German Central Bank Chief Outlines Vision of Financial Regulation Reform

The coming reform of financial regulation must enhance transparency concerning unregulated business areas and markets, including hedge funds, OTC traded derivatives and off-balance-sheet vehicles, emphasized Axel Weber, President of the Deutsche Bundesbank. In remarks at the Euro Banking Congress in Frankfurt am Main, he said that effective reform must also address fair value accounting which, in his view, amplifies the cyclicality of leverage. Just as war is too important to leave to generals, he noted that financial accounting has become too important to leave to accountants. While recent changes in accounting rules have been useful in protecting banks’ current results from further crisis-driven exaggerations, he cautioned that the one-sided easing of accounting rules entails the risk of sowing the seeds of a growing risk appetite in the future.

According to the German central bank head, executive compensation is also in need of urgent reform in order to free the financial system from procyclicality, which he described as the reinforcement of the natural cycle of the system. In his view, executive compensation schemes that reward quick success with annual bonuses without penalizing the long-term consequences of decisions that were taken enhances procyclicality and contributes to boom and bust cycles.

Mr. Weber joins the growing consensus that the originate and distribute system of securitization is here to stay, but must be reformed. Recently, remarks by the two most senior officials of the European Central Bank reflected a growing consensus that the originate and distribute securitization model will be retained in the wake of the subprime crisis. Both ECB President Jean-Claude Trichet and Vice President Lucas Papademos believe that the benefits of securitization argue for its retention so long as major reforms are effected. The ongoing reform of securitization must center on the principles of transparency, liquidity risk management, and cross-border cooperation, in the view of President Trichet

Finally, Mr. Weber noted that Germany has set up an emergency rescue regime, with the core instrument being the German Market Stabilization Fund. In order to eliminate liquidity shortages and to support refinancing in the capital markets, the Fund is authorized to guarantee, for a suitable fee, newly issued refinancing instruments with maturities of up to 36 months. The Fund may also purchase shares or dormant equity holdings of financial institutions in order to recapitalize them. Finally, with the option of acquiring problematic assets, it can improve capital ratios. After initial reluctance, a growing number of banks, both from the private and the public sector, have asked the Fund for help. An important feature of the Fund is that it is voluntary. He cautioned that the use of public funds for these purposes should be as temporary as possible.