reinsurers de facto are relied on in the insurance sector to play a risk-mitigating role and want to be trusted to be a risk aggregator, they should equally develop or expand risk-mitigating techniques. If reinsurers ask legislators to rely on the insurance they provide to direct insurers – which does appear to be part of their business model – they could embrace this role in a proactive manner by mitigating such aggregation/concentration risks. It should not be necessary to assume that each can withstand a multiple of risks arising at the same time, it should be certain. In other words: if reinsurers would like policyholders, direct insurers and supervisors to embrace a core role of reinsurers, it becomes more important that they are bankruptcy remote.

Learning from the CCP example and from what has worked well in the insurance sector, it might be good to take a second look at the benefits of solo supervision and the assets reserved for the calculated technical provisions (i.e. the calculated maximum potential pay-out under open policies). Instead of relying on untested new solvency ratios – even if they are calibrated to be higher for systemic entities – a better response to a systemic reality would be to rely on a combination of:

• more conservatively calculated technical provisions for the maximum potential pay-outs under the reinsurance contracts they have written;
• segregated assets for those;
• collateral rights held by the collective of (policy holding) direct insurers on those segregated assets;
• with a clear pay-out schedule that guarantees equal treatment of various current and future claims;
• and perhaps a mutual guarantee system if overwhelming claims arrive at a reinsurer.

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Also see:

• Buffett clout brought to bear in rules fight, FT 14 October 2015 (published under different title on ft.com on 13 October 2015).
• EU Banking Supervision, chapter 6.2, 6.5, 19.4 and 22.
• Are EU Banks Safe?, chapter 4.5.
• FSB, 2014 update of list of global systemically important insurers (G-SIIs), 6 November 2014.
• IAIS, Reinsurance and Financial Stability, 19 July 2012.

A new component of the recovery and resolution framework for banks is the mandatory bail-in of shareholders and unsecured creditors that will become mandatory across the EU at the latest in 2016. The bail-in of creditors has been introduced to avoid having member states (ultimately at the expense of its taxpayers) chipping in to bail out a bank that is too important for its economy to let fail. As a policy choice this is understandable, even if much of the initial investment in bailing out a failing bank is normally recouped when the bank or its assets are sold at a later point in time (unless the public sector owner manages the bank for other public policy reasons than recouping its investment).

For subsets of depositors/investors at banks the new mandatory bail-in at the behest of resolution authorities requires a new mind-set in risk management. Specifically this applies to those depositors holding funds at the bank that are not protected under the applicable depositor guarantee system, such as companies or individuals keeping more than 100.000 euro at the bank, or (from 2019) those that bought bonds issued by the bank.

The new rules aim to the public budget, while continuing to protect small depositors, and anyone with a secured claim on the bank (such as central banks). Really new in this line-up is the protection of the public budget, or as politicians/legislators name it: ‘the taxpayer’. Increasing the protection for the public budget does mean that the losses will have to be suffered by someone else, in this case the ‘senior unsecured creditors’ that used to rely on (1) implicit government support for large banks, (2) good banking supervision that would fail and liquidate the bank when it was still solvent enough to pay back each senior unsecured creditor after the liquidation process, or (3) for bondholders that qualify as consumers or small companies on the explicit deposit guarantee system for bond portfolios up to 100.000 euro. These are all in the process of being removed, as senior unsecured creditors will no longer be protected under any of them but instead will be forcibly bailed in when there are signs that the bank might be in trouble. The thinking is probably that very wealthy individuals will ultimately bear these costs, but in practice the impact is more likely to be suffered by pension funds, insurers, banks, investment funds that hold cash at the bank in their current accounts, have bonds or own shares issued by the bank, or have to replenish deposit guarantee systems that have to cough up the cash under a bail-in. And by the consumers and companies dependent on them of course.

