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Six Questions for the Banking Sector

Speech | 03-03-2009 | Eumedion Conference, Minister

Speech held by minister Bos at the Eumedion Conference.

On 4 March 1934, exactly 75 years ago tomorrow, Franklin Delano Roosevelt delivered his inaugural address.
Like President Obama, he began his presidency in the middle of a global economic crisis.
Some of the things he said about the crisis are painfully relevant today.
I quote: 'Values have shrunk to fantastic levels; taxes have risen; our ability to pay has fallen; government of all kinds is faced by serious curtailment of income; the means of exchange are frozen in the currents of trade; the withered leaves of industrial enterprise lie on every side; farmers find no markets for their produce; and the savings of many years in thousands of families are gone.
More important, a host of unemployed citizens face the grim problem of existence, and an equally great number toil with little return.
Only a foolish optimist can deny the dark realities of the moment.'

Today, we are once again experiencing the same 'dark realities' worldwide.
And this raises questions.
Questions about how it could have happened and who is responsible, about what measures we need to take and, most important, how we can we prevent such crises in the future.
This is what I want to talk to you about today.
About scenarios, changes in the way the market is organised and overseen, so that we can prevent crises like this ever happening again. But I would like to emphasise that my primary concern at present is to manage the crisis.
Both the financial crisis and the economic recession.
That is my chief responsibility.

Managing the crisis is made more difficult by the fact that it appears to be a moving target.
But it has one central element: confidence.
The loss of confidence and the need to restore it.
Step by step.
The government has been dragged into this crisis up to its neck - further than I had hoped, and further than I think is healthy - and, as a result, much of the responsibility for restoring confidence has come to rest with the government.
I can assure you that we are doing everything in our power.
Europe has so far managed to keep all the key financial institutions intact.
The importance of this was demonstrated by the collapse of Lehman Brothers.
We will continue to pursue this course until confidence in our financial institutions has been restored, until they start lending to one another again and start investing in the real economy again.
In other words, until they are once again doing what they are supposed to do.

It goes without saying that the government is also trying to manage the crisis affecting the real economy.
For the Netherlands too is facing 'dark realities'.
Two weeks ago the Dutch Bureau for Economic Policy Analysis forecast that the budget deficit would rise to 3 per cent of gross domestic product in 2009 and 5.5 per cent in 2010, and that unemployment would double. This shows that the measures taken to date, especially as regards the financial sector, have not prevented the financial crisis from turning into an economic recession with dramatic effects on the real economy.
The Dutch government has therefore been working hard in recent weeks to find solutions: measures to tackle the effects of the crisis and measures to put public finances on a sound footing.
It is clear that these two goals are hard to combine.
And it is also clear that there is no conceivable government response to the economic recession that can fight it effectively.
The best way to fight a recession is to let automatic stabilisers do their work, to distribute the pain fairly and to focus on one or two key areas where government intervention can make a difference.
Above all, we need to ensure that the foundations of the economy are not damaged during the recession to such an extent as to prevent a speedy recovery once world trade picks up again.

Restoring confidence is something the government cannot do alone. Everyone needs to work together - government and business, employers and employees, politicians and the public.

Shareholders also have a part to play, and they certainly carry a responsibility.
If we are going to discuss how we can prevent this type of crisis in the future, we cannot avoid asking ourselves what you, the shareholders, have done to prevent and manage the crisis.
Unfortunately, and I know you don't like to hear this, the answer is: almost nothing.

In recent years, many financial institutions felt that they were being hounded by their shareholders: yields and leverages were driven up, resulting in financial bubbles that could only be regarded as healthy if the risks were ignored or denied.
So, as far as prevention is concerned, shareholders have done little.
Nor do they seem to be doing much to manage the crisis.
I don't know why.
Perhaps they don't have time.
The financial crisis has already been in progress for over one and a half years.
During that time, have shareholders helped to steer boards of directors in the right direction?
Away from irresponsible risk-taking?
Or was it politicians and governments that did the job?
 You can answer these questions for yourselves.
But maybe you can understand that if Fortis shareholders take legal action against the State of the Netherlands because of the rescue operation we had to carry out, I'm likely to have very mixed feelings.
Of course, I am well aware that shareholders too are feeling the pain of the financial crisis, but that does not relieve them from the duty of thinking about what needs to change in the future.

