EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term

1. EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETSDr Helen Weeds2013-14, Spring Term Lecture 9: Financial regulation

2. LEARNING OUTCOMES • Summing up: what went wrong in 2007-09? • Financial regulation: why regulate? • Types of financial regulation • Micro-prudential regulation • Macro-prudential regulation • Principles of financial regulation • Reform of financial regulation • Global: Basel III • US • EU • UK

3. SUMMING UPWhat went wrong in 2007-09? • Events of 2007-09 revealed weaknesses that had built up in the financial system before that time, especially in the early 2000s • Market developments • Liquidity mismatch: reliance on short-term funding to finance long-term lending • money market funds, not just retail deposits • Securitisation of mortgage loans • large increase in securitisation, largely by private entities (not just GSEs) • resecuritisation: ‘CDO squared’ (CDO^2) • Credit expansion, leading to house price bubbles in many countries • Risk-taking, e.g. unhedged writing of CDS contracts (AIG) • Regulatory background • Deposit insurance and regulation of deposit-taking institutions • Role of credit rating agencies in regulation • Lack of regulation of OTC derivatives • Regulatory arbitrage

4. WHY REGULATE?Market failures in financial markets • Asymmetric information • Between providers and consumers • solvency of the financial institution (bank, insurance co, counterparty) • behaviour of provider, e.g. risk-taking by bank, portfolio manager • Deposit insurance creates moral hazard on part of insured entities • risk-taking by deposit-holding banks • depositors have little incentive to check out bank solvency • Social externalities • Failure of a financial institution causes losses to others (externalities) • ‘contagion’ spreads from one institution to another (in contrast with the impact of failure of a firm in other industries) • economic impact of financial failures; bail-out at public expense • Market power: monopoly / oligopoly • Consumer protection • Complexity of financial products; consumer behaviour • Importance and time-span of financial decisions (e.g. pension)

5. ‘Social contract’ for banking (Tucker 2011) • Role of deposit-taking banks in society • Banks provide liquidity to the economy • In doing so, banks face mismatch of maturities: risk of bank runs • To mitigate risk of bank runs, govt provides support to banks • Deposit insurance scheme • Lender of last resort • Implicit guarantees: likelihood of bail-out and recapitalisation • This support transfers some risk to the public • Increases returns to banks and bank shareholders • Increases tendency for risk-taking behaviour • In return: regulation and supervision of banks and their activities

6. Scope of financial regulation • Pre-crisis narrow view: regulation focused on deposit-taking banks • US Glass-Steagall Act • Separation of retail and investment banking, from 1933 to 1999 • Repealed by the Gramm-Leach-Bliley Act 1999 • Lack of regulation of OTC derivatives • 1998: chair of the US Commodity Futures Trading Commission (CFTC), BrooksleyBorn, called for CFTC to be given oversight of OTC derivatives (especially swaps) • This was opposed by Fed chairman Alan Greenspan, Treasury Secretaries Robert Rubin and Lawrence Summers, and SEC chairman Arthur Levitt • September 1998: failure of Long-Term Capital Management (LTCM), a hedge fund trading in OTC derivatives • 2000: US Congress passed legislation prohibiting regulationof OTC derivatives

7. Scope of the financial crisis • The 2007-09 financial crisis was much broader than deposit-taking banks • Support was provided to a range of financial institutions, and to markets as a whole • Government guarantee of money-market funds (Sept 2008) • Liquidity support extended to non-bank financial institutions • Federal Reserve brokered and financed bail-outs of non-deposit taking institutions • Investment bank (Bear Stearns) • Privatised GSEs • Insurer (AIG)

8. Regulation after the crisis • The 2007-09 financial crisis revealed many flaws in financial regulation • Narrow focus on ‘banks’; ‘shadow banks’ largely unregulated • Focus on individual institutions rather than the system as a whole • Regulation failed to keep up with innovation in the financial sector (e.g. swaps) • Trend towards deregulation: desire for ‘light-touch’ regulation to minimise costs to business • Competition between financial centres; regulatory arbitrage by financial institutions • Regulatory responses • Strengthen rules, improve performance of financial regulation • Broaden the scope of financial regulation • Greater focus on systemic risk