Though the commitments to the pension fund of the employees of the failing bank are protected, any debts to other pension funds or insurance companies are fair game. Regulators can still opt – in an optional and thus non-dependable manner – to exclude bail-inable creditors at the moment of the bail-in if they for instance fear unrest. This might benefit certain senior creditors, but will only increase the burden on the remaining senior creditors that do not get this benefit from the resolution authorities (for instance because they are based in another member state, or are too small to start a crisis if they in turn fail due to writing down the money they had entrusted to the bank).

For bonds, the exclusion from deposit guarantee protection and accompanying bail-in-ability may be somewhat defendable (in spite of the potential financial instability risks of writing down bank bond values), as long as the right risk premium is paid by the bank for this risk. I understand that after downgrades of bank bonds by rating agencies in anticipation of the bail-in instrument, the (ultra low) interest rates on unsecured senior debt have shown an increase in the risk premium paid to investors in such bonds. It is doubtful whether that risk premium is enough to compensate for the de facto highly increased risk that bank supervisors will deem a bank to be potentially in trouble and potentially to cause financial instability, and ‘rescuing’ the bank by increasing its capital by writing down or converting these bonds. This can and perhaps should be judged part of normal risk management at the institutions investing in such bonds. It could be a conscious assessment by a well-trained lender that the likelihood of such an event is sufficiently low per bank in a diversified portfolio of bank bonds that even at the current low interest rates the small add-on constitutes an acceptable risk premium. Perhaps. For non-deposit protected consumers and non-financial companies that invest spare cash in bank bonds after the deposit insurance expires for bank bonds in 2019 it is unlikely to be as well prepared for.

A risk perhaps less well understood is that any cash held at any bank on a savings/payment/current account (to the extent it exceeds the coverage by the deposit guarantee system or collateral, and thus also constitutes a so-called senior unsecured credit) is subject to the same write down or conversion as unsecured bonds are. For instance, if a pension funds uses one single bank to collect the liquidity needed to make out the monthly payments to its pensioners, it is in fact making a high risk investment in the bank. This high risk materialises if the banks’ supervisor and resolution authority decide that the time for failing the bank has come before the order for the transfer to pensioners has been given. The bank will in that case re-open the next Monday as usual, but the cash needed by the pension fund to make the payment to pensioners will no longer be available as such cash was bailed-in. The supervisor/resolution authority may or may not give an exemption to the bail-in, but this would increase the burden for others (and is certainly not a right of the pension fund).

The main dependable exception is if the bank gives collateral to the owner of the cash, in the example to the pension fund. Senior unsecured debt is bail-inable, but secured debt is excluded. This is for instance the case with central bank loans that will be collateralized by sovereign bonds or other acceptable collateral. Other examples are for funds owed in the clearing and settlement process, or in the case of bonds so-called pfandbriefe and other covered bonds (that are secured by specific assets of the bank). Small pension funds and small insurers will normally not have the market power or political power to ensure such security is given to them for payment accounts. If they do not get it, they may be wise to spread their cash holdings over a wide range of banks in order to avoid potentially losing all their cash in one go. They could also seek insurance e.g. via derivatives on the potential that a bank will fail, but that may be costly, and it would need to be certain that the writer of that derivative/insurance is not itself linked to or exposed to the bank that is failing.

Should the shares in a bank, bonds issued by a bank, and savings held at a bank by an institutional investor be bailed in, this may have an impact on its own obligations to pay out. An investment fund will be worth less (and so will the pro rata investments by its investors, and the investors in such investors), which may or may not have been understood by those investing via such a fund. At an insurance company or pension fund it may mean that premiums will need to be increased, or payouts reduced. Though their clients may not always be taxpayers in the country where the bank was based, they will definitely be taxpayers somewhere. Taxpayers will thus still bear the costs directly or indirectly via their pension funds, investment funds and insurance firms. The main change is that this burden will only to a lesser extent arrive via state budgets (which will still contract due to lower tax receipt as a result of the losses suffered by banks, insurers, and individual taxpayers, as well as via bailed-in cash held by municipalities, provinces and other state bodies at the bank). The main advantage is the public relations benefit that the burden will not go via the state budget immediately, and that the costs – if pension funds, insurers etcetera have limited their risks via risk management – will be spread out over time and many consumers. Small increases in premiums or limits to payments are less noticeable than a big headline number of initial investment by the state in a traditional bailout. Saving the taxpayer by bailing taxpayers in (directly or indirectly) does, however, appear to be logically impossible.

