I. Introduction
The title of my presentation is the future of the financial system. Discussing this future seems fundamental to me for at least two reasons.
1) Every cloud has a silver lining. This crisis is going to be, and already is, long and protracted, but it will undoubtedly end someday. And we must prepare for it. Moreover, our individual and collective response to the crisis must be adapted to what the post-crisis financial system will be or what we want it to be.
2) We are too absorbed in the short term and the present crisis. We tend to focus on the present pain, lamenting the crisis and how little others, especially the Government, are doing to get us out of it. Of course, what the Government does is fundamental, necessary, and decisive. But it is not sufficient. What institutions and companies do for themselves is equally important or more so. They are ultimately responsible. But to act, they must have clear ideas about what awaits them on the other side of the tunnel.
The future of the financial system depends on two major factors:
a) How the current economic and financial crisis is resolved.
b) The new rules of the game that are ultimately adopted at the national and
international levels.
This approach is valid for Spain as well as for Europe or the rest of the world. The Spanish banking system should only be viewed as part of the European system, and the latter as part of the global system. And our objective is to compete in them, to become stronger in Europe and in the world. Without this perspective, we will misjudge our response to the crisis, and when we emerge, we will realize that our effort has been in vain. But let us not deceive ourselves. Spain has its own characteristics. Our economy, our banking system, our economic and financial crisis have distinctive features that must be understood and addressed if they are negative, or promoted if they are positive. Let us highlight three distinctive characteristics:
1) The functioning of the Spanish banking system, its business model, its regulation and supervision, are fundamentally sound. And the crisis has highlighted this. Having said that, the other two characteristics I would like to emphasize are:
2) In the years prior to the crisis, we experienced a clearly excessive increase in credit and, in turn, an excessive concentration of it in certain activities.
3) As a corollary, cause, or effect, the Spanish economy—businesses and households—has reached unsustainable levels of debt. And as the BIS points out, excessive debt cannot be addressed by increasing credit or issuing more debt. Debt and credit, therefore, must contract in proportion to GDP. This now includes debt corresponding to the Public Sector. The excessive debt of the Spanish economy cannot be solved by increasing Spanish Public Debt. Something more will need to be done.
II. How is the crisis being resolved?
In short, through massive intervention by the Public Sector, which has proven its existence and purpose. The Public Sector has replaced private demand, capital, and markets. The market has not only been unable to self-correct but, in addition to generating the crisis, its dynamics led to an increasingly negative spiral. Public Sector intervention has been implemented through: massive liquidity injection by Central Banks.
Fiscal stimulus. The rescue, restructuring, and capitalization of banking institutions. All three measures were necessary and essential in the short term, but once their mission is accomplished, their continuation would be destructive and would trigger another crisis of unknown dimensions. That is why all International Organizations emphasize the need to agree on and have exit strategies prepared for each of them. Spain should do the same. I only have time to address the Banking Sector. We all agree that rescuing the Banking Systems was a priority. The question was and is how to carry it out. The IMF has clearly and precisely established its criteria. First, rigorous assessment of the viability of banks. Then:
a) Viable banks:
Recapitalization must be subject to careful restructuring and strict conditionality.
b) Non-viable banks:
They must merge with viable ones or be closed if they do not affect the stability of the system.
c) In case of nationalization, it must be temporary and with the sole purpose of restructuring the bank and returning it to the private sector as soon as possible. These criteria, established in the Global Financial Stability Report (GFSR) last April, essentially coincide with the criteria that the AEB has been demanding from both the Government and the European Commission since the inception of capitalization programs. The European Commission’s criteria have been and remain more ambiguous due to strong pressure from Member States.
In general, we could say that the criterion of financial stability has been considered a priority over preserving competitive equality and the internal market. Consequently, although the Commission requires the restructuring of rescued institutions, that restructuring is yet to be defined and, in any case, will be carried out much later. On the other hand, the conditionality of aid is of very limited transparency and real effectiveness. The Competition Commissioner herself has recently acknowledged the serious distortions that the European Internal Market has suffered, while asking how rescued banks will be able to become self-sufficient again and repay the public aid received. Without a doubt, the question is fundamental, but the issue does not end there. Who compensates the banks that, without aid, have suffered distortion in competition?
