How banking regulation is changing Facoltà di Economia, Sapienza Università di Roma, 7 November 2013 Riccardo De Bonis

1. How banking regulation is changingFacoltà di Economia, Sapienza Università di Roma,7 November 2013Riccardo De Bonis

2. Current issues in banking regulation The goal of this lecture is to summarise innovations of regulation that the new agreement Basel 3 will introduce We will also look at other issues that are at the centre of the discussion, such as the rules for the systematically important financial institutions and the shadow banking system Finally, we will summarise the proposals to reintroduce specialisation rules for banking business 2

3. Outline More capital and of better quality The leverage ratio Reducing pro-cyclicality Liquidity ratios Systematically important financial institutions Shadow banking system Are new specialisation rules needed for banks?

4. 1. More capital and of better quality: why? The crisis showed that capital was insufficient to cover losses and that the definition of “supervisory capital” was not harmonized across countries In some countries financial instruments classified as “capital” did not have the capacity to absorb losses. These instruments were more similar to bonds than to shares

5. 1. More capital and of better quality The predominant form of bank capital will be common shares and retained earnings, the so-called common equity tier 1 (CET1) The remainder of the Tier 1 capital base – i.e. additional Tier 1 - must be comprised of instruments that (i) are fully subordinated (the holders are residual claimants); (ii) have fully discretionary dividends; (iii) have neither a maturity date nor an incentive to redeem.

6. 1. More capital and of better quality: the new requirements The minimum capital requirement will be always equal to 8 per cent of risk weighed assets (RWA) but common equity must reach 4.5 per cent (against the current level of 2 per cent) Tier 1 capital must be at least 6.0 per cent of risk weighted assets (RWA) Tier 2 capital instruments will be harmonised

7. 1. More capital and of better quality: the conservation buffer In stress periods, banks must have another buffer – a common equity capital conservation buffer – equal to 2.5 per cent of RWA Those banks that will not be able to maintain the capital conservation buffer will have to limit dividend distribution and bonus to managers

8. 2. The leverage ratio: why? The risk-based capital requirement will be supplemented with a leverage ratio, having two goals: to constrain leverage in the banking sector in good times and therefore deleveraging in bad times to introduce safeguards against model risk and measurement error by supplementing the risk-based measure with a simple and transparent measure of risk

9. 2. The leverage ratio: the new limit According to the leverage ratio, Tier 1 should be at least 3 per cent of total un-weighted assets. The latter will include on and off balance sheet items, plus derivatives The leverage ratio should enter in force in 2018 and will impact mostly on investment banks, whose leverage is traditionally higher than commercial banks

10. 3. Reducing pro-cyclicality and promoting countercyclical buffers: why? The crisis confirmed that credit tends to grow too much during expansions and to be cut too much during recessions, when credit losses affect the availability of capital and banks’ risk aversion

11. 3. Promoting countercyclical buffers: the new requirement Banks might be requested to respect a countercyclical capital buffer equal to 2.5 per cent of risk weighed assets Banks should accumulate reserves when credit growth is greater than GDP growth

12. 4. Liquidity ratios Liquidity risk was at the core of the crisis Banks were very reliant on wholesale funding When interbank markets suddenly froze, the initial illiquidity of some intermediaries became insolvency Central banks had to intervene to stabilise markets For the first time two harmonized measures – two liquidity ratios – are under discussion

13. 4. Liquidity coverage ratio (i) liquidity coverage ratio (LCR): banks should hold high quality liquid assets to be able to face funding problems in stress conditions over a thirty day horizon The LCR will be introduced gradually in 2015

14. 4. Net stable funding ratio (ii) net stable funding ratio (NSFR): it requires a minimum amount of stable sources of funding at a bank relative to the liquidity profiles of the assets, as well as the potential for contingent liquidity needs arising from off-balance sheet commitments, over a one year horizon The goal of NFSR is to limit over-reliance on short-term wholesale funding during times of exuberant market liquidity and encourage assessment of liquidity risk across all on- and off-balance sheet items Works on the NSFR are still ongoing: its introduction has been scheduled for 2018

15. 5. Systematically important financial institutions (SIFIs) SIFIs are large bank and financial groups that were often at the core of the financial crisis They were “too big to fail” The current goal of regulators is to strengthen the capacity of SIFIs to bear losses and to allow an eventual their liquidation A group of global SIFIs has been selected

16. 5. Systematically important financial institutions The global SIFIs will have to maintain a higher capital requirement than other banks The additional capital requirement might vary between 1.0 and 2.5 per cent of RWA, according to the “systemic relevance” of each intermediary The prudential controls on SIFIs will be stronger than those applied to other banks The new rules on SIFIs will be introduced in 2019 Each country should introduce rules to allow a regular liquidation of a SIFI