I believe that change is both necessary and possible.
That shareholders need to adopt a different course in the interests of business and market stability.
Recently, the Dutch government has taken various measures to allow more active oversight, but naturally we can't order you around. Shareholders themselves need to realise that short-term gain is not the same as long-term profit, and that the task of shareholders is not to hound directors but to contribute to checks and balances in corporate governance.
In other words, to keep the company and its management moving forward.
The reason I dare to say all this here is because I think that an organisation such as Eumedion is open to this point of view.

What applies to shareholders also applies to supervisory boards: What have they done to prevent and manage the crisis?
They too, have done less than expected and certainly less than we had hoped.
Despite the fact that we have tried to strengthen their powers and responsibilities - by introducing a corporate governance code, for example.
Here too, I hope that a crucial lesson has been learned, and that non-executive directors will start playing a far more stringent role in ensuring the long-term health of their businesses.

My reason for asking shareholders and supervisory boards these provocative questions is to highlight the fact that the financial crisis is not just a crisis of laws and regulations.
It is also a crisis of ethics and individual responsibility in the financial sector.

All these issues need to be addressed when seeking to identify the flaws in the way the market is currently organised.
But the main question that needs to be asked is: How can we prevent governments and therefore taxpayers being saddled in the future with hundreds or even thousands of billions of euros or dollars worth of financial risks in order to maintain financial stability?
That is surely not the aim.
Why not?
Because taxpayers have never asked for all those risks.
And because even social democrats have opted for a private financial sector.
Clearly something has gone wrong.
But what?
Was it the people whom FDR rather unflatteringly called 'unscrupulous money changers', 'false leaders' and 'self-seekers'?
Was it the bonuses, the perverse incentives that led to infectious greed? Was it the system of governance, regulation or supervision, or perhaps market organisation itself?
Or was it all of these things?

Asking these questions is easy.
Finding answers is far more difficult.
A fundamental rethink is required.
This is already happening on certain issues.
Nationally and internationally, modern 'Brain Trusts' are thinking about regulation, improved supervision and crisis management, for example. Let me mention Basel, the G-20, the IMF and the FSF.
In my own ministry too, a major effort is under way.
This is all very worthwhile, but not enough.
For the real answers, we need to look at market organisation itself. Institutions have been able to grow without restraint, and their balance sheets are now often larger than those of many states.
There has been an enormous increase in interconnectedness due to the large number of cross-sectoral products.
As a result, market risks have become systemic risks.

Like I said, we need a fundamental rethink.
To make the financial sector reliable and stable again, and keep it that way.
So that the public and economic interests of the financial sector are sufficiently guaranteed again, without putting the sector, or part of it, into public hands.
And without saddling taxpayers with tremendous risks.

So today I want to ask the banking sector - through you - six questions. Six questions fundamental to our reorganisation of the financial markets. Six questions that have not yet received sufficient consideration.

The first question is: Should we introduce a system of 'savings banks' and 'venture banks'?

I am well aware that the terms 'savings bank' and 'venture bank' do not do justice to the size and complexity of the financial sector.
But it is an interesting question and this is certainly not the first time it has been asked.
Would a division into these two types of banks help to contain risks? Would it help to limit public responsibility for ensuring systemic stability? This could be achieved through a public utility bank.
A sort of Sparkasse that attracts guaranteed savings, never lends money it hasn't got, is strongly capitalised and strictly supervised.
A bank where avoiding and spreading risk are paramount.
In other words: less risk, but also less profit; or even better: less loss.

