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Ladies and Gentlemen,

Oscar Wilde said, "When bankers get together for dinner, they discuss art. When artists get together for dinner, they discuss money." Apart from the fact that money and art are subjects which make for a good debate at any time, I ask myself whether these matters can really be so strictly separated. Doesn't anyone who wants to be exceedingly successful on the moody financial markets have to be a little bit of an artist in addition to having expertise in the subject? It is well known that investing legend André Kostolany believed that success on the stock market was an art, not a science. I would like to suggest that financial regulation, too, is as much of an art as a science.

Certainly, no one doubts that regulation requires quantitative analysis, models, algorithms and quantitative methods. But let me turn our focus to that part of regulation which seems to be more of an art than a science. By this, I mean a broad spectrum of questions, the answers to which will not come from models, but for which we have to weigh up difficult decisions between different regulatory objectives which sometimes are even in opposition to each other. In short: questions where it comes down primarily to human judgement.

The financial markets’ dynamic nature and innovative strength means that creating a functioning and sustainable normative order by means of regulation is a huge task.
Moreover, the markets cannot be viewed in isolation from their political and social environment and that is, to use the language of traders, quite volatile at the moment. Of course the Brexit debate plays a role in London's financial community. Although fog is not a completely unusual phenomenon here, it is not really possible yet for any of us to see right through the fog which lies over the forthcoming Brexit negotiations. Even though the prime minister has outlined her vision for the future of the United Kingdom in more detail, plenty of water is still likely to flow under London's bridges before we know precisely how soft or hard the Brexit will ultimately turn out to be. Particularly in such an environment, regulators and supervisors will also need to find unusual answers. We will have to show steadfastness and continuity in our principles, and pragmatism and flexibility on many individual issues.

This is where we find the first area of overlap with art. It is not the job of regulation, nor is it possible, to exclude any conceivable uncertainty and every risk from the start. On the contrary, it is part of the regulatory mandate to give the market the necessary freedom for innovation, entrepreneurial activities, and indeed, failure and that is why it is important to seek the best possible balance between responsibility and liability, which are inseparable. Liability and, in fact, the prospect of a bail-in should be the best friend of financial regulation. Banks and their customers are also entitled to expect regulatory certainty and dependability from regulators. Regulators must, therefore, strive to establish a lasting, appropriate framework. Regulation always walks a tightrope. It is a tightrope from which it is easy to fall if we get onto it without taking into account the many competing forces influencing the outcome.

Let me offer four current examples to demonstrate the art required of regulation:

1. Financial Stability vs. Profitability (incl. Moral Hazard)

Let's turn first to the relationship between financial stability and profitability. Here, a basic issue is the extent to which banking business must be curbed by capital, liquidity and other requirements. Opposed to this, there is the financial institution's need to generate profit and thus also to offer investors an appropriate return on the risk capital they have provided. To alleviate this tension, we need to define precisely what the primary purpose of banking business is supposed to be. In the first place, of course, banks should live up to their role as intermediaries between capital supply and demand. This is no problem as long as such a business model – which is what we mean when we talk about the financial sector's function to serve the real economy – can achieve sufficient returns. It gets problematic if either income diminishes dramatically due to market conditions or if undue return expectations and goals are set which can only be fulfilled by excessive risk taking. The latter was a prime concern prior to the crisis, the former is a major concern ever since.

Empirical experience shows that this pressure can become very strong and banks seek to improve or maximise their business model. This, in itself, is – of course - neither illegal nor illegitimate. Indeed, it even contributes to a certain extent to making banking business more profitable, and possibly, resilient.

But where is the limit? Some politicians would say, "at the point where profit is distributed to shareholders but heavy losses have to be borne partially or completely by taxpayers." This would disrupt the unity of responsibility and liability, which I mentioned earlier as a key principle. The Lebanese-American philosopher and mathematician Nassim Nicholas Taleb puts it very concisely when he calls for those who take risks in business to also bear the consequences if it goes wrong. He talks about "skin in the game", which basically means that the tendency to moral hazard sinks if someone is risking their own skin and not just "other people's money". In regulatory language: Excessive originate-to-distribute-models are unwanted.

Regulation has to ensure that taxpayers' money is not used or only under very limited and extraordinary circumstances. The establishment of the Single Resolution Board, the European Bank Recovery and Resolution Directive and the trio of higher capital requirements, improved liquidity and good governance structures are a step in the right direction. The art of the regulator lies in reconciling such different objectives as prevention, crisis management and avoidance of moral hazard by using the right interaction of these tools.

Surely, some are asking why it all has to be so complicated, when it would be possible to make banks just as resilient with, for example, a much higher leverage ratio or comparable tools. Is that so? I can understand the idea behind it, but I cannot follow the argument.
Previous experience shows that a crude capital approach kills all risk sensitivity. What is more: if I, as an institution, have to protect my banking and trading book with flat-rate capital requirements anyway, I am left with no alternative but to take on maximum risk in my business in order to recoup the high capital costs. I am absolutely convinced that, rather than leading credit institutions to a less risky way of doing business, a leverage ratio of, say, 10 percent or even beyond would actually make many of them act in a riskier way. The longing for easy answers is understandable, also in the financial world, but we should not give in to it.

Turning away from risk sensitivity as a regulatory principle would be a step backwards. Seriously, resurrecting Basel I cannot be a reasonable regulatory goal. On the other hand, regulation must of course limit the application of internal models so that model risk or risks arising from an excessive tendency to game the system can be kept under control.

