The narrow path to a new equilibrium: the view from Basel

1. The narrow path to a new equilibrium: the view from Basel Jaime Caruana, General Manager, Bank for International Settlements Graduate Center of the City University of New YorkNew York, 1 December 2011 1

2. 1. Main issues posed by the crisis • 2. Challenges for central banks • 3. The BIS and the Basel process • 4. The regulatory response to the crisis

3. Three key features of the ongoing financial crisis • Balance sheet crisis: excessive leverage • Intertwining of sovereign and bank risks • Role of excessively loose monetary conditions

4. Before 2007: rising leverage in advanced economies

5. Leverage did not rise in EMEs

6. Credit falls sharply after a financial bubble

7. Leverage remains high four years after 2007

8. Sectoral indebtedness in selected advanced economies

9. Sectoral indebtedness in the US

10. Three key features of the ongoing financial crisis • Balance sheet crisis: excessive leverage • Intertwining of sovereign and bank risks • Role of excessively loose monetary conditions

11. Intertwining of sovereign and banking risks (advanced economies)

12. The case of Ireland

13. The case of Greece

14. The US case

15. Implicit public support for banks

16. Linkages in the international banking system at end-2010 US dollar credit linkages Euro credit linkages Source: BIS locational banking statistics by residence. The size of each circle is proportional to the stock of cross-border claims and liabilities of reporting banks located in that geographical region. Some regions include non-reporting countries. The thickness of a line between regions A and B is proportional to the sum of claims of banks in A on all residents of B, liabilities of banks in A to non-banks in B, claims of banks in B on all residents of A, and liabilities of banks in B to non-banks in A.

17. Three key features of the ongoing financial crisis • Balance sheet crisis: excessive leverage • Intertwining of sovereign and bank risks • Role of excessively loose monetary conditions

18. Real US short-term rates

19. Real US long-term rates

20. In per cent Interest rates and trend growth 1 From 1998; simple average of Australia, France, the United Kingdom and the United States; otherwise only Australia and the United Kingdom. 2 Trend world real GDP growth as estimated by the IMF in WEO 2011 Apr. 3 G20 countries; weighted averages based on 2005 GDP and PPP exchange rates. 20

21. Global liquidity: more of the same?

22. Risks of keeping interest rates too low for too long • Interest rates stay low • Return expectations stay high • Continued expectations for official support Perpetuate vulnerabilities by: • Providing incentives to muddle through via • Forbearance • Delayed balance sheets repair • Over-reliance on short-term funding • Weakening solvency of pension funds / life insurers • Encouraging risk-taking behaviour

23. Euro area: no discrimination among sovereigns in the 2000s Ten-year government bond yields

24. 1. Main issues posed by the crisis • 2. Challenges for central banks • 3. The BIS and the Basel process • 4. The Basel regulatory response

25. Where do we stand? Economic challenges • Demand must be supported … but we must address the root problem of excessive leverage. • Large-scale interventions had to be undertaken to cure the financial system … but we must strengthen the fiscal positions of sovereigns. • Interest rates have been lowered to counter deflationary forces … but we must not let excessive monetary accommodation pose fundamental risks.

26. Three challenges for central banks • Economic challenges • Intellectual challenges • Institutional challenges

27. Financial system stability Resilience of institutions, markets and infrastructure Risk-taking of institutions Riskiness of instruments The macrofinancial stability framework Enforcement and monitoring Macroeconomic policies Prudential policies Monetary policy • More symmetrical response • Consider financial stability in setting monetary policy Macroprudential • Reduce common exposures and interconnectedness • Mitigate procyclicality Microprudential • Improve risk capture • Strengthen capital and liquidity buffers • Enhance transparency Proactive supervision • Pillar II Market discipline • Transparency • Accounting rules • Market integrity Fiscal policy • Sustainable fiscal positions Monitoring of systemic risks • Financial stability reports Other policy areas Consumer protection Financial infrastructure Bank resolution • Bankruptcy regimes • “Living wills” International cooperation • BCBS capital and liquidity standards • G20 • Other standard setters • BCBS capital surcharges • FSB work on procyclicality • FSB/IMF Early Warnings Exercise • FSB peer reviews • Cross-border resolution