9. TYPES OF FINANCIAL REGULATION • Micro-prudential regulation • Seeks to enhance the safety and soundness of individual financial institutions • Risk is treated as exogenous, i.e. potential shocks triggering a financial crisis come from outside the financial system • Macro-prudential regulation (‘macro-pru’) • Focuses on the stability of the financial system as a whole • Considers systemic risk, i.e. risk factors that arise endogenously from within the financial system • To do this, macro-pru looks at • interconnectedness of individual financial institutions and markets • their common exposure to economic risk factors • the procyclicalbehaviour of the financial system

10. Macro- and micro-pru From: Claudio Borio (Head of the Monetary and Economic Department at the Bank for International Settlements), “Towards a macro-prudential framework for financial supervision and regulation?”, BIS Working Paper no. 128, February 2003

11. PRINCIPLES OF FINANCIAL REGULATION (Brunnermeier et al. 2009) Recommendations of a group of respected academic economists and former regulators, covering: • Capital requirements • Liquidity risk • Other considerations • Executive pay • Maximum Loan-to-Value (LTV) for residential mortgages • Credit rating agencies • OTC derivatives • Resolution procedures for SIFIs

12. Capital requirements The report recommends • Minimum capital requirements for banks/institutions benefiting from deposit insurance • Identification of systemically important financial institutions (SIFI) • individually systemic: causes risk spillovers to other institutions • so large, interconnected and important that no govt would let it fail • SIFIs should be subject to both • micro-prudential regulation: individual risk characteristics • macro-prudential regulation: contribution to systemic risk • Some supervision of and controls on non-SIFIs • if highly leveraged and holding assets at risk of low market liquidity • risk that ‘herd behaviour’ may result in systemic effects • Counter-cyclical macro-prudential regulation • ‘Leaning against’ bubbles by raising capital adequacy requirements

13. Liquidity risk Issue: ‘marking-to-market’ of asset values seen as heightening asset price booms & busts, and worsening liquidity problems The report recommends • ‘Mark-to-funding’ accounting rule • Assets which have long-term funding secured can be put in a ‘hold-to-funding account’ and do not have to be marked to market • e.g. 20-year asset funded with short-term borrowing ( 1 month): value using current market prices • 20-year asset funded with issuance of a 10-year bond: value using PV of likely average price over the next 10 years • Capital charge for liquidity risk • Raise capital adequacy ratio (CAR) to reflect liquidity risk (maturity mis-match between assets and liabilities)

14. Other recommendations • Executive pay: widely blamed for incentivising risk-taking • Improve shareholder monitoring; independent remuneration committee • Remuneration guidelines set by the regulator • improve incentives inherent in remuneration schemes, e.g. bonuses • penalise non-compliance by increasing capital adequacy ratios • Central Bank to have authority to set maximum Loan-to-Value (LTV) for residential mortgages, as a macro-prudential measure • Credit rating agencies • Remove CRAs from the regulatory system • tightening of conflict-of-interest and transparency regulations not enough • OTC derivatives • Favour centralised clearing houses for ‘systemic’ markets • While retaining flexibility of OTC contracts where economically justified • Each SIFI to produce a ‘living will’ to plan for its own bankruptcy

15. REFORM OF FINANCIAL REGULATION • Global • Basel III reforms • International organisations Measures adopted in individual countries • USA • Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 • EU financial regulation and reforms • UK financial regulation and reforms

16. GLOBAL REGULATION • Need for coordination of regulatory rules • Avoid a ‘race to the bottom’ • Or regulation that hinders competitors more than national companies • But reaching agreement is slow • Basel Committee on Banking Supervision (BCBS) • Basel III reforms • Financial Stability Board (FSB) • Coordinates the work of national financial regulators and international standard-setting bodies • Established in April 2009, as successor to the Financial Stability Forum • Chaired by Mark Carney, Governor of the Bank of England • Industry associations • E.g. International Swap and Derivatives Association (ISDA) • Self-regulation to promote higher standards of behaviour

17. Basel III reforms Rules being formulated and agreed, to be phased in by end-2018 • Capital requirements • ‘Capital’ narrowed to ‘core tier 1’: bank equity + retained earnings • Capital requirement raised from 4% (for tier 1) to 7% (core tier 1) • Possible additional counter-cyclical buffer (0-2.5%) Basel III core tier 1 capital as % of risk-weighted assets:

18. Basel III reforms (cont.) • Improve risk coverage of capital adequacy system • Take greater account of counterparty credit risks • Provide incentives to move OTC derivative to central clearing houses • Leverage ratio • Minimum leverage ratio, calculated by dividing Tier 1 capital by the bank's average total consolidated assets • Simple measure, aim to put a floor under banking leverage • Liquidity requirements • Liquidity coverage ratio (LCR) • requires banks to hold sufficient high-quality liquid assets (cash, Treasury bonds) to cover net cash outflows over a 30-day period • Net stable funding ratio (NSFR) • proportion of long-term assets funded by long-term, stable funding • Bank stress tests to include widening credit spreads in recessionary scenarios

19. Implementation of Basel III

20. REGULATORY REFORM IN THE US Dodd-Frank Act (2010) • Consumer protection • Consumer Financial Protection Bureau(CFPB) set up • Within the Federal Reserve system, but independent from it • Aim: to protect retail users of banking products from ‘abusive’ mis-selling of mortgages, credit cards and other loan products • e.g. CFPB might require straightforward financial products; clear statements • Systemic risk regulation • Financial Stability Oversight Council (FSOC) set up • Chaired by the Treasury secretary • To identify systemically significant companies (SIFIs) which then • face stricter capital, leverage and liquidity standards • are regulated by the Federal Reserve (not state agencies) • are obliged to draw up a ‘living will’ describing how they would be broken up in the event of failure • To monitor markets for bubbles

21. Dodd-Frank Act (cont.) • No reinstatement of Glass-Steagall separation between retail and investment banking • ‘Volcker rule’ limiting proprietary trading (‘prop trading’) • Named after Paul Volcker, former Federal Reserve chairman • Dodd-Frank Section 619 states: “a banking entity shall not • (A) engage in proprietary trading; or • (B) acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund” • But many exemptions (more than 7 pages) • Hedge funds • Registration and reporting requirements • Limits on bank ownership (above)

22. Dodd-Frank Act (cont.) • No powers to break up institutions deemed ‘too big to fail’ (SIFIs) • Resolution powers • Federal Deposit Insurance Corporation (FDIC) can seize and wind up a large financial institution if it is failing and poses a risk to the financial system • No bail-outs: payments to creditors initially paid by the government are to be recouped later from industrylevies (if not covered by the failing bank’s assets) • Aims • to avoid Lehman-style failure • to end implicit government guarantees to institutions deemed ‘too big to fail’

23. Dodd-Frank Act (cont.) • Securitisation • 5% ‘skin in the game’ for securitisers • aim: to improve incentives by retaining small ownership stake • Derivatives • Reform of OTC derivatives • standardised contracts required to go through central clearinghouses (as for futures) • aim: to mitigate counterparty risk • and to increase transparency, improving competition and pricing • Regulation of swaps dealers • subject to capital and margin requirements • record-keeping and reporting requirements • Exemptions for non-financial companies using derivatives to hedge • Banks required to spin off derivatives dealing operations • but permitted to retain trading in interest-rate and foreign-exchange swaps

24. Dodd-Frank Act (cont.) • Credit rating agencies • Tighten SEC regulation of CRAs • Reduce regulatory use of ratings • Intention to improve CRA incentives • Securities and Exchange Commission (SEC) and Government Accountability Office (GAO) are both asked to study alternative compensation systems • meanwhile issuer-pays model continues • Executive compensation • Idea that bank bonuses encouraged risk-taking behaviour • Relatively weak measures adopted • disclosure of CEO compensation schemes • independent compensation committees • ‘say on pay’ advisory shareholder votes for public listed companies

25. FINANCIAL REGULATION IN THE EU Aim of EU financial regulation • To establish a single market in financial services regardless of national boundaries • Financial Services Action Plan (FSAP), 1999-2004 • Establish a single market in wholesale financial services • Make retail markets more open and secure • Strengthen rules on prudential supervision • Markets in Financial Instruments Directive (MiFID), 2004 • Sets agreed minimum standards for financial services • not full harmonisation; no central regulator • Firms are authorised and regulated in their ‘home state’ • Mutual recognition: once authorised in one EU/EEA member state, firms can use MiFID ‘passport’ to operate in other member states