The other banking functions can be assigned to separate institutions - venture banks.
I don't know whether this is an ideal model.
There are also other, perhaps less radical ways of ensuring that the interests of bankers, savers and borrowers run parallel.
The issue merits further study.
The key question is whether we would be able to control the risks of the entire financial system, or whether it might be better to make a small part risk-free while leaving the rest free to take chances but with greater responsibility if things go wrong.

Especially since we also need to keep savers' interests in mind.
The second question is therefore: How can we protect savers?
In the Netherlands, we realised just how important this is when Icesave collapsed.
Many companies and governments, as well as private individuals, had deposited money in it.
By working closely with the Dutch central bank, we were fortunately able to ensure that savers recovered a considerable amount of their savings - up to 100,000 euros.

The European Union operates a deposit guarantee scheme that protects savers if the financial institution with which they keep their savings runs into difficulties.
The EU recently decided to raise the thresholds for the scheme.
The thresholds and funding differ for each member state.
The system would work better if there were more harmonisation.
This would ensure equal treatment of savers and healthy competition between financial institutions.

The question is how to achieve this. First and foremost, European countries need to take a close look at how the deposit guarantee scheme is organised.
It was not designed to deal with a systemic crisis but with the collapse of a single bank.

A sound starting point for funding might be: 'the polluter pays'.
In the Netherlands, a bank that goes bankrupt does not contribute to the deposit guarantee scheme.
Whereas it may be precisely such banks that have taken the most risks, and perhaps the most irresponsible risks.
This constitutes a moral hazard within our current deposit guarantee scheme and it needs to be tackled.
So maybe we could require such banks to make an ex ante contribution. It is certainly worth considering the possibility of requiring banks that take greater risks to make a greater contribution.

A bank that has attracted a comparatively large amount of savings in relation to its capital base, and therefore runs more risk of having to make use of the deposit guarantee scheme, should therefore make a larger contribution.
We can also make a financial institution pay ex ante.
If an institution collapses and has to make use of the scheme, it will at least have already paid its own contribution.

But however we organise the scheme, savers also have a certain responsibility of their own.
Saving is by far the safest way of managing capital, but is never entirely risk-free.
Opting for half a per cent more interest sometimes means opting for more risk.
The difference between opting for a savings bank or for a venture bank, for example.

But we need to consider not only the breadth of financial institutions - that is, the type and number of products they offer - but also their size. This brings me to my third question: Are there limits to growth?
Is there a trade-off between growth and financial stability?

We have all watched it happen: a considerable number of financial institutions, including Dutch ones, have become very large and complex since the 1990s.
This strengthens their international position, but is a drawback if they run into problems.
If that happens, they have to be rescued because their collapse would threaten the stability of the financial market: they are too big to be allowed to fail.
These rescue operations often cost the public a lot of money, especially if they involve nationalisation.
That arouses bad feelings.
Among other financial institutions that are able to survive alone, among non-financial companies that also face difficulties, and - not least - among taxpayers.

Another major vulnerability is that some financial institutions grow so big that it becomes impossible to rescue them.
What is the maximum size of a bank that can realistically be nationalised?
Should the assets not exceed 50 per cent of the GDP of the nationalising state, or 100 per cent or 150 per cent?
Can banks become too big to save?
Should supervisors allow a bank to become so large that options which are needed in times of crisis become infeasible?

It is doubtful whether excessively large financial institutions are good for the stability of the financial system.
The pursuit of growth in order to compete is increasingly clashing with the need to limit growth in the interests of stability.
How should we handle this paradox?
One option is for institutions not to grow so much that they may pose a serious risk to stability.
For instance, by discouraging the combination of too many different types of financial services.
Or by applying progressive capital requirements.
There are plenty of possibilities.
I am interested to see what other ideas you can come up with.

The financial institutions that the Dutch government has prevented from collapsing in recent months are certainly too big to be allowed to fail.
In this process, we made use of all sorts of old and new, tested and untested instruments.
The fourth question is therefore: Do governments have sufficient instruments to avert a systemic crisis?