17. 6. Shadow banking system Each country should ensure that rules also apply to the shadow banking system (SBS) Examples of SBS include structured investment vehicles, money market funds and securitization vehicles The issue is complex because the same intermediary – e.g. a money market fund - may belong or not to the shadow banking system in different countries The SBS has a key role in the US while it has a smaller size or is even absent in other countries

18. 7. Are new specialisation rules needed in banking? As a consequence of the 2007-2009 crisis in the US and in Europe specialization rules have been proposed to regulate banking business 18

19. Universal bank vs specialised bank: a definition • “Universal bank” is a bank that offers both banking and investment services, such as proprietary trading and market making • Universal bank is the banking model of European directives. Germany offers the best example of universal banks • “Specialised bank” may refer to the distinction between commercial banks and investment banks 19

20. A brief history of bank specialisation in the US In 1934 the Glass Steagall Act prohibited to operate both traditional banking activities and proprietary trading in the securities market, to prevent abuse and conflicts of interest In 2000 the limits to the activities of trading and brokers by commercial banks have been deleted, allowing the creation of universal banking: the US returned to the years preceding the Glass-Steagall Act, when universal banking was allowed After the financial crisis, in 2010 the Dodd Frank Wall Street Reform and Consumer protection Act introduced the Volcker Rule The Volcker rule prohibits depository banks from proprietary trading for the entire banking group 20

21. Specialisation limits in the US • In the US banks cannot invest in hedge funds • The Volcker rule has some exemptions: proprietary trading in Treasury bonds, bonds issued by government-bank agencies and municipal bonds is allowed • Which are the main negative consequences of universal banking? • There is not an agreed answer to the question 21

22. Some questions on universal banks • Do universal banks crowd-out the stock market? • Do universal banks create an unhealthy concentration of power? • Can universal banks give impartial investment advice? Is there a conflict of interest between commercial and investment banking? • Do universal banks increase the risk of financial instability?

23. Universal vs SpecializedBanks in Europe • The crisis suggested to introduce reforms of banking structures also in Europe, similar to the Volcker rule in the US • There are the proposals of the Liikanen Report to the European Commission (but also the Vickers Report in the UK and draft legislation in France and Germany)

24. Some reasons to separate banking structures • Some economies of scale and scope may exist, but only up to a given level, as diseconomies become increasingly important beyond a given size and scope • Excessive complexity may result as banks expand their activity range • When risks are difficult to measure with precision, asset and activity restrictions provide a more robust measure to limit risk-taking than capital requirements

25. Should we break up universal banks? • Many commentators said that breaking up universal banks is a bad idea • The stability argument is dubious: because they are diversified, universal banks might spread their risks • Universal banks during the crisis saw a sudden slump in investment banking offset by their retail-banking income, and vice versa (but the issue is very debated) • Lehman Brothers and Bear Stearns had no such hedge and imploded: they were specialized (investment) banks • Even if regulators and shareholders might agree on a separation between the two kinds of banking, it is hard “to unscramble the eggs that have gone into making them”

26. The Liikanen Report proposals The Report proposes for banking groups a mandatory separation of certain trading related activities according to the following three principles (i) If the share of proprietary trading, market making and certain other securities-related businesses in the balance sheet exceeds a given threshold, banking groups must organize these businesses to a separate legal entity (“trading entity”). These separate businesses include proprietary trading and market making

27. The Liikanen Report proposals (ii) The “trading entity” must be separately capitalized and must not be funded by insured deposits (iii) The deposit-taking part of the banking group – the deposit bank – is not allowed to support the trading entity by making transfers or commitments. Only the deposit bank is allowed to provide retail payment services. The deposit bank may offer securities underwriting

28. The Liikanen Report proposals • The Liikanen report recognized the value of universal bank • The deposit bank and the trading entity are allowed to co-exist within a holding company structure • A complete separation similar to the former Glass-Steagall Act in the US is not required

29. References Basel Committee of Banking Supervision (2010), “Basel III. A global regulatory framework for more resilient banks and banking systems” Financial Stability Board (2011), “Policy Measures to Address Systematically Important Financial Institutions”, November Financial Stability Board (2013), “Strengthening Oversight and Regulation of Shadow Banking”. An Overview of Policy Recommendations” August Gambacorta L. and A. van Rixtel (2013), “Structural bank regulation initiatives: approaches and implications”, BIS Working Papers, n. 412 Liikanen E. (2012), “Is a reform of banking structures necessary?”, speech held at a meeting with Finance Watch, 20 November Tirole J. (2011), “Illiquidity and All Its Friends”, Journal of Economic Literature, 49:2, 287-325