Re-Regulating the Financial System

1. Re-Regulating the Financial System Mario Tonveronachi and Elisabetta Montanaro University of Siena, Italy IDEAs Conference on “Re-regulating global finance in the light of the global crisis” Tsinghua University, Beijing, China, 9-12 April 2009

2. Why did “It” happen again? • Roots: • International financial architecture • Laissez-faire approach to financial regulation

3. International Architecture • After the end of Bretton Woods • Dominance of private international finance • Persistent external imbalances are funded with mobile and volatile capitals • Speculative and ponzi positions  global fragility

4. Fundamentals of Current Regulation • Laissez-faire approach to risk-taking • This has been the mayor financial innovation of the last twenty years • Maniacal focus on capitalisation • Disregard of the traditional tenets of banking, i.e. liquidity and provisioning • Ability to fine-measure risks (firms) and fine-assess them (supervisors) • Expected and unexpected risks. Fat tails. • A market-friendly approach by supervisors • Recent proposals converge on giving even more discretionary powers to supervisors and to new Global Boards, without changing the rules of the game

5. Effects on the financial structure • Liberalisation and de-regulation produced: • Higher financial returns • Enormous increase of financial deepening

6. Financial deepening Financial deepening and financial multiplier Development of key financial aggregates, 1970-2007. Deflated by GDP, 1970=100 Averages for Canada, Japan,Uk, US, Germany, Italy and the Netherlands Sources: 1970-2000, G. Schinasi; 2001-07, R. Traficante

7. Financial pyramid • Expansion of financial assets characterised by: • An increasing pyramid of volatile liquidity • An increasing pyramid of debt

8. Pyramid of Volatile Liquidity Derivatives • Inverted pyramid ordered in terms of liquidity of decreasing quality • The growth of assets was concentrated on the areas of liquidity of lower quality • In Minskyan terms, highly speculative and ponzi positions dominates the areas of worse liquidity • Since flight to quality means flight to better liquidity, an increase of fragility follows • Pollution of secondary liquidity produced by the increased contiguity between banks and markets Private securities Secondary liquidity Public debt Primary liquidity

9. Financial Pyramid and Debt • Growth potential coming from finance exceeds potential growth coming from real determinants • Can finance push real growth to its own level? • Permanently no, since it cannot dictate the pace for the determinants of real growth • Yes, for a while, relaxing the liquidity constraints of non-financial units • The rate of growth of aggregate demand accelerates as a consequence of the growth of indebtedness by non-financial units

10. Financial Pyramid and Debt • However: • The increasing weight of the debt service steals resources from the dynamics of aggregate demand • In Minskyan terms, debtors’ margins of safety continuously decrease • When the degree of indebtedness reaches a point where cash flows are not enough to service the debt, interests are capitalised and the debt takes an autonomous upward dynamics. Debtors increasingly shift into ponzi positions • In these conditions the economy structurally requires very low interest rates • When interest rates required for financial stability become significantly lower than the rates required for monetary stability, deleveraging and debt deflation sooner or later necessarily follows

11. Increasing Fragility Let’s look at the U.S. experience Components of U.S. Debt/GDP

12. Increasing Fragility The US experience suggests an increasing mutual interaction between fragility and monetary policy Starting from the mid-80s, the trend of Fed Funds rate has nothing to do with the trend of inflation • LEGENDA • - Fed Funds = average quarterly nominal effective rate • - Inflation = CPI quarterly % change on year earlier

13. Increasing Fragility The trends of Fed’s rate and of % change of GDP are highly related. Fed’s policy is also responsive to GDP movements • LEGENDA • - Fed Funds = average quarterly nominal effective rate • - GDP, % change = quarterly % change on year earlier

14. Increasing Fragility In the last part of the period assets’ prices enter de facto into Fed’s responses • LEGENDA • - Fed Funds = average quarterly nominal effective rate • - S&P's 500 = averge quarterly index at constant prices, CPI January 1959=100