2. Risk Sensivity vs. Procyclicality

There is also a certain conflict between the objectives of risk sensitivity and procyclicality. In recent years, the greater market orientation of the valuation of assets and liabilities has most certainly made the risk situation of financial actors and markets more transparent.

In banking regulation, this has happened gradually with the transitions from Basel I to Basel III, while in the insurance sector the launch of Solvency II was a milestone.

The market-value orientation is intended to reduce companies' assumption of risks and strengthen their solvency, among other things. In addition, the loss-absorbing capacity is supposed to be increased. But there's no rose without a thorn. Risk sensitivity, if not appropriately limited, can turn long-term movements into excessive short-term volatility. It can promote the tendency towards too much credit expansion in boom phases and more restricted lending in recession phases – with potential repercussions for the real economy. To what extent this is economically justified is doubtless one of the toughest questions of both financial regulation and accounting standards.

For insurers, too, there is a danger that a market value-oriented solvency assessment in times of crisis encourages procyclical investment behaviour. For example, when undertakings carry out very long-term investments in ongoing periods of low interest rates like the current one – flight into duration – in order to achieve a minimum level of returns, or when they have to make emergency sales in stress phases to maintain their solvency ratio.

Happily, much has been done to mitigate procyclical effects. In banking regulation, for example, the countercyclical capital buffer was designed so that institutions should accumulate an additional capital cushion during periods of excessive credit growth. A range of measures for the insurance sector was integrated into the Solvency II rules. This is intended to avoid the fluctuations in results caused by market excesses in, amongst others, the spreads for fixed-income securities. Of course, such measures need to be monitored in practice and room for improvement must be identified early. However, in the end it will not be possible to avoid the regulatory linking of capital and risk with market valuation to go along with a certain degree of procyclicality. The art lies in finding the right balance between market-value orientation and prudence which enables a targeted, risk-based regulation with the least possible procyclical effect.

3. Principles-based vs. rule-based

The dynamic nature of the markets can only be kept on track when regulation does not spell out everything to the last detail but rather restricts itself to forming a framework of principles within which it grants a certain amount of leeway and freedom to day-to-day supervision. In the banking sector, the move to a more principles-based regulatory regime was completed with the transition to Basel II, while in the insurance sector it happened with the start of Solvency II at the beginning of last year.

A principles-based approach, applied properly, means that the risk profile of each institution can be identified and assessed individually. Nevertheless, working according to principles calls for a close relationship between companies and their supervisors: the important thing is that we, as the supervisory authority, can get a full picture of whether an institution has set its risk management system up in such a way that it is actually appropriate to its risk situation. Institutions, for their part, have a right to supervision which is fair and comparable, and yet essentially individual. Supervision is fact-based judgement. And judgement remains indispensable, however far supervision is based on analyses, models, pre-set schemes and tools.

Calls for more rules-based regulation start to get louder in particular if something has just gone fundamentally wrong: the real-estate crisis, sovereign debt crisis, crisis of confidence, misselling scandals. Too many rigid rules do not do justice to dynamic financial markets and individual risk profiles. Too much principles-based regulation, oh the other hand, reduces predictability and the harmonisation of the legal application of supervisory measures across individual institutions and countries. It is the mix of both – principles and a rules-based approach – which ultimately makes for good regulation. And which brings us back to the notion of art.

4. Diverging goals in conduct regulation

Ladies and Gentlemen,

it is not just in traditional prudential regulation that a sense of proportion is called for. The same applies, possibly even more so, for conduct regulation. As you know, this branch of regulation has been and is still moving increasingly into public focus, partly because of growing expectations in society of consumer protection. This development is essentially a good one. Consumers deserve special attention because they are at a disadvantage to providers and professional investors. They do not have the same know-how and they do not have whole teams of experts to help them decipher the small print and assess the returns promised. Information and a greater focus on financial education are important but do not replace hard supervision of violations of conduct regulation. However, we may run the risk of creating a tightly knit web of rules and complexity which could call into question the comprehensive provision of financial products altogether. For if it is no longer a paying proposition to offer certain financial products, or if this involved incalculable legal risks, eventually, there will not be any such products on offer any more. I have my doubts whether consumers, in particular, would be helped by that.

Even though regulation cannot be the sole explanation for market developments of course, these considerations show that possible market reactions must be carefully looked at so as to avoid disadvantages to consumers despite the best of intentions. Therefore, conduct regulation, in particular, is also a balancing act – or, to put it another way, precision work.

Ladies and Gentlemen,

I hope my little tour d` horizon through various aspects of regulation has made clear that models and statistics alone cannot live up to the reality of the financial markets. These markets are inconceivable without uncertainty, without risk. "Banking is risk taking", and regulation has to ensure that this takes place in a controlled environment. Good regulators are characterised in particular by the fact that they can balance differing policy and economic goals, even in situations of extreme crisis. And good supervisors sometimes even have to be able to improvise. With improvisation, it is like playing jazz; it really only works if you can play the instrument and the tunes perfectly well. But even then we should not ignore the good advice from Miles Davis, a legend of the genre, who said about improvisation: "What divides a great player from a good one is the ability to keep control, even when something unexpected happens. When you hit a note wrong, it's the next note that makes it good or bad."

Therefore, I must warn against too high expectations: crises cannot be averted forever. It is not the job of regulation to exclude any conceivable uncertainty or wrong note from the start. What we can do is to make it less likely and if a crisis happens succeed in subduing its destructive power.

And: Even regulation itself is exposed to volatility. Once again, the art lies in limiting this volatility. Proportionality, differentiation and lessons learned are always important and welcome; full-fledged deregulation should be avoided.

Thank you for your attention. I look forward to your questions.