Part 2: Policy responses Rationale for financial regulation Financial regulation Topical issues

1. Part 2: Policy responses • Rationale for financial regulation • Financial regulation • Topical issues

2. 2.1. Rationale for financial regulation and macro-prudential policies Lessons from the recent crisis

3. 2.1. Rationale for financial regulation and macro-prudential policies Lessons from the recent crisis • Moral hazard: gives rise to borrowing constraints where the borrowing limits may depend on asset prices (Kiyotaki and Moore, 1998) • “Pecuniary” (e.g. fire sale) externalities arise when (i) banks face borrowing constraints, (ii) the borrowing limit depends on asset prices, (iii) assets are held by “experts” (e.g. industry peers) • Banks are hit by an adverse shock that eats up their capital. To maintain their capital ratio constant (moral hazard) they sell assets to pay back some debt. These assets are held by peers, so price goes down. Additional capital losses call for another round of sales. Banks could otherwise raise equity. But they don’t because they do not internalize the fire sale • Because of fire sale externalities, the asset supply curve may be downward sloping, give rise to multiple equilibria, and coordination failures (e.g. Diamond and Dybvig, 1983)

4. 2.1. Rationale for financial regulation and macro-prudential policies Lessons from the recent crisis • Address the market failures that make the banking sector as a whole (i) at the origin of adverse shocks, (ii) more exposed to shocks, (iii) less resilient to shocks • (i) calls for risk prevention policies • (ii) calls for risk absorption policies • Micro-prudential policies, which aim at protecting individual financial institutions, is not only ill-equipped but may even at times destabilize the financial system as a whole • Need for a dynamic, general equilibrium, coordinated, macro-prudential approach

5. 2.2. Financial Regulation Institutional architecture Group of 20 Ministers and CB Governors (G20) High-level discussion of policy issues pertaining to the promotion of international financial stability • Basel Committee on Banking Supervision • Provides a forum for regular cooperation on banking supervisory matters. Formulates supervisory standards and recommendations on best practice in banking supervision in the expectation that member authorities and other nations' authorities will take steps to implement them through their own national systems. The purpose of BCBS is to encourage convergence toward common approaches and standards. • Basel III: • Capital: “ A global regulatory framework for more resilient banks and banking systems” • Liquidity: “The Liquidity Coverage Ratio and liquidity risk monitoring tools” • European Union • The CRD IV package transposes – via a Regulation and a Directive – the new global standards on bank capital (e.g. Basel III-Capital) into the EU legal framework (July 2013) • European banking Authority and Banking Union: • Single Supervisory Mechanism (SSM) • Single Resolution Mechanism (SRM) • European Deposit Guarantee (DGS)

6. 2.2. Financial Regulation Institutional architecture

7. 2.2. Financial Regulation Institutional architecture

8. 2.2. Financial Regulation Institutional architecture

9. 2.2. Financial Regulation Institutional architecture

10. 2.2. Financial Regulation Roadmap • Basel Accord (1988): micro-prudential regulation, with the objective is to safeguard individual financial institutions from idiosyncratic shocks. Banks must hold regulatory capital • Basel II (2008, in EA): Enhanced Basel Accord, with three pillars: • Pillar 1: Risk-sensitive minimum capital requirement, takes into account credit risk and operational risk, banks have their own risk evaluation models • Pillar 2: Supervisory review, evaluate banks’ internal procedures • Pillar 3: disclosure and market discipline • Basel III (2013-, in EA): Enhanced Basel II, with higher quality capital requirements, capital buffer, liquidity requirements, macro-prudential approach (counter-cyclicality), with the objective to take into account the interaction between financial institutions. General equilibrium approach

11. 2.2. Financial Regulation Roadmap

12. 2.2. Financial Regulation Basel Accord (1988) • Improve the soundness of the international banking sector • “Level playing field”, international coordination: banks must hold • Banks are required to have “Tier 1” capital above 4% of assets and “Tier 2” capital above 8% of assets • Assets are weighted based on their types

13. 2.2. Financial Regulation Basel II (2008) • Risk weights are based on credit risks, not on asset types • Standardized approach (risks evaluated by Rating Agencies) or Advances Internal Ratings Based (IRB) approach (risks evaluated internally)

14. 2.2. Financial Regulation Basel III (2013-) • Raise the quality of the capital required, supplement capital ratio with a simple leverage ratio • Reduce pro-cyclicality capital regulation (macro-prudential aspect of Basel III): • Forward looking provisioning • Capital conservation buffer • Counter-cyclical buffer • Enhance risk coverage (capital, market liquidity risk, funding liquidity risk)

15. 2.2. Financial Regulation Basel III (2013-) – Capital quality • Tier 1 = Common shares and retained earnings • No hybrid instruments (e.g. bonds convertible into equity) in Tier 1 • Change the weights: raise capital requirement for the trading book and complex securitization exposures. More weights on OTC derivatives (exposures) not cleared through CCP (against counterparty credit risk) • Additional capital charge for potential mark-to-market losses associated with a deterioration in the creditworthiness of a counterparty