28. FISCAL POLICY PRUDENTIAL POLICY Manage aggregate demand Taxes Automatic stabilisers Counter- cyclical (discretionary) approach Limit distress of individual banks(microprudential) Quality / quantity of capital Leverage ratio Liquidity standards Counterparty credit risk Limits to bank activities (eg prop trading) Strengthened risk management Limit system-wide distress(macroprudential) Countercyclical capital charge Dynamic provisioning Systemic capital charge Leverage ratio LTV caps Robust infrastructure (CCP) Build fiscal buffers in good times Reduce debt levels Taxes / levies on financial sector Provide financial sector support in times of stress Capital injections Deposit and debt guarantees Bank rescue packages Discretionary stimulus Interaction among tools requires adequate structural policies and more global cooperation between policymakers Building the global financial stability framework: policy tools MONETARY POLICY Maintain price stability Policy rate Standard repos Collateral policies Interest on reserves Policy corridors Lean against booms Policy rate Raise reserve requirements Mop up liquidity (central bank bills, exceptional repos) Provide support on downside Liquidity injection Quantitative andcredit easing Emergency liquidity assistance Exit strategies FX reserves as buffers

29. Two essential features for policymakers • Need to have a long-term view • Keeping your own house in order is not enough

30. 1. Main issues posed by the crisis • 2. Challenges for central banks • 3. The BIS and the Basel process • 4. The regulatory response to the crisis

31. Mission of the BIS • Serve central banks and financial authorities in their pursuit of monetary and financial stability. • Foster international cooperation in those areas. • Act as a bank for central banks.

32. BIS Structure

33. International financial and monetary cooperation in Basel • Bimonthly meetings of Governors • Global Economy Meeting (30 central banks in major advanced and emerging market economies that account for 82% of global GDP): provides guidance to central bank committees. • Group of Central Bank Governors and Heads of Supervision: oversees the work of the Basel Committee.

34. G20 Leaders The Basel process Financial Stability Board (FSB) Participates and supports National central banks, treasuries, regulators International organisations(IMF, World Banketc) Non Basel- based standard setters(IASB etc) BIS Basel- based standard setters Other central bank committees Basel Committee Others(IAIS…) Supports Oversee Arranges cooperation Central banks, financial supervisors, other national authorities

35. Four key features of the Basel process • Proximity: synergies and exchange of ideas among committees. • Flexibility and ability to leverage the expertise of the participating institutions. • Research capacity and market savvy: input of the BIS’s economic research and its banking experience. • Dissemination: the Financial Stability Institute raises awareness of the work of the standard-setting bodies.

36. International cooperation: the “Basel way” • Bretton Woods system: intergovernmental decision-making and (IMF) multilateral surveillance was essential • The international monetary system has become more market-driven: increased role for regulation and supervision • Policy interaction instead of coordination: eg the G7 / G20 process, Financial Stability Forum after the Asian crisis • Basel way of international cooperation and informal exchange of experiences

37. 1. Main issues posed by the crisis • 2. Challenges for central banks • 3. The BIS and the Basel process • 4. The regulatory response to the crisis • The new Basel III framework • Progressive setup • Focus on actual implementation • Additional financial regulatory reforms

38. The new Basel III framework • Banking regulation: a rapid policy response to the crisis. • Aim for better and more capital. • Tools to address systemic risk: • (i) time dimension: countercyclical capital buffer • (ii) cross-sectional dimension: additional loss absorbency requirement for G-SIBs • Need for better liquidity management – two key liquidity ratios: • liquidity coverage ratio • net stable funding ratio

40. Progressive implementation of the new standards • Impact assessment: • Macroeconomic Assessment Group: transition to higher capital levels will have a very small impact • Long-Term Economic Impact group: benefits largely outweigh the costs over the long run • Transition period designed to prevent higher capital ratios from derailing the recovery. • Persistence of vulnerabilities calls for building strength now and for going even faster where possible.

41. The Basel III calendar

42. Consistent implementation of the regulatory standards • Full, consistent and timely implementation of Basel III by national jurisdictions is essential: peer review process. • Both the Basel III capital requirements and their calendar are a minimum. • Need to be supported by strong and enhanced supervision of individual banks. • Macroprudential oversight bodies and frameworks will complement microprudential measures.

