Does new international regulation help crisis prevention? The European sovereign debt crisis

1. Does new international regulation help crisis prevention? The European sovereign debt crisis Warwick lecture February 2012 Prof Stephany Griffith-Jones, sgj2108@columbia.edu

2. Overall context Aims of the financial system • Managing risk and avoiding crisis • Allocating capital to the real economy efficiently • Financial system did neither leading to crises Do we need a completely different financial system? • Restricting or isolating speculation • private banks to lend to real economy • Role of public banks to fund real economy

3. Some key problems • One major problem: increased leverage and maturity mismatches which increase systemic risk • Crisis revealed too low core capital, leverage too high and • Both accounting and regulation was pro-cyclical, reinforcing procyclicality of finance • Lack of instruments like GDP linked bonds

4. Basel 3 • Size and quality of core capital improved (but is it enough?) • Simple leverage ratio 1:30 (too generous) • Counter-cyclical regulation • Liquidity coverage ratio positive

5. Lack of debt management tools • Growth or GDP linked bonds to smooth debt service payments to avoid debt crises and allow counter-cyclical fiscal policies • More ambitiously, international orderly workout arrangements needed • Would help in both developed (eg European) and developing country crises

7. Higher capital requirements – cost benefit analysis • Benefits: • Stronger Financial System => Lower probability of banking crises => Lower crisis-induced output losses • Reduction of amplitude of output fluctuations • Costs: • Higher lending rates => lower output level (but trend growth rate unaffected)

8. Impact of increasing capital • Increasing capital by 1%: • Increases lending spreads by 0.13% • Decreases output by 0.09% • Therefore, even if temporary crisis-generated output losses are assumed: Net benefits of increasing capital from 7% to 8% = = Benefits – Costs = 0.30% - 0.09% = 0.21% > 0 Source: BIS estimates

9. Countercyclical regulation • Need for countercyclical regulation to compensate for pro-cyclical finance • History; dynamic provisioning • Rules preferable to discretion • The gap between credit-to-GDP ratio from its long-term trend is the benchmark guide for Basle • International coordination

10. Implications for national implementation • Several elements of Basel 3 positive, such as countercyclical buffers and liquidity ratios; increasing quantity and quality of core capital if needed • Too slow and gradual introduction of reforms desirable to accelerate ?

11. Shadow Banking system definition • Buiter definition (2008) : • “The shadow banking sector consists of the many highly leveraged non-deposit-taking institutions that lend long and illiquid and borrow short in markets that are liquid during normal or orderly times but can become very illiquid when markets become disorderly. • They are functionally very similar to banks but : • -are barely supervised or regulated. • -hold very little capital, • -are not subject to any meaningful prudential requirements as regards liquidity, leverage or any other feature of their assets and liabilities.”

13. Challenges of regulating shadow banking - Regulate all financial activity in comprehensive and equivalent manner, for capital adequacy, leverage and liquidity (D’Arista and Griffith-Jones, 2010) - What quacks like a duck should be regulated like a duck! - Put all banking activity on banks balance sheet - Aim: reduce shadow banking scale

14. Dodd-Frank Act • More rigorous than initially expected, but weakened by lobbying, e.g. Volcker rule and derivatives, further diluted in implementation • Positive institutional developments: consumer protection agency (prevents abuse) and systemic risk regulator also in EU (prevents silo-thinking about systemic risk)

15. Policy suggestions for developing countries • Key: link financial sector to its main aim, financing the real economy • Counter-cyclical regulations and instruments • Increase of quantity and quality of core capital; increase liquidity requirements • Regulate all shadow banking system in equivalent way • Putting all transactions on the balance sheet • Forcing derivatives on exchanges • Borrow less internationally; issue GDP linked bonds