16. 2.2. Financial Regulation Basel III (2013-) – Capital quality

17. 2.2. Financial Regulation Basel III (2013-) – Capital conservation buffer • Banks have to build up capital buffers, i.e. hold capital above and beyond the 8% regulatory capital, outside periods of stress • When buffers have been drawn down, one way banks should look to rebuild them is through reducing discretionary distributions of earnings. This could include reducing dividend payments, staff bonus payments. • A capital buffer of 2.5%, comprised of Core Tier 1 capital, is established above the Tier 1 regulatory minimum (i.e. above 4.5%). Dividend distribution constraints will be imposed on a bank that falls within this range. But strong incentives more than constraint (otherwise would be in effect a minimum requirement)

18. 2.2. Financial Regulation Basel III (2013-) – Capital conservation buffer

19. 2.2. Financial Regulation Basel III (2013-) – Counter-cyclical buffer • Banks have to build up more capital in good times, less in bad times (when they need it) • The CCB aims to ensure that capital requirements take account of the macro-economic environment • Based on credit growth and other indicator that may signal a build-up of systemic risk, banks may be required to hold an 2.5% countercyclical buffer, comprised of common equity capital Tier 1 • Banks are force to retain earnings if they do not meet the CCB requirement

20. 2.2. Financial Regulation Basel III (2013-) – Counter-cyclical buffer

21. 2.2. Financial Regulation Basel III (2013-) – Counter-cyclical buffer • Banks have to build up more capital in good times, less in bad times • The CCB aims to ensure that capital requirements take account of the macro-economic environment • Based on credit growth and other indicator that may signal a build-up of systemic risk, banks may be required to hold an 2.5% countercyclical buffer, comprised of core Tier 1 capital • Banks are force to retain earnings if they do not meet the CCB requirement

22. 2.2. Financial Regulation Basel III (2013-) – Counter-cyclical buffer

23. 2.2. Financial Regulation Basel III (2013-) – Liquidity Coverage Ratio (LCR) • Banks are required to hold liquid assets, have an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted easily and immediately into cash to meet their liquidity needs for a 30 day liquidity stress scenario

24. 2.2. Financial Regulation Basel III (2013-) – Liquidity Coverage Ratio (LCR) • Prevent runs and increase resilience of banks to adverse funding liquidity shocks • Prevent fire sales and increase resilience to adverse market liquidity shocks • Liquid assets are not claims issued by industry peers • Flight to quality (“safe heaven” assets), like banknotes, central bank reserves, sovereigns • The liquid buffer may be used in period of stress (i.e. the LCR may fall below 100%), another macro-prudential aspect of Basel III • Net cash outflows based on banks’ stress tests

25. 2.2. Financial Regulation Basel III (2013-) – Liquidity Coverage Ratio (LCR)

26. 2.2. Financial Regulation Basel III (2013-) – Net Stable Funding Ratio (NSFR) • Banks are required to have a minimum amount of stable sources of funding relative to the liquidity profile of their assets over a one year horizon • The longer the maturity of the assets, the more stable funding need to be, so as to avoid too big a “maturity mismatch”

27. 2.2. Financial Regulation Basel III (2013-) – Net Stable Funding Ratio (NSFR) • Stable funding: Tier 1 and Tier 2 capital, term deposits • Unstable funding: unsecured wholesale funding • Liquid assets (as defined for the LCR) do not require as much stable funding as non-marketable assets

28. 2.2. Financial Regulation Basel III (2013-) – Net Stable Funding Ratio (NSFR)

29. 2.2. Financial Regulation Basel III (2013-) – Other features • Capital surcharges for SIFIs to increase the loss absorbing capacity of global banks • Capital incentives for banks to use central counterparties for OTC derivatives • Higher capital requirements for trading and derivative activities, as well as for complex and off-balance sheet exposures • Higher capital requirements for inter-sectoralexposures • …

30. 2.2. Financial Regulation Basel III (2013-) – Remember the leverage cycle Liabilities Assets Equity Retail deposits from non-financial sector Wholesale funding Retail loans to NFCs Retail loans to HHs Non-financial securities Government bonds Wholesale lending

31. 2.2. Financial Regulation Basel III (2013-) – Remember the liquidity spirals Liabilities Assets Equity Retail deposits from non-financial sector Wholesale funding Retail loans to NFCs Retail loans to HHs Non-financial securities Government bonds Wholesale lending

32. 2.3. Topical Issues The European Banking Union • The European Central Bank (ECB) is preparing to take on new banking supervision tasks as part of a single supervisory mechanism (SSM) • The SSM will create a new system of financial supervision comprising the ECB and the national competent authorities of participating EU countries • The main aims of the single supervisory mechanism will be to ensure the safety and soundness of the European banking system and to increase financial integration and stability in Europe • The ECB will be responsible for the effective and consistent functioning of the single supervisory mechanism, cooperating with the national competent authorities of participating EU countries

