After the Reform of Banking Regulation: Has the Financial System - PowerPoint PPT Presentation

MPI Collective Goods Martin Hellwig After the Reform of Banking Regulation: Has the Financial System Become Safe? Amsterdam, June 12, 2014

Safer is not safe  Since 2008, the financial system has become safer, but safer is not the same as safe  If all the new regulations had been in place in 2000, would the crisis have been avoided?  No!  A truck explodes in a tunnel at 150 km/h  We lower the speed limit to 140 km/h  ... And we impose a limit on gas consumption of SUVs  Has the tunnel become safe?

Reforms since the Crisis  „Basel III“= „Basel 2.01“  No reform of the model based approach  Changes in quality of „capital“ – ABE?  A tripling of something close to zero ...  Leverage ratio 3 % of total assets...  Macroprudential regulation ... A new form of fine tuning?  Liquidity Coverage Ratio ... diluted ABC principle (Anything but cash!)  Net Stable Funding Ratio, yet to be introduced

Reforms since the Crisis  New Organizations: EBA, EIOPA, ESMA, ESRB, …  As if the crisis had been caused by lack of European integration  New rules for hedge funds, As if the crisis had been caused by hedge funds   Prohibition of short sales  As if short sales had caused the disaster at Lehman Brothers or Hypo Real Estate

Reforms since the Crisis  Financial Transactions Tax As if the crisis had been caused by stock market  speculation  Structural Reform (Volckers, Vickers, Liikanen) As if deposits were the only thing that might require a bailout  Restructuring Levy and Funds  As if this would pay for future bailouts  Improvements (?) in recovery and resolution: UK, D, US, EU ... Not practical and ineffective

Resolution? Unsolved Issues  Cross-border banking with systemically important acitivities in different countries: Lehman Brothers, Deutsche, BNP Paribas, Barcleys  Funding: Money market funding and derivatives need to be maintained – how?  Bail-Ins? Legal uncertainty  Fiscal backstops?  Procedures?  WE NEED PREVENTION

„The Bankers New Clothes“ Main Message  Equity requirements are key.  Banks should be forced to fund with much more with equity than they currently do, i.e., borrow relatively less and use relatively more of their own funds  Equity requirements should NOT be calibrated (downwards) to account for purported differences in asset risks  Proposal: 20 – 30 % of total assets (no netting)

Assessment of the Crisis  The crisis has not one cause, but several  Bad Loans: Real estate, sovereign  Excessive leverage and maturity transformation  Excessive Interconnectedness  Flawed financial system architecture generating a downward spiral based on the interplay of asset price declines, fair-value accounting, inadequacy of bank capital, deleveraging, asset price declines….

A brief overview over the crisis  Buildup of risks: Subprime lending and securitization  August 2007 – Downgrades of AAA rated securities by several grades at once  August 2007 – Breakdown of ABCB funding of conduits and SIVs (Gorton‘s „panic of 2007“ – except that it wasn‘t repo and the SIV‘s were taken into their parents‘ balance sheets)

A brief overview over the crisis 2  August 2007 – Capital squeeze:  Taking SIVs into the parent‘s balance sheet implied a capital squeeze of the parent  ... In some cases insolvency from writedowns on the SIVs assets  August 2007 – September 2008: Deleveraging, asset price declines, writedowns, further fire sales  Not a panic but a slow implosion  Several breakdowns of interbank markets, smoothed by central banks

A brief overview over the crisis 3  March 2008, September 2008: Funding breakdowns at Bear Stearns and Lehman Brothers, driven by repo runs on these banks, which had been exposed to the risks of subprime assets that they had been unable to sell.  September 2008: Post Lehman: Contractual dominos, runs on money market funds, runs by money market funds, enormous asset price declines...

Liquidity versus solvency narratives  Liquidity narrative: The crisis was due to a breakdown of confidence, final assets were not doing so badly, uncertainty as to where the problems were led to exagerations, defensive reactions etc.  Solvency narrative: Losses on final assets were substantial. Because everybody had borrowed a lot (97% of balance sheets), many institutions were (and probably still are) insolvent. The liquidity breakdowns were a reaction to realizations that borrowers were insolvent.

