Systemic regulator

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See also Council of Regulators, European Systemic Risk Board, Financial Stability Oversight Council and Trading book risk.


Legislative oversight

See also Council of Regulators and Resolution authority.

House oversight of systemic regulation

See also Financial Stability Improvement Act of 2009

House hearings on systemic risk

Click Here To View Archived Webcast

Testimony of Mr Daniel K Tarullo, Member of the Board of Governors of the US Federal Reserve System, before the Committee on Financial Services, US House of Representatives, Washington DC, 29 October 2009.

9 a.m., Thursday, September 24, 2009, 2128 Rayburn House Office Building

Rep. Barney Frank (D-MA), Chairman of the House Financial Services Committee, today announced that the committee will hold a hearing titled “Experts’ Perspectives on Systemic Risk and Resolution Issues” on Thursday, September 24.

Panel One

  • The Honorable Paul Volcker, Former Chairman of the Board of Governors of the Federal Reserve System

Panel Two

  • The Honorable Arthur Levitt, Jr., Former Chairman of the United States Securities and Exchange Commission, Senior Advisor, The Carlyle Group
  • Mr. Jeffrey A. Miron, Senior Lecturer and Director of Undergraduate Studies, Department of Economics, Harvard University
  • Mr. Mark Zandi, Chief Economist, Moody’s
  • Mr. John H. Cochrane, AQR Capital Management Professor of Finance, The University of Chicago Booth School of Business

"Geithner is scheduled to speak at the House Financial Services Committee on Thursday afternoon. Rep. Paul Kanjorksi (Pa.), a leading Democrat on the committee, said in prepared remarks that there are many parts of the plan that he supports, but he has lingering concerns about the Fed.

“Without denying the white paper’s many important reforms, I must reiterate my deep and profound concerns about the selection of the Federal Reserve as the primary entity in charge of systemic risk, I believe that we need someone with political accountability in this role,” Kanjorski said....

...Sen. Robert Menendez (D-N.J.) said he was concerned that the administration's plan to set up a council of regulators to assess risk alongside the Fed would not have any enforcement power. “My concern is that it is basically advisory,” Menendez said. Geithner said that giving the council more power would “create the risk of more confusion.”

Sen. Jon Tester (D-Mont.) questioned whether it would still be possible to merge the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), but he also raised questions about the broader outlines of the proposal.

“I still have concerns,” Tester said. “I'm not sure that the accountability is there.”

Sen. Bob Corker (R-Tenn.) said that the plan avoided major questions on the future of Fannie Mae and Freddie Mac, as well as a merger of SEC and CFTC. “A lot of the heavy lifting wasn’t addressed,” Corker said."

Source: Obama’s Fed Risk Regulator Plan Fades as Lawmakers Back Council July 23 (Bloomberg)

"The Obama administration’s plan to expand the Federal Reserve’s powers to oversee financial firms is failing to win supporters in Congress as some lawmakers back a proposal to give the responsibility to several regulators.

“It’s going to be shared authority,” House Financial Services Committee Chairman Barney Frank, whose panel will write the measure, told reporters July 21, without providing details.

Frank and lawmakers leading discussion on regulatory reform fault the central bank for slow action on lending abuses and want the Fed to focus on monetary policy. Support is emerging for a council of the Fed, Treasury Department, Federal Deposit Insurance Corp. and other regulators. The Senate Banking Committee will consider the systemic-risk plan today.

“The more eyes on the problem the more likelihood that someone will raise an alarm,” Representative Spencer Bachus, top Republican on the House panel, said in a July 21 interview.

Obama, as part of the overhaul of U.S. financial rules, released a proposal last month giving the Fed power to supervise all large firms “whose failure could threaten the stability of the system” regardless of whether they own a bank.

The administration said the proposal is aimed at avoiding failures similar to insurer American International Group Inc., which has required a U.S. rescue package valued at more than $182 billion, and investment banks Lehman Brothers Holdings Inc., which is being liquidated, and Bear Stearns Cos., bought by JPMorgan Chase & Co. with U.S. backing.

Fed Chairman Ben S. Bernanke downplayed the extent of the new powers while testifying yesterday to the Senate Banking Committee. The Fed supervises almost all firms that would likely fall under its review, he said.

‘Specific Role’

“We’d have a very specific role, which is to supervise and look at the systemic implications of a specific set of companies,” Bernanke said.

Lawmakers fault the Fed for taking more than a decade to use authority Congress gave the central bank to write rules aimed at protecting consumers.

Senate Banking Committee Chairman Christopher Dodd and Richard Shelby, the panel’s top Republican, are concerned about giving the Fed additional power.

“Monetary policy is the primary function,” Dodd, a Connecticut Democrat, said yesterday in an interview. “The Fed’s job is to be somewhat of a cheerleader on the economy, whereas a systemic-risk regulator is the cop.”

White House National Economic Council Director Lawrence Summers said it was too early to dismiss the Fed idea.