26. EU regulatory reform: MiFID II • Oct 2011: European Commission (EC) released proposals to amend MiFID, referred to as MiFID II • Proposals • Broaden scope of MiFID • more firms: commodity firms, data providers, third country firms • additional instruments: structured products, emissions allowances • Electronic trading • derivatives that are sufficiently liquid will be traded on Organised Trading Facilities (OTFs), to be introduced • requirements to be imposed on operators of OTFs • Transparency and transaction reporting • To be extended to additional instruments, e.g. bonds and derivatives • Product interventions • powers to ban products • position limits for products such as commodity derivatives • Investor protection • measures to ensure independence of investment advice

27. EU regulatory reform: EMIR • European Market Infrastructure Regulation (EMIR) • new requirements to improve transparency and reduce the risks associated with derivatives markets • imposes requirements on entities that enter into any form of derivative contract, including non-financial services firms • Regulation (EU) 648/2012; comes into force during 2013-14 • Entities that enter into any form of derivative contract must • report every derivative contract they enter into to a trade repository • OTC derivatives subject to a mandatory clearing obligation must be cleared via a central counterparty (CCP) • new risk management standards must be implemented for OTC derivatives not traded on CCPs • e.g. operational processes and margining

28. European Financial Supervisors • Three authorities created in 2011, responsible for different aspects of financial services • European Banking Authority (EBA) • EU-wide coordination of bank regulation and supervision • focus on stability of the financial system • European Insurance and Occupational Pensions Authority (EIOPA) • EU coordination of rules to protect insurance policy-holders and pension scheme members and beneficiaries • implementing new capital adequacy rules for insurance cos. • European Securities and Markets Authority (ESMA) • EU coordination on functioning of markets • harmonisation of rules on e.g. issuance and trading of securities, corporate governance, financial reporting, takeover bids, etc. • Also: European Systemic Risk Board (ESRB) • Role: to issue warnings about threats to the financial system

29. FINANCIAL REGULATION IN THE UK • Before and during 2007-09 crisis • ‘Tripartite’ approach to ensuring systemic safety of banking: Bank of England, Financial Services Authority (FSA) and Treasury • Criticised for lack of clarity in responsibility for systemic risks • FSA now split in two; prudential regulation concentrated in BoE • Financial Conduct Authority (FCA) • Regulates a wide range of financial services • Prudential Regulatory Authority (PRA) • Subsidiary of Bank of England • Responsible for micro-prudential bank supervision • Financial Policy Committee (FPC) of the Bank of England • Ensures financial stability of the system as a whole, including avoidance of credit and asset bubbles

30. Financial Conduct Authority

31. Responsibilities of the FCA • Protecting consumers and preserving market integrity • Investor protection, including of bank customers • Market supervision and regulation • Business conduct of banks and financial services • approval of consumer-related managers • supervision of investment managers • and other firms whose failure would be non-systemic (i.e. would not cause a contagion) • Civil and criminal enforcement of market abuse rules • UK Listing Authority • supervision of initial public offerings (IPOs) and subsequent monitoring of listed companies

32. Bank of England

33. Responsibilities of the PRA Micro-prudential supervision of financial institutions • Safety and soundness of individual banks, insurers, brokers • Grant permissions for their activities • Approve senior management • May take measures to reduce risk of failure • Adjust capital requirements • Limit leverage • Change risk-weighting of assets

34. Responsibilities of the FPC Macro-prudential regulation • Decisions that apply to the entire sector to ensure system-wide financial stability • Including the avoidance of credit and asset bubbles • Meets four times a year to set rules • Powers to make various adjustments, e.g. • Cyclical adjustments to capital requirements • Higher system-wide risk weights for certain assets • Require banks to increase loss provisioning when lending growing fast • Nationwide borrowing limits, e.g. maximum LTV • Responsible for identifying threats from the ‘shadow banking sector’ • Non-bank entities, e.g. hedge funds, private equity funds, money market funds, securitisation vehicles, commodity funds, clearing houses, inter-dealer brokers