Both are right  There were extensive losses and extensive insolvencies  The breakdown did take the form of liquidity breakdowns  Some of the defensive reactions may seem excessive  But were they?

Insufficiency of Bank Equity I  Practically no “Free” equity  Write-Downs induce an immediate need for corrective action  Corrective Actions: - Recapitalization - Deleveraging  Deleveraging enhances sales pressures in markets, lowers market prices even further  Induces further write-downs at other banks, etc.

Insufficiency of Bank Equity II  With equity amounting to 1 - 3 % of unweighted assets, two problems arise:  Multipliers for Deleveraging are exorbitant  There quickly are problems with solvency  Doubts about solvency endanger funding  „Runs“ Problem  Examples:  Bear Stearns, Lehman Brothers  Europe in 2011

Deficits of Regulation and Supervision  Intransparency about system exposure to risk  Excessive leverage, maturity transformation, liquidity assistance promises,  Insufficiency of bank equity under the model based approach  Procyclicality of deleveraging induced by regulation

Reasons for these Deficits  Anti-regulation stance of governments, ideology of “national champions”  Fear of regulators to invoke the second pillar of Basel in order to forbid excessive maturity transformation etc.  Political Economy (German Landesbanken)  Lack of Conceptual Foundations for regulation as a basis for capture

Prehistory  1988 Basel I: 8 % equity requirement for (ordinary) credit risks  1993: First Proposal for equity requirements for market risks (Standard approach)  1993-1995: Regulatory Capture by Sophistication: “We understand much more than you do about risk management and risk control”  1995: Revised Proposal for equity requirements for market risks (Standard Approach + model based approach)  1996: Amendment of Basel I for Market risks  1996 – 2005: Discussion about Basel II

Critique of the Model Based Approach 1  Model Based „Economizing on equity capital“ has been a reason why solvency became an issue so quickly  10 % “Core Capital” or 1 – 3 % of the balance sheet – which number is more meaningful?  … in the crisis, we have seen the realization of risks that had not been accounted for in the models!

Critique of the Model Based Approach 2  … Correlations of MBS due to a common dependence on the same underlying factors (Interest Rates, Real Estate Prices)  … Correlations between counterparty credit risks and underlying risks in hedge contracts  … system risk exposure due to excessive maturity transformation and leveraging at investment banks, conduits, etc.

Critique of the Model Based Approach 3  These deficits are fundamental:  Time series are nonstationary, some of them much too short to provide a reliable basis for statistical analysis (contrast the papers of the Basel Committee on Backtesting!)  Credit risks are endogenous  … and change over time … unobservably  Correlations of underlying and counterparty credit risk can hardly be measured  Incentives for better models are missing

A Cynical Interjection  Risk-based capital regulation treats sovereign debt as riskless  Funding risks of loans in the bank book are overlooked  Correlations between credit risks in the bank book are overlooked

Conceptual Deficits Facilitate Capture  “… surely you agree that a system of capital regulation with risk calibration is better than one without“  Conceptual deficits induce helplessness in the face of such statements  If only I knew what capital regulation is supposed to be doing!!!

Conceptual Deficits of Bank Capital Regulation Four Deficits:  The objectives of capital regulation are not specified  … nor is there an account of how the regulation will serve those objectives  Neglect of the dynamics of regulation  Neglect of systemic interdependence

Conceptual Deficits of Bank Capital Regulation: Objectives What is the purpose of capital regulation?  Equity as a buffer against losses  Equity as an incentive mechanism to reduce gambling for resurrection  Equity requirements as a basis for supervisory intervention in advance of an insolvency  All three aims are usually mentioned, but conflicts and tradeoffs are not discussed

Conceptual Deficits of Bank Capital Regulation: Objectives  BCBS 180:  Regulatory Minimum: The amount of capital a bank needs to be regarded as viable by creditors and counterparties  Buffer: The amount needed to withstand shocks so that they do not go below the regulatory minimum.  No notion of externalities  No notion of endogeneity of creditor attitudes