‘Best Way’

“I think it’s way premature to be talking about anything like that,” Summers said in a July 20 interview with Bloomberg News. “We’re very focused on what we think is the best way to contain these risks.”

Senator Charles Schumer, a New York Democrat and a member of the banking panel, said he supported the Obama plan.

“The Fed has one major advantage that the opponents would have to answer, which is they have knowledge,” Schumer said in a July 22 interview.

Shelby, of Alabama, said the Fed has “utterly failed” at regulation.

“We’d better look at the role of the Fed,” Shelby said yesterday. “You load the Fed up with too many responsibilities and I think it weakens the Fed.”

Senate oversight of systemic regulation

Senate hearings on systemic risk

Senate hearing July 23

The witnesses will be:

    • The Honorable Sheila Bair, Chairman, Federal Deposit Insurance Corporation
    • The Honorable Mary Schapiro, Chairman, U.S. Securities and Exchange Commission
    • The Honorable Daniel Tarullo, Member, Board of Governors of the Federal Reserve System
    • Ms. Alice Rivlin, Senior Fellow, Economic Studies, Brookings Institution
    • Mr. Allan Meltzer, The Allan Meltzer University Professor of Political Economy, Tepper School of Business, Carnegie Mellon University
    • Mr. Vincent Reinhart, Resident Scholar, American Enterprise Institute
    • Mr. Paul Schott Stevens, President and CEO, Investment Company Institute

view archive webcast

The witness was: The Honorable Ben Bernanke, Chairman, Board of Governors of the Federal Reserve System.

Sudeep Reddy of the Wall Street Journal blogged the following about the hearing:

10:05: Bernanke emerges from his pre-hearing gathering with the committee. Photographers get a couple extra minutes to get that perfect up-close shot of Bernanke while senators stroll in.

10:07: Banking Committee Chairman Christopher Dodd gets the hearing started. He has some “serious issues” about the institutional response to the crisis. Then he gets into his prepared statement.

10:15: Sen. Richard Shelby, the top Republican, begins his prepared statement. He’s not terribly pleased with the Fed’s performance as a regulator.

10:19: Bernanke begins his testimony, which repeats yesterday’s House statement.

10:36: Dodd wants to know what other problems are out there. Bernanke suggests training for the unemployed. On commercial real estate, Fed is encouraging banks to do workouts like they do for homeowners.

That first question was meant to be an easy one. Dodd takes the Fed to task for its consumer-protection performance and a “pattern of behavior” over the years. Bernanke says the Fed wasn’t entirely inactive, but not quick enough and not aggressive enough on that front. He recommends several changes. Among them: put consumer protection in the Federal Reserve Act (a Fed mandate like full employment and price stability), require reports on consumer protection like for monetary policy, bolster the Consumer Advisory Council that meets with the Fed board.

10:45: Shelby suggests the Fed is putting too many activities under the umbrella of independence. He asks, would you support a general view — perhaps by the GAO — as to what should be independent?

“We are quite willing to work with Congress to figure out where the line should be,” Bernanke says. “Where we are nervous is where the GAO begins to second guess our monetary policy” decisions."

Narrow banking and investment banking: the Glass Steagall debate

"The third complex issue is the appropriate relationship between retail and commercial banking and investment banking activity, and in particular risky proprietary trading. It is clear that there is a problem which has to be addressed.

In the years running up to the crisis, we had large commercial banks taking the benefits of retail deposit insurance and perceived too-big-to-fail status and using these to support risky proprietary trading activities which created large bonuses for individual bankers but large costs to taxpayers and financial instability which has produced a recession. That is not acceptable: the question is not whether we need significant change but how to achieve it.

One way would be to enforce a legal separation between narrow banking activities and investment banking activities, re-imposing, or in some countries imposing for the first time, Glass Steagall type distinctions. And some legally enforced distinctions of economic functions are clearly possible – indeed we already have one in the UK, with building societies not allowed to participate in the full range of financial activities which banks can perform – certainly excluded from exotic investment banking activities and subject to limitations on the percentage of their balance sheet which can be invested in for instance commercial real estate. Having such a tier of clearly narrow institutions does make sense; and indeed in my report to the Chancellor on the Dunfermline Building Society, I raised the issue of whether perhaps the freedoms to perform functions beyond residential mortgage lending had been set too loose after the various deregulations of the 1980s and 1990s.

But the real issue is not what the existing very narrow institutions should be allowed to do, but what should be the freedoms for those large commercial banks which are involved in the provision of services not only to residential customers and SMEs, but also to large complex corporates operating in the global economy and therefore involved in the management of complex foreign exchange, interest and credit risk. Can we keep these banks out of the trading activities which played a role in the crisis by writing a law which defines what they can and cannot do?

I suggested in The Turner Review that this was difficult. The key point to recognise is that the activities which caused the crisis were not ones which had been previously defined, under for instance Glass Steagall, as clearly outside commercial banking – activities such as equity underwriting and distribution – but activities which seemed close to the core functions of commercial banks such as credit intermediation, liquidity provision and interest