15. Increasing Fragility • Every time the Fed tried to push interest rates towards ‘normal’ levels it was obliged to go back, and increasingly so, each time validating more fragile positions • Stages: Financial liberalisation and de-regulation increase financial fragility. Monetary policy validates fragile instruments and positions. Financial fragility accumulates further, thus increasing the constraint on monetary policy and its inefficacy. An so on. • As Jan Kregel aptly commented on the above analysis: “The rescue via low interest rates validates the fragile financial instruments that are developed in each phase, and they become built into the system as the frame for even more fragile instruments and structures” • A long-term Minsky Process was let inflating, which finally exploded in 2008

16. A Radical Change of Perspective • International financial architecture and regulation • Basel’s systemic preconditions. Their inefficacy opens two routes: • Maintain a laissez-faire approach to risk-taking and incorporate macroeconomic anti-cyclical measures into the existing micro-stability scheme (the solution favoured by most current proposals) • Adopt a structural approach to regulation in order to transform the same financial structure into the systemic precondition for stability (our proposal) • We should: • Completely abandon the Basel construction • Over-regulate for at least the next 10-15 years • Simplify regulation, lower its costs and reduce supervisors’ discretionary powers • Increase the autonomy and responsibility of local jurisdictions over a common international regulatory base

17. A New Approach • General lines: • Oppose a rentier-approach to wealth accumulation. This is possible with a financial structure that does not allow for highly risky financial instruments and institutions • Regulation must not evaluate fat tails, but must slim them down • Shift from a risk-measurement to a risk-control approach to regulation • We propose to: • Introduce structural measures for avoiding hard-to-value risks, limiting paper-value financial deepening and the size of intermediaries • Regain focus on margins of safety, particularly on liquidity and provisioning • Re-direct incentives towards a sustainable financing of the real economy

18. Main Features of Our ProposalStructural Measures • Regulators agree on “a positive list of financial instruments and institutions. Anything that is not explicitly allowed is forbidden” (Buiter, 2009). Among “institutions” we include organised markets • Hard-to-value and hard–to-manageinstruments and intermediaries are not permitted • Common rules extend to all leveraged financial firms • Regulated institutions are not permitted to have direct or indirect relations with countries not adopting a basic regulation homogeneous with their own • Foreign banks are allowed to operate only as subsidiaries

19. Main Features of Our ProposalStructural Measures end • Leveraged institutions are not allowed to enter into securities and derivative contracts not traded in organised secondary markets • Supervisors are obliged to set up clear and binding crisis resolution procedures for all leveraged institutions • False information to the supervisory authorities and attempts to skim off value from the institution are considered as corporate fraud and are subject to criminal prosecution. They thus include all significant misstatements not only of allowances for credit and portfolio losses, but also of provisions • Separation of leveraged financial firms from Collective Investment Schemes (CIS), insurance companies, pension funds and commerce

20. Main Features of Our ProposalPrudential Measures • All prudential requirements must be observed both on a stand alone and consolidated basis • Foreign subsidiaries have to met regulatory requirements on a local basis • Fair value accounting is applied neither to the banking nor to the trading book • The banking book is evaluated at amortised cost • The trading book is marked to market • A specific Reserve the trading book is set up to smooth the effects of potential gains or losses on the income account

21. Main Features of Our ProposalPrudential Measures Capitalisation • Maximum limits to un-weighted leverage ratios are imposed, distinguishing between banking and trading books • The maximum leverage for the trading book is lower than the one allowed for the banking book. The trading book is defined in terms of its gross value, at market prices • Maximum leverage requirements are established in relation to categories of intermediaries defined in terms of size intervals. Larger the size, significantly lower is the maximum permitted leverage ratio. The size refers to consolidated balance-sheets, distinguishing between the banking and the trading books

22. Main Features of Our ProposalPrudential Measures Liquidity • Coefficients to limit maturity mismatches are introduced • Different liquidity requirements for the banking and the trading book • For the banking book the liquidity requirement is an increasing function both of the value of the book and of the customer funding gap • For the trading book the liquidity requirement is an increasing function of portfolio’s market value • Liquidity requirements must be met with cash and/or risk-free assets

23. Main Features of Our ProposalPrudential Measures • Dynamic provisions are introduced as a direct function of interest income. Fiscal treatment of provisions must follow supervisory rules, and not vice versa • Lower regulatory requirements coming from risk transfer are admitted only when risks are integrally shifted to unconnected subjects and no new obligations are linked to them