FSA Congres

Ladies and gentlemen,

Corporate finance was the foundation on which the Dutch built their empire.
We invented banks and bankers, shares and options, and a dedicated place for trade and sometimes tricks: the stock exchange.
Sir William Temple, a 17th-century English ambassador to our country, once wrote: “Holland is a country where the ground is better than the air and profit counts for more than honour.”
For the Dutch that was not an insult but a compliment.
We were – and still are – proud of our contribution to international financial capitalism, because the trade in money is not only a lucrative but also an honourable trade.
As long as we trade with honour, of course...

Because there is banking and there is banking.
And, of course, there is shadow banking: the topic of this conference.

To grasp a shadow, you have to grasp the object that is blocking the light.
So to understand shadow banking, you first need to understand banking. And banking is basically the movement of money from where it is available to where it is needed.
In other words, put simply, a bank acts as an intermediary between savers and lenders.

This intermediary role is necessary because there is often a mismatch between what both groups want.
Not only because the first group wants to save money at the highest rate and the second group wants to get credit at the lowest rate.
But also because they usually want to save or lend for different periods of time:
A family wants to save one year for a holiday.
A student wants a loan for ten years.
Or maybe forever.... ?

The banks bridge the gaps: they offer two different ‘made to measure’ products to saver and lender, and take on the corresponding risk.
For instance, the risk that the saver will want his money back earlier.
Or the risk that the borrower will default on his loan.
That risk is reflected in the rate of interest.

But risks are real.
They can materialise.
The biggest risk is a bank run: when all the savers want their money back on the same day.
Because if you take your money to a bank it never stays there:
It is converted into loans and investments.
That’s how banks make a profit.
Only a small part of all deposits is kept in cash.
So if all the savers withdraw their deposits at the same time the bank is in trouble.

We saw the long queues in the UK outside the local branches of Northern Rock, we heard Pieter Lakeman urge the customers of DSB to get their money out.
And we know the outcome: both banks failed.
And when that happens, when risk materialises and losses emerge, savers and shareholders can lose their money.

But a bank that fails is not only bad for savers and shareholders, for management and employees.
It also affects confidence in the financial sector, and can have severe repercussions for the real economy.
The credit crunch made that crystal clear.

To protect against the risk of failure, banks are obliged to hold certain minimum levels of capital to limit their leverage.
This level is calculated according to the rules of the Basel committee.
In its simplest form, this regulation requires banks with riskier assets to hold more capital.

To protect against the risk of a bank run, we introduced deposit insurance.
Deposit insurance protects customers from the risks of a banking failure. Throughout the EU, depositors are guaranteed to get back €100,000 in the event of a bank default.
The purpose of this insurance is to prevent a bank run.
Another safeguard against failure is the access of banks to liquidity facilities at the central bank.
A bank can apply for liquidity at the central bank to bridge a gap in the balance sheet.
(...)
That was ‘banking for beginners’.
Now we can move on to the question of the day: what is shadow banking?
And, is shadow banking a threat or an opportunity?
(...)
Shadow banking is a fairly new term, coined in 2007 by Paul McCulley of PIMCO at a conference held by the Kansas Federal Reserve.
McCulley described it back-then as “a whole alphabet soup of levered-up non-bank investment conduits, vehicles, and structures”.
The alphabet soup refers to entities and their products that fill this shady side of the financial spectrum.
All with impossible names like SPVs, SIVs, conduits, hedge funds, money market funds, monoline insurers, CDOs and so on.
Some of these terms describe real institutions with real employees and real buildings.
Others exist only on paper.
But whether real or on paper, their balance sheets include mortgages, consumer credit, student loans and whatever else they come up with. Together they hold almost 20 trillion US dollars; that is twice as much as the traditional banking sector in the USA!
On a global basis, we reckon it could be as much as 40 trillion dollars. These are serious figures.

But what makes for the difference between banking and shadow banking?
In short: regulation and supervision.

The underlying assumption is that holding saving deposits justifies regulation.
And those who do not attract savings are not subject to regulation.
So unlike banks, shadow banks are not obliged to hold minimum levels of capital.
But nor are they allowed to attract savings, or have access to central bank liquidity facilities.
Even more important: there is no regulatory framework that limits leverage or the build-up of risks in the system.
In other words: shadow banks work in the shadow of the system.
Hence their name.

But what do they do?
What do they sell?
A prime example of a shadow banking product is securitisation.
For the few of you who have never heard of it: securitisation involves bundling loans into packages that are then sold to outside investors: including shadow bankers.
For conventional banks, this is a very good way of spreading risk, because they earn fees for originating loans without the burden of holding them on their balance sheets.
For shadow banks, it is a very good way to hold assets that yield more than government bonds and represent claims on a diversified group of borrowers.
Through securitisation, European banks have increasingly used capital markets for funding.
As a result they have become more reliant on this ‘outside’ capital to manage their leverage and capital ratios.
Especially in the Netherlands, where securitisation is an important source of funding for our banks.
Why is this?

Two reasons: on the asset side of their balance sheet, Dutch banks have a very substantial mortgage portfolio.
On the liability side of the balance sheet, Dutch banks have – relatively speaking – a smaller amount of Dutch saving deposits.
Not because the Dutch do not save money.
They do!
But because of our pension funds, which are among the largest in the world.
That is where a lot of our savings go.
A situation highlighted recently by the IMF in its Article IV report.
That is why Dutch banks need shadow banks: they need ‘outside’ savings to balance the books.
And if properly executed, securitisation is highly beneficial for banks and consumers.

But there is a risk.
As I said, shadow banks have no access to central bank facilities: a lifeline in times of emergency.
To fill that gap, regulated banks act as a sort of central bank to shadow banks.
And therein lies the risk to the stability of the financial system: if a shadow bank fails, it risks taking down the conventional bank with it. That’s what happened in the credit crisis, and that’s what we never want to happen again.
Don’t get me wrong: the aim is not necessarily to reduce the size of shadow banking, but to make it stronger.
To reduce systemic risk, so it has a better chance of weathering tough market conditions.
We want banks and shadow banks to compete on a level playing field, with proportional regulation for each institution.
In other words: we want to reform shadow banking and turn it into parallel banking.

Not in the shadows, but in the open.

Not outside the system, but parallel to the system.

So they do not pose a systemic risk, but create added value.

Since the start of the financial crisis we’ve strengthened and intensified the regulation of the banking sector.
At national and international level.
New rules such as Basel 3 aim to make not only banking safer, but the system as a whole.

If we want to make this work – and we do – we need to set out general principles for the shadow banking system in order to avoid past mistakes.

The first principle is transparency.
As I’ve explained before, we need to put a spotlight on shadow banking. That means that we need to know what is going on and where.
That way we can identify risks in the system.
That’s why we need to establish a minimum level of transparency for all shadow banking activities worldwide.

The second principle is resolvability.
Shadow banks should be able to fail without serious consequences to the stability of the financial system. Any possible systemic risk in the shadow banking sector must be contained, to minimise risks to society.

The third principle is proportionality.
We want all systemic risk in the financial system to be accounted for, properly supervised and capitalised.
That’s why rules must be robust and complementary to existing rules. And, just as important, rules should be proportionate to risks and activities in the system.
That means that the rules must fit the system; they must be proportionate to the amount of systemic risk.
That way we level the playing field between traditional banking and shadow banking.

I am sure that these principles will help us set clear rules for a ‘new’ system of parallel banking.
This will not necessarily mean an increase in the cost of credit, but it will mean a huge step forward in creating a more stable and safe financial system.
Only if we are willing to invest in that, can we make the Dutch financial sector sound and robust again!

Thank you.