What can we do now? We can provide new capital, as the Dutch government did in the case of ING, AEGON and SNS.
Or we can guarantee or secure certain loans provided by financial institutions.
The government did this too.
A third option is to buy up all the toxic assets from a financial institution and deposit them in a 'bad bank'.
The Netherlands used that option as well.
The most radical measure, which has probably caused many shareholders sleepless nights, is what The Economist has called the 'nuclear option': nationalisation.
We have also had to use this option in the Netherlands.
The Dutch subsidiaries of Fortis have been nationalised by the Dutch state.
This was a voluntary nationalisation: Fortis Holding voluntarily sold its shares to the Dutch government.
For a fair price.

Involuntary nationalisation - nationalisation without the consent of the shareholders - has not been carried out in the Netherlands, nor does current legislation readily allow it.
In some countries, such as the UK, Ireland and Austria, specific legal instruments have been created in order to nationalise financial institutions - often listed ones - involuntarily.
Involuntary nationalisation is very radical because it involves expropriating shareholders.
But however radical, it may be necessary in times of crisis.

These instruments are useful and necessary in a severe crisis.
But are they always effective enough?
That is something we need to discuss.
What is certainly required is reliable information - information from the institutions themselves and those supervising them.
This is essential to enable the government to take quick, targeted measures when problems arise.

There is a saying that 'prevention is better than cure', and this particularly applies to crisis management.
So it is a good idea to scrutinise governance and management, owners and managers, how financial institutions are organised and run.
In other words, and this is my fifth question: How should we tackle the conflict between shareholders' interests and financial stability?

Most of the financial institutions that have received assistance in the Netherlands and the rest of the world, are or were listed.
Shareholders play a key role in such institutions.
A role that can affect an institution's future and stability.
A good example is the takeover of ABN AMRO by Fortis, RBS and Santander.
From the point of view of the shareholders - or in any event AA shareholders - it was an excellent deal. However, many people doubt whether, in retrospect, it was such a good idea in terms of financial stability, or from the standpoint of stakeholders other than shareholders. At an early stage in the crisis, Fortis had to be partially nationalised to stave off bankruptcy.

Even if less radical measures are taken to rescue listed financial institutions, a conflict with shareholders' interests can still arise. In exchange for capital injections - in various forms - governments have obtained core 1 capital.
In the Netherlands, this happened with ING, AEGON and SNS. Some shareholders see this as a watering down of their interests. Governments, in turn, especially if they make a substantial capital injection, sometimes feel irritated with shareholders who, despite everything, remain the owners of the company in question.

I certainly do not want banks to start recruiting members instead of shareholders, though I must say that Rabobank is doing very well.
Nor do I want all financial institutions to stop being listed on the stock exchange, though, again, Rabobank is doing very well.
We have to be careful not to throw the baby out with the bathwater.
So let's not forget all the advantages of shareholders being involved in financial institutions through capital markets.

This is especially true in the Netherlands, where listed companies, including financial institutions, apply the stakeholder model.
It involves taking all interests into consideration, with the long-term aim of creating more value for all stakeholders, not just shareholders.
This model is in keeping with the goal of promoting financial stability.

But there is a downside. In the event of takeovers or sudden changes of strategy, the stakeholder model comes under pressure.
In the turbulent situation that may then arise, quick wins - often in shareholders' short-term interests - carry most weight.
Partly because management is usually driven by short-term incentives. This is not in the interests of either stakeholders or stability.

What should we do about this?
We should certainly not resort to more protection constructions, as these can obstruct innovation and efficiency.
Nor do I think that drastically curtailing the rights of shareholders in financial institutions is the right approach, as this can reduce the ability to attract capital and can contribute to inefficient management.

So what can we do?

First, more emphasis should always be placed on weighing up the interests of all stakeholders, with a view to long-term profitability.
Not only by the shareholders themselves, but also by the directors. Especially when important decisions about a company's future have to be made.
There is of course nothing wrong with shareholders focusing on making a profit.
That is what they are required to do by those they represent: often insurance policyholders and present or future pensioners.
But this does not mean that they - that you - may disregard the interests of other stakeholders - from employees to taxpayers - and of the company itself.
The greater your interest, the greater your responsibility!

