ECB director warns of regulatory 'cliff effect'

29th September 2010, Comments 0 comments

New regulations aimed at bolstering the banking system could have a "cliff effect" which could create challenges for the European Central Bank, a member of its executive board warned on Wednesday.

He referred to a central issue of how rules on the way types of risk are judged affects the way financial firms in particular structure the type of risks they take on and how they finance them.

"It can be expected that the categorisation of assets into certain classes of liquidity will lead to a 'cliff effect,' by which the regulatory categorisation of assets as either liquid or illiquid plays a crucial role for the future of their market," Lorenzo Bini Smaghi told a banking conference in Milan.

The effect could lead to "sudden changes in the market conditions" for some kinds of assets, including a possible rapid drying-up of market activity or liquidity, he added.

Such an event occured after the US investment bank Lehman Brothers declared bankruptcy in September 2008, and many financial institutions had problems with the refinancing of their operations at that time, the ECB executive noted.

New global banking regulations known as Basel III rules have been drafted to ensure that banks sit on solid foundations and can absorb heavy losses from risky investments without needing to be bailed out by taxpayers again.

"An issue to be considered is whether the intended changes in banks' behaviour resulting from the new regulation may have some unintended consequences," Bini Smaghi said.

"Since market participants will adjust to the new regulation, it is possible that the changes affect market structures, perhaps fundamentally so, and not necessarily in ways that are foreseen or desired by the regulators," he added.

The ECB executive nonetheless concluded that the new rules would stabilize the financial sector and reduce overall levels of risk.

"Real economic activity will profit from such increased stability and, in my view, outweigh the direct cost of the regulation, especially in the long run," he said.

© 2010 AFP

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