Moral Hazard

1. Moral Hazard Sergio Lugaresi, Public Affairs Milan, 8 November, 2012

2. AGENDA • The issue • From “too big to fail” to systemic relevance • SIBs additional capital requirements • The main issue: still unsolved 2

3. Moral hazard: the issue • Government interventions have been of three kinds: guarantees, recapitalisation, and impaired assets relief. • In many countries government guarantees have been extended to banks’ liabilities: this has been the most cost-effective way for restoring confidence of investors as it is a contingent liability which does not imply any immediate government outlay and whose “take-up rate” has been relatively low. • Recapitalization schemes have been provided in some countries either for the bank sector as a whole or as an ad hoc measure for individual troubles institution. • In a few countries (including UK and Ireland) government have either provided an insurance against assets devaluation or directly bought some bank troubled assets. • Financial markets perceived all these government measures as an implicit bail-out guarantee to the financial sector, linking the financial risk to the sovereign risk. 3

4. Moral hazard: public aids to the financial sector in percentage of GDP (June 2007–June 2009) 4

5. From “too-big-to-fail” …… • In Pittsburgh (November 2009) the G20 Leaders asked to “create more powerful tools to hold large global firms to account for the risks they take.” They also stated that “Standards for large global financial firms should be commensurate with the cost of their failure”. 5

6. “Too big” to manage in time of crisis • This is particularly true for cross-border financial institutions operating in different jurisdictions. • International coordination of authorities would ease the solution of the issue; • a facilitator would be a firm contingency plan for orderly wind-up (Recovery and Resolution Plan). 6

7. Recovery and Resolution Plans (“living wills”) • The first step taken by the authorities has been to request SIFIs to set out a recovery plan, (i.e. the set of measures that the bank could take to recover from a crisis scenario while still a going concern) and • ..provide information for authorities to draw up a resolution plan, (i.e. the set of measures they could take to wind up or resolve the failed bank while minimising systemic contagion). • If a firm cannot demonstrate its structures enable orderly, cross-border resolution in its recovery and resolution plan (RRP) (or “living will”), it could be required to change its business organisation. • Following the FSB recommendations in 2010, national European authorities (including UK and Spain) requested their major banks develop RRPs. The Bank of Italy also requested that the Italian major banks develop possible Recovery and Resolution Plans. • The results of these exercises are still unknown. However, the picture, particularly in the resolution phase, is still likely to be confusing, which only highlights the need for legislative changes and international coordination. 7

8. “Too big” with respect to what? 8

9. Interconnectedness • Even if the bank size could be managed, financial institutions may be too interconnected to fail (i.e. exposedto each other in such a way that the failure of one of them may trigger the failure of all the others). • Financial institutions, no matter what size, may be so exposed to each other that the default of one, results in the failure of all. • Securitisation and off-balance-sheet vehicles have allowed individual lenders to divide and repackage their initial risks for sale and distribution to other investors, often generating maturity mismatches. • Financial activities in unorganized and unregulated market were traded on a bilateral basis: this means that the counterparty risk is widespread and it is impossible to net operations with third parties. • The sophistication and opacity of financial instruments traded in unorganized and unregulated markets prevented supervisory authorities from tracing the risks and mapping the interconnections. 9

10. ….. to “systemic relevance” • In Toronto (2010) the G20 Leaders identified the third pillar of financial reform in “resolution and addressing systemic institutions. We are committed to design and implement a system where we have the powers and tools to restructure or resolve all types of financial institutions in crisis, without taxpayers ultimately bearing the burden, and adopted principles that will guide implementation.” • In Seoul (November 2010) they asked for “measures to better regulate and effectively resolve systemically important financial institutions, complemented by more effective oversight and supervision”. 10

11. Systemic risk • Endogenous: Idiosyncratic crises may propagate through contagion and be amplified by interconnection and so generate a systemic crisis • capital requirements, • Micro-prudential supervision • crisis management • Exogenous: systemic risks generated by macro-imbalances and interconnectedness • Macro-prudential supervision (European Systemic Risk Board and US Financial Service Oversight Council) and • countercyclical buffers (Basel 3) • Is this enough? 11

12. Systemic risk • ‘The optimal policy response is not to increase capital requirements, as the current fashion has it, but to remove the aggregate risk from systemically important leveraged financial institutions’ balance sheets. […] This should be done by public private partnerships whereby the government explicitly assumes most of the macro risk, while the private sector provides the capital necessary to deal with microeconomic risk and small aggregate shocks’. This would avoid‘crippling the financial industry with the burden of brute-force capital requirements.’(Caballero 2010). 12

13. Systemic relevance The authorities response: Basel 3 is not enough • Negative externalities (systemic risks) to be internalised • Dimensions of systemic relevance: • Size. SR = PD * SLGD. Does PD increase with size? Does SLGD increase disproportionately with size? NO evidence. • Interconnectedness • Complexity 13

14. G-SIBs additional capital requirements • SIFIs = G-SIBs + other G-SIFIs + D-SIFIs • For G-SIBs additional capital requirements (from 1 to 3.5% of RWA) based on: • Size (measured by total assets), • interconnectedness (i.e.: volume of interbank lending / borrowing; correlation in equity prices, in the return on equity, in CDS prices, etc.) • complexity • Global activity (measured by cross-border claims) • Substitutability, i.e. product specialization and market share (measured by assets under custody, the values of payment system settlements, bond/loan/equity underwritings, etc). 14

15. The main issue: crisis management and resolution All the discussion went around the real issue: • how to manage and with which institutions the crisis and the resolution of cross border banks? • This need international coordination, legal expertise, trust among authorities.

16. References • Caballero, Ricardo, Crisis and Reform: Managing Systemic Risk, MIT and NBER, February 13, 2010 16

17. Next • Th. 11 Oct. h 10.30-12.15, aula 3 1. Introduction. Cross-border banking and regulation • Wed. 17 Oct. dalle 14.30 alle 16.15, aula seminari 2. Prudential Regulation: Lessons from the Crisis • Fri. 26 Oct. h 10.30-12.15 aula 3 3. From Basel 2 to Basel 3 • Thu. 8 Nov. h 10.30-12.15 aula 3 4. Moral hazard • Thu. 15 Nov. h 10.30-12.15 aula 3 5. Crisis Management and Resolution • Thu. 22 Nov. h 10.30-12.15 aula 3 6. Shadow Banking • Thu. 29 Nov. h 10.30-12.15 aula 3 7. Rules and supervision • Thu. 6 Dec. h 10.30-12.15 aula 3 8. Overall assessment of the regulatory reform • Thu.13 Dec. h 14.30-16.30 aula 20 9. The Euro debt crisis and the Banking Union • Mon.17 Dec. 10.30-12.15 aula seminari 10. Wrap-up and conclusion 17