Second, I am convinced that shareholders' rights can contribute to financial stability.
Failing corporate governance structures were clearly a factor in precipitating the financial crisis.
This weakness can be rectified by improving and tightening up corporate governance structures.
Shareholders can play a key role in this regard.
For example, you can use your weight to influence management.
Not only to ask for money, as the merchant Isaac Le Maire did 400 years ago, but by attending shareholders' meetings, helping to determine the company's direction, and defending the interests of other stakeholders. In the Netherlands, steady progress is being made in this regard.
Partly thanks to organisations such as Eumedion, the dialogue between companies and shareholders has improved.
The number of people attending shareholders' meetings has risen sharply in recent years.
As a policymaker, and also as a shareholder and investor - though hopefully only a temporary one - I will do whatever I can to help improve the governance of financial institutions.

Bankers, managers and the directors of financial institutions also need to do what they can and shoulder their responsibility.
My sixth question is: How can we encourage financial institutions to recognise their own responsibility?
And this brings us back to our starting point: How can we ensure that governance leads to better management?

'We are profoundly, and I think I would say unreservedly, sorry at the turn of events.'
That's what Dennis Stevenson, the former chairman of HBOS, said at the hearing held by the UK Treasury Committee a few weeks ago.

'Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity - myself especially - are in a state of shocked disbelief.'
That's what Alan Greenspan said at a congressional hearing several months ago.
Greenspan had not expected that shareholders in financial institutions would put their own interests before the interests of the company itself. He saw the economic model in which he had blindly believed for over 40 years shatter before his very eyes.
While the whole world looked on.

Looked on in much the same way as the whole world is now watching how governments are trying to resolve the financial crisis.
I am not talking about short-term solutions, but about the solutions for tomorrow and beyond.
A great deal of thought and discussion is being devoted to this problem. In the Netherlands, in Europe and in the rest of the world.
However a ready-made answer has not been found.

What is certain is that, regardless of all the efforts made by governments, supervisors and hopefully shareholders too, reforming the financial sector cannot succeed unless the sector itself is willing to cooperate.
It needs to recognise its responsibility.
It needs to take measures to reduce future risks. Unfortunately, it is still doing too little in this respect.
For instance, a survey conducted by KPMG among 500 risk managers at financial institutions in October 2008 showed that only 42 per cent of the institutions have drawn up a plan to overhaul their risk management processes.
76 per cent of the managers who took part still saw the position of risk manager as a support function, even though the full force of the crisis was already being felt at the time of the survey.

That is not the way to restore confidence in the financial sector.
Things can and must change!
How?
To begin with, financial institutions must place greater emphasis on good governance: a stable internal governance structure and expert, independent supervisory directors and non-executives, with a strong focus on risk control.
For example, the most senior risk officer could be made a member of the board of directors, preferably with the right of veto in matters of risk control.

In addition, more attention must be paid to the public tasks and responsibilities of financial institutions.
One way of highlighting this is to introduce an oath for bankers.
Their own version of 'first, do no harm'.
Perhaps this could be linked to a regular exam to be taken by executives in the banking sector.
How many of them would have passed their exams on 'Do I understand my own products?'

Remuneration policy also needs to change.
It needs to become more balanced, to focus more on the long term.
And I'm not just talking about senior executives, but about all employees. For the public, hearing the words 'bank' and 'bonus' in the same sentence is like a red rag to a bull.
This must change quickly if we are to restore confidence in the financial sector.

Confidence and responsibility.
I see these as the new buzzwords for the financial sector.
We all need to make a concerted effort.
Not just in our short-term interests, but also for our long-term future.

Let me conclude.
Today we are still fighting the fire.
So some of you may find my questions about how to rebuild everything that is now still burning a bit premature.
I don't think they are.
But I do agree that our top priority right now is to fight the fire, to end the crisis, to restore confidence, to do what is necessary.
That is what we have done and that is what I will do.

Thank you.