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Stable Banks in Challenging Times

Contributions of Andreas Dombret at the Deutsche Bundesbank 2010–2018

Andreas Dombret

Stable Banks in Challenging Times is a collection of speeches delivered by Dr. Andreas Dombret, during his eight-year tenure as a board member of the Deutsche Bundesbank, the German central bank. As witness to the challenges created by the global financial crisis of 2008, Dr. Dombret helped shape large parts of the new regulatory framework. He successfully monitored future developments such digitalization, Brexit and climate change and their effects on the risk situation in the global banking industry and his insights are an invaluable look at the inner workings of global financial regulation and policy.
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Foreword by Jens Weidmann

Andreas Dombret

Andreas Dombret joined the Bundesbank’s Executive Board in May 2010, just as the embers smouldering in the euro area burst into angry flame. Some euro-area countries felt the temperature rising in the bond markets. Entering the world of central banking during this critical phase was something of a baptism of fire for Andreas Dombret: less than ten days after he joined the Bundesbank’s Executive Board, its members agreed to implement the majority decision taken earlier by the Governing Council of the ECB to also purchase Greek, Portuguese and Irish government bonds as part of the securities markets programme (SMP). This came in spite of substantial misgivings surrounding the decision, as these purchases shifted individual countries’ liability risks onto the central bank’s balance sheet, leaving the taxpayer on the hook. This was how the Eurosystem stepped in to tackle the blaze. Further deployments were to follow.

These first-response measures were flanked by regulatory and institutional modifications at both the global and European level.

International bodies overhauled the regulatory requirements for the global financial and banking system with a view to making it more resilient. A great deal of progress was made on this front. For instance, banks were asked to build up far more capital than they had held in the pre-crisis era. Being required to hold a higher quality of capital and more of it, banks are now better equipped to cushion losses. It also means that banks’ shareholders are more exposed to risk and therefore tend to act with greater risk awareness. On top of this, new total loss-absorbing capacity (TLAC) standards for systemically important banks are helping to stabilise the financial system. These should make it possible to resolve even a large bank without using taxpayers’ money. The cornerstone of this new regime is the Basel III reform, which the Basel Committee on Banking Supervision endorsed in December 2017. It was largely thanks to Andreas Dombret that the Basel III negotiations, which lasted many years, were wrapped up successfully.

A response to the crisis also came from the European level, where the institutional framework of the euro area was strengthened. The end of 2014 saw the launch of the Single Supervisory Mechanism (SSM) in the euro area, with responsibility for banking supervision passing from the national authorities to the ECB as the supranational banking supervisory authority. Since then, uniform supervisory standards have applied across the euro area, and systemically important institutions are supervised by joint supervisory teams consisting of staff from the ECB and the national authorities. The objective here is to suppress regulatory arbitrage. The SSM also acts to make the euro area’s banking sector more resilient. What is more, it was arguably the most important step on the path towards European integration since monetary union was founded. And in organisational terms, it was a mammoth project which Andreas Dombret, as the Bundesbank’s highest-ranking supervisor and its representative on the Supervisory Board of the SSM, navigated with impressive dedication and skill.

The SSM, the first pillar of the banking union to be established, was joined by the second, the Single Resolution Mechanism (SRM), in 2016. The SRM’s mission is to facilitate the orderly resolution of failing banks and to ensure that the key market economy principle of being liable for one’s own losses is revitalised and that a clear hierarchy of liability is in place: if a bank has to be restructured or resolved, its shareholders and creditors are first to be bailed in. The Single Resolution Fund financed by the banking sector is next in line. Only then, as a last resort, are taxpayers in the country concerned or even in other member states called upon to bear the losses. “Bail-in instead of bail-out” is now the guiding principle when a bank runs into difficulties.

Lastly, another response to the crisis came in the shape of a permanent rescue facility known as the European Stability Mechanism (ESM), which grants conditional financial assistance to countries facing a crisis. The country can use ESM assistance as a temporary liquidity bridge and commits to embracing reforms which will put its government finances back on a sustainable footing, as well as making its economic structures more competitive. In this way, a national crisis can be prevented from jeopardising the stability of the euro-area financial system as a whole.

Even this brief summary of all the changes which have been made since the onset of the crisis shows just how much has been done to make the financial and banking system more stable. But that is not to say that all the items can be ticked off the post-crisis agenda just yet. ESM funds, for instance, are mostly used not only to cover fiscal deficits but also to repay maturing government bonds. If a haircut were the last available avenue for restoring a country’s debt sustainability, it would be Europe’s taxpayers in this case – and not the investors – who would be called upon to foot the bill. This contradicts the principle of liability, and it might also undermine member states’ willingness to agree to the restructuring of a country’s debt. As a result, a strategy of “muddling through” might win the day over a sustainable solution. This is why the Bundesbank is recommending that the maturity of a euro-area country’s government bonds be automatically extended if this country requests assistance from the ESM. That would keep the original creditors on the hook, and if the sovereign debt does indeed need to be restructured, that could be done in an orderly fashion without jeopardising financial stability. This proposal has the welcome side effect of reinforcing the disciplining effect which capital markets have on unsound public finances and therefore its preventive function – the greater the risk of insolvency, the higher the premium that potential creditors will demand as compensation for providing a country with further funding.

But more needs to be done to unravel the sovereign–bank nexus. As well as introducing automatic maturity extensions, the privileged supervisory treatment afforded to government bonds should be done away with. The current regime does not require banks to set aside any capital for their sovereign exposures as these are assumed to be risk-free. Yet the sovereign debt crisis well and truly put paid to that notion. Banks presently have a strong incentive to invest in government bonds. The trouble is, it is precisely those institutions which are already short of capital. The key is to prevent risk from building up in this way on bank balance sheets. In future, sovereign exposures need to be backed with capital commensurate with the risk – just like exposures to private debtors are – and associated concentration risks should be limited.

So there is still very much a post-crisis agenda, even though much has already been done to make the financial and banking system more stable. But there is more to it than looking back at past developments and only learning the lessons from the last crisis. The next one may well look completely different to anything that has previously shaken the financial world. Therefore, it is the task of those responsible to recognise any potential new risks on the horizon before they materialise and to develop strategies that can be used to respond to them. The financial industry now has to dedicate just as much attention to cyber risks as it does to risks on their loan books, and they have now also become an issue for international regulatory bodies. Andreas Dombret flagged these new dangers early on, just as he did more recently with climate risks on bank balance sheets as a result of climate change.

Albert Einstein famously once said, “I’m more interested in the future than in the past, because the future is where I intend to live”, and that is the attitude that Andreas Dombret lived by during his tenure at the Bundesbank. He passionately advocated making the financial and banking system fit for the future and, in doing so, he implemented the Bundesbank’s stability mandate in an exemplary manner.

Jens Weidmann

President, Deutsche Bundesbank

Frankfurt am Main, Germany