In Spain, the recent approval of the Bank Restructuring Fund (FROB) has largely cleared up existing doubts about the Spanish approach to bank rescue. The Fund’s very name includes the word restructuring, and for that reason it is welcome. There will hardly be a restructuring that is simultaneously effective in ensuring the long-term viability of an institution and respectful of competitive equality that is not implemented as a full merger of the affected institutions. If, additionally, these operations must minimize the cost to public coffers, the task is formidable. The AEB, in any case, acknowledges the effort being made by the Spanish Authorities and offers them its full support to advance such an essential project. As you can see, the way the crisis is resolved fundamentally affects the future of the financial system and its configuration. The AEB regrets that in Europe a nationalist and protectionist solution has had to be adopted that fragments the internal market instead of promoting it. In Spain, we must not make the same mistakes; we all have the duty and obligation to collaborate so that the Spanish banking system remains one of the most efficient and effective in the world.
III. The New Rules of the Game
When it comes to explaining the causes of the crisis, the most comfortable, simple, and least compromising thing to say is that everything failed. A cascade of errors, according to President Obama. No one—not the market, nor the Governments, nor the Central Banks, nor the Supervisors, nor the International Organizations, nor the institutions themselves—no one noticed the catastrophic accumulation of systemic risk that ultimately triggered the crisis. No one, either, knew how to implement effective measures to contain the crisis once it was unleashed, until its consequences became irreparable. Consequently, everything must be fixed. To this end, a formidable set of initiatives has been launched, driven by countries, economic areas, and international organizations and forums striving to be protagonists and safeguard their interests in the design of the new regulation.
A schematic summary of the various solutions being negotiated can be seen in the PowerPoint I used in a recent presentation at the Menéndez y Pelayo University. It is available on the AEB website. I cannot go into them in detail. Nor will I comment on the most well-known topics such as the reform of macro and micro supervision. I will focus on some points that I consider decisive in shaping the future of banking. First of all, it must be noted that what has failed, as recently pointed out by the Governor of the Bank of England, Mervyn King, is the very established system of banking, we could say the modern model of banking and lending. That system/model was built on securitization, structured credit products, the Originate to Distribute (OTD) system, derivative instruments, Over the Counter (OTC) markets, and non-bank financial intermediaries. What is now being debated, with varying degrees of transparency, is the future of all these elements. Which parts of that system can be saved. To do this, it is necessary to determine whether these elements failed because,
1) they were misused, poorly designed, or poorly regulated
2) or because, in themselves, they are perverse, generate negative incentives, irresponsible behavior, lead to excessive risk accumulation, and are impossible to control.
The debate is not purely academic. The political and economic interests at stake are incalculable. Alongside this debate, linked to it, another is taking place that once again raises the need to separate investment banking activities from commercial banking. To reinstate, now on a global scale, the American Glass-Steagall Act as the most effective way to prevent a new crisis.
More important to me is the issue of systemic institutions. Their definition, identification, and regulatory treatment. What to do with institutions that, because they are so large or so interconnected with others, cannot be allowed to fail without endangering the entire system. These institutions, moreover, tend to be too complex to be supervised or even managed. Some of them may be too large to be rescued by their respective national state. For all of them, the Bank of England and now the BIS have stated their opinion clearly: if they are too big to fail, they are too big to exist.
The key point in my view is not so much size as complexity, often deliberately designed for purposes of regulatory arbitrage or tax evasion. And the solution I consider most effective for the problem is to establish legal mechanisms that allow, in the face of systemic risk, the regulator to take over the institution that is too large or complex for proper resolution at the lowest possible public cost.
All these issues ultimately pose two dilemmas on which the Authorities will have to make a decision. First, the dilemma of innovation versus stability. Second, the dilemma of globalization versus the national sovereignty of each state. Finding a balance among these four poles will determine the future of the banking system. The battle, in reality, is being fought on dozens of fronts, across different regulations and directives. It would be extremely laborious to analyze them in detail, a task that, unless professionally required, I do not recommend.
It is simpler to summarize them, following the IMF, as follows: The crisis will require profound changes in the structure and functioning of financial markets. The financial system of the future will be characterized by: lower levels of leverage, lower liquidity and funding mismatches, lower counterparty risk, simpler and more transparent financial instruments, better supervision and regulation. Given their business model and their current rigorous supervision and regulation, Spanish banks will have fewer difficulties adapting to the new regulatory framework. Their main challenge undoubtedly lies, first, in dealing with an economy in recession both this year and in 2010, and second, in facing the new competitive framework that will result from the restructuring of the banking system by the FROB. If this is done correctly, not only will the system emerge stronger, but it will be a decisive element in shortening the crisis and boosting the economy.
Thank you very much for your attention.