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– Recital 1, 5, 8, 31, 67 and art 44, 47, 48, 108, 109 and 130 BRRD directive 2014/59/EU

– Recital 5 and 6 Recast Banking Directive 2006/48/EC (part of the previous version of the CRD)

– Art 27 SRB regulation 806/2014

– Art 1.1 and 1.4 of the currently applicable Deposit guarantee directive 1994/19/EC, and Recital 47 and art 5, 20 and 21 Deposit guarantee directive 2014/49/EU (of which 5.1 sub k on excluding bonds will be applicable from July 2019)

– Italy/Romanelli, EU Court of Justice 11 February 1999, Case C-366/97, §13-15.

– EU Banking Supervision, chapter 4.4, 18 and 19

– Are EU Banks Safe?, chapter 3

Increasing mortgage loan risk weights in a depressed property market is likely to be procyclical, as would reducing risk weights in booming property market. Strangely, this procyclicality appears to be acceptable under the contemplated EBA standards on adjusting risk weights due to financial stability considerations that are currently out for consultation. The draft binding rules do not specify when they should best be adjusted up, and when down, nor how to take into account such potential procyclical effects. Nothing in the proposed binding rules clarifies at which part of the cycle this lever should be used, which is a bit odd for nominally technical rules that have as their key ingredient that a specific lever can be used for financial stability considerations.

The EBA proposals do give a clue as to what information is relevant, but mainly leave the type of response to the supervisor itself. A supervisor eager to apply the law in a conservative manner is left scratching his head as to the optimum course and timing. A supervisor eager or under political or monetary policy pressure to boost a growing economy, or to stop a sliding property market, is free to do whatever it wants even if the longer term effects might be a less safe banking system. For example, the economies of many of the member states currently need a stimulus. Increasing house prices and office prices based on cheaper lending – if banks do not need to hold so much capital – could help provide such a stimulus. Even though bad lending practices and too low risk premiums and risk buffers for mortgage loans in the USA subprime sector actually kicked off the latest worldwide crisis, the solution to help growth in the short term could be to keep risk weights low, and to keep all options open for national legislators and supervisors. As a result of such pressures it is difficult to blame EBA and its voting members for building in this leeway. However, it does mean that the new binding rules are not very useful if a supervisor or financial stability regulator would like to be able to take measures to ensure the stability of the banking sector and/or the property market. The standards instead excel in less than clear guidance such as ‘Take into account housing market developments’, which kicks in a wide-open door, and says nothing on whether rising values or buyers interest should lead to an increase in risk weighting (and thus higher capital requirements), or to a decrease in risk weighting (and thus lower capital requirements).

This leaves aside that a discussion could be had on whether a higher risk weight would be best from a technical point of view in the upslope of a boom (to stop irrational exuberance, and build up capital buffers for the eventual decline in property values a few years hence and thus in an anticyclical manner), or on the downslope towards a trough (to increase the potential for bank capital being sufficient to deal with future losses in a value-declining property market, thus limiting the scope for banks to lend to potential new purchasers and forcing them to double down capital for existing and new downward developing mortgage loans, even though for the wider economy this would be procyclical). In this light, an analysis performed by supervisors on the basis of the lengthy data sets available over the boom period and the bust in immovable property markets in almost every member state could have been used to base these standards on an analysis of the costs and benefits of heightening and reducing risk weights in each national or regional property market in the period from e.g. 2000 until now. Indicating when Dutch, Spanish, Irish or any other national supervisor in hindsight would have wished that they used the existing risk weight-adjustment instrument either in a pro- or anticyclical manner during that period might lead to useful indicators as to when it should be used in the future with the best impact on wider financial stability as well as on the resilience provided by larger bank financial buffers.