43. New capital ratios ● Common equity ● Tier 1 ● Total capital ● Capital conservation buffer Macroprudential overlay Raising the quality of capital ● Focus on common equity ● Stricter criteria for Tier 1 ● Harmonised deductions from capital Leverage ratio Mitigating procyclicality ● Countercyclical buffer Capital Capital ratio = Mitigating systemic risk(work in progress) ● Systemic capital surcharge for SIFIs ● Contingent capital ● Bail-in debt ● OTC derivatives Risk-weighted assets Enhancing risk coverage ● Securitisation products ● Trading book ● Counterparty credit risk Combining the micro and macro approach to bank supervision

44. Financial regulatory reforms: further FSB-led work • SIFIs • Global versus national • Banks and other institutions • Financial market infrastructures • Over-the-counter (OTC) derivatives • Central counterparties (CCPs) • Stronger resolution regimes • Ongoing / gone concerns • Bailing in / equal treatment • Cross-border issues • Shadow banking system • Regulation / monitoring • Institutions / functions

45. Financial regulatory reforms: further FSB-led work • SIFIs • Global versus national • Banks and other institutions • Financial market infrastructures • Over-the-counter (OTC) derivatives • Central counterparties (CCPs) • Stronger resolution regimes • Ongoing / gone concerns • Bailing in / equal treatment • Cross-border issues • Shadow banking system • Regulation / monitoring • Institutions / functions

46. Financial regulatory reforms: further FSB-led work • SIFIs • Global versus national • Banks and other institutions • Financial market infrastructures • Over-the-counter (OTC) derivatives • Central counterparties (CCPs) • Stronger resolution regimes • Ongoing / gone concerns • Bailing in / equal treatment • Cross-border issues • Shadow banking system • Regulation / monitoring • Institutions / functions

47. Financial regulatory reforms: further FSB-led work • SIFIs • Global versus national • Banks and other institutions • Financial market infrastructures • Over-the-counter (OTC) derivatives • Central counterparties (CCPs) • Stronger resolution regimes • Ongoing / gone concerns • Bailing in / equal treatment • Cross-border issues • Shadow banking system • Regulation / monitoring • Institutions / functions

48. Final financial stability warning • Basel III is only part of the new regulation • Need to complete the regulatory agenda • Action required in all policy areas – fiscal, monetary, macroprudential… • Private sector’s vital role in building a more resilient financial system. • Strengthening the financial system to lessen both the severity and the probability of future financial crises.

49. Further reading (see www.bis.org) • “Financial and real sector interactions: enter the sovereign ex machina”, speech by J Caruana, GM BIS, 15 November 2011. • “Sovereign risk in bank regulation and supervision: Where do we stand?”, speech by H Hannoun, DGM BIS, 26 October 2011. • “Regulatory reform: remaining challenges”, speech by J Caruana, GM BIS, 7 July 2011 • “The Basel III Capital Framework: a decisive breakthrough”, speech by H Hannoun, DGM BIS, 22 November 2010. • “Basel III: towards a safer financial system”, speech by J Caruana, GM BIS, 15 September 2010. • “Systemic risk: how to deal with it?”, paper by J Caruana, GM BIS, 12 February 2010. • “The international policy response to financial crises: making the macroprudential approach operational”, panel remarks by J Caruana, 21–22 August 2009. • “Three policy challenges for the world economy”, speech by J Caruana, GM BIS, 28 June 2010. • “Towards a global financial stability framework”, speech by H Hannoun, DGM BIS, 26–27 February 2010. • “Long-term sustainability versus short-term stimulus: is there a trade-off?”, speech by H Hannoun, DGM BIS, 7 February 2009. • “Policy lessons from the recent financial market turmoil”, speech by H Hannoun, DGM BIS, 8–9 May 2008. • BIS 80th Annual Report (AR) 2010, “Beyond the rescue: exiting intensive care and finishing the reforms” – policies looking ahead • BIS 79th AR 2009, “Rescue, recovery, reform” – overview of the crisis • BIS 78th AR 2008, “The unsustainable has run its course” – the crisis outbreak • BIS 77th AR 2007, “Piecing the puzzle together” – before the crisis