33. 2.3. Topical Issues The European Banking Union

34. 2.3. Topical Issues The European Banking Union

35. 2.3. Topical Issues The European Banking Union

36. 2.3. Topical Issues The European Banking Union

37. 2.3. Topical Issues Central bank as bank supervisor? Cons • Loss of independence: the central bank could become more prone to political capture as its role gains importance, thereby undermining its independence • Credibility and reputational risks for the central bank: credibility risk is greater in the area of financial stability as only failures are observed and there is no quantitative objective. • Regulatory forbearance: at times where the economy is weak and on the brink of deflation, the central bank may not allow unsound banks to fail • Conflicts of interest: to the extent that higher rates may harm banks, the central bank may not raise interest rates to fight inflation

38. 2.3. Topical Issues Central bank as bank supervisor? Cons (Di Noia and Di Giorgio, 1999)

39. 2.3. Topical Issues Central bank as bank supervisor? Cons (Ioannidou, 2003)

40. 2.3. Topical Issues Central bank as bank supervisor? Pros • Coordination is necessary, ex: there is an house price bubble and the financial regulator wants to raise capital requirements; this has a negative effect on inflation; the central bank may lower rates; this has a positive effect on house prices… (“push-me pull-you” behaviors ) • Financial stability is crucial for the conduct of monetary policy (e.g. interbank market) • Information on banks is crucial, notably if the central bank is a lender of last resort

41. 2.3. Topical Issues Central bank as bank supervisor? Pros (Peek, Rosengren, Tootel, 1999)

42. 2.3. Topical Issues Should macro-prudential supervision be centralized? Cons • National supervisors have better knowledge of domestic financial conditions • Large, federal regulators may be more prone to lobbying

43. 2.3. Topical Issues Should macro-prudential supervision be centralized? Pros • To the extent that macro-prudential and monetary policies complement each other, in a monetary union (where monetary policy is centralized) macro-prudential policy too should be centralized • National macro-prudential regulations may generate (negative) externalities that only a centralized authority can internalize, e.g. global banks and cross-border capital flows • A centralized macro-prudential authority may be less prone to regulatory capture by private interests • Federal regulators are found to be tougher on banks

44. 2.3. Topical Issues Should macro-prudential supervision be centralized? Pros (Agarwal et al., 2013)

45. 2.3. Topical Issues Coordination between micro- and macro-prudential supervisors • Micro- and macro-supervisors have the same tools (capital ratios, liquidity ratios, etc) but… • …they have different objectives (bank versus system stability) • …they do not use the tools the same way (granular versus uniform) • There maybe conflicts of interest: tougher macro-prudential rules in good times may imply more bank defaults; tougher micro-supervision in bad times may amplify the recession due to lack of general equilibrium perspective • Conflicts are probably more acute during recessions

46. 2.3. Topical Issues Coordination between micro- and macro-prudential supervisors • Macro-prudential supervision must not necessarily prevail over micro-prudential supervision, though • Because it pays attention to collective (macro) behaviors, macro-prudential supervision tends to be counter-cyclical and subject to collective moral hazard • Paradoxically, banks may collectively take risks in good time anticipating bail out in bad times (gambles). Ex: If all banks hold more liquid assets in good times, then the assets may paradoxically become illiquid in bad times due to industry exposure • Macro-pru policies only have a bite if market failures come from the banking sector • In contrast, micro-prudential supervision does not pay attention to collective behavior, and may punish the banks that take more risk than average

47. 2.3. Topical Issues The political economy of financial regulation • Government intervention (regulation) corrects market inefficiencies to maximize social welfare • Regulation may sometimes be the outcome of private interests who use the coercive power of the state to extract rents at the expense of other groups • Benmeleck and Moskowitz (2007): “The evidence suggests regulation is the outcome of private interests, highlighting the endogeneity of financial development and growth” • Usury law in the 19th century (US): by limiting the interest rate charged by banks, usury laws cause credit rationing and give a competitive edge to wealthier (low rates) borrowers • Voting restrictions based on wealth are highly correlated with tight usury laws

48. 2.3. Topical Issues The political economy of financial regulation (Benmeleck and Moskowitz, 2007)

49. 2.3. Topical Issues The political economy of financial regulation • What about Basel III? The membership of the BCBS was extended to G20 countries in March 2009, to include emerging market economies • Public consultations and Quantitative Impact Studies on the new regulatory standards • Bengtsson (2013): “Our findings indicate that the changes in the governance structure and influence of private actors seem to have led the BCBS to develop a capital accord that is relatively less beneficial for large international banks and the traditional BCBS member countries. This suggests that a tilting of power in favour of emerging markets has occurred in the political economy of banking regulation”

50. 2.3. Topical Issues The political economy of financial regulation