A compromise solution could be to try to aim for the upper slopes of the boom for an increase, and reduce it when property prices have gone below reasonable long term values. At the bottom of the trough this would stimulate the housing market, especially if the expected losses on the housing portfolio have already been written down in full under a possibly wider definition of default and/or lower valuation of the collateral. Higher risk weights on the remaining fully covered mortgage loans would then no longer be necessary, if – and only if – the risk weight setter is able to correctly call when a boom is under way, or when a property market recession is entering irrationally depressed territory.

It would thus be helpful if the standards clarify whether their primary target is to stabilise the immovable property market in a certain market segment, or to stabilise the banks that lend in that area even if that means restricting loans to a already plummeting property market, or both. That would also help indicate whether there is a need to coordinate across financial sectors and across banks on the standardised and IRB approach (to ensure that banks, insurers, pension funds and other non-bank mortgage loan providers increase or decrease their exposure to the market segment involved in the same manner) which I would favour, or not (to ensure that the banks are safe by being able – to put it bluntly – to offload the risky and more costly exposure to the overheated property segment, even if that is to unsuspecting insurers or securitisation-investors such as pension funds).

This overall lack of clear indicators and purposes means that I am a bit reluctant to criticise the only clear benchmark that EBA does provide, which has been referenced in the draft standards and made more concrete in the impact assessment. According to it, loss expectations should be a key factor to determine how high the risk weights should be. It is a welcome clarification of intent, and something supervisors might be benchmarked to. However, though I applaud its inclusion, this specific benchmark does clarify two things that in view of pro and anti-cyclical thinking are a bit unwelcome. The first is that higher loss expectations are expected to be the trigger for an increase in risk weighting. As soon as market based loss expectations are made the determining factor, any irrationality in the market suddenly becomes less easy to deal with. This irrationality is part of the accepted market wisdom at that time, so if for ten years prices have gone up, no one ‘expects’ losses any more. Only once the bust period actually arrives, loss expectations suddenly swing up (sometimes to irrational heights in a panic). Increasing risk weights at that point in time will only strengthen the slide into the abyss. If risk weights instead are already up when loss expectations are still close to nil, then the lever could helpfully be used to lighten the load on the way down, helping to dampen the cycle. That does, however, require supervisors actually to take a stand against ‘the sky is the limit’ politicians and realtors, which as indicated above may not be their favoured role.

Second, the table appears to indicate that the lowest risk weights are appropriate in ‘normal’ times. If so, the lever of risk weights is unavailable during the entire trough of the cycle, meaning it has no dampening effect to get the market (and the banks’ capital requirements) into a mood that indicates light at the end of the tunnel. From a macroprudential point of view, that seems unhelpful. The lowest risk weights should be only in force at the ‘apex’ of the bust, so that the lever can be used both in the downswing and the upswing. No doubt this is more the role of the ESRB to point out, but strangely their role as providers of warnings and advisors on the cyclicality of draft-rules is not visibly reflected in the EBA draft standards.

In conclusion, it may be good to re-assess and clarify some of the key concepts, main goals and direction of adjustments in the draft binding rules before they enter into force. Building upon the experience in the past crisis with a ‘in hindsight’ analysis as to when and how this tool would have been most effective and efficient would be helpful. Both changes would help shelter banking supervisors from being put under pressure to sacrifice long term bank stability against short term political pressure for economic growth.

Also see:

• The separate comment on adjusting the mortgage risk weights
• EU Banking Supervision, chapter 6.2, 6.5, 8, 18.3, 21.2-21.4, and 22.5
• 124-126 CRR
• 128.2 sub d CRR
• 164-166 CRR
• EBA consultation paper EBA/CP/2015/12 of 6 July 2015 on determining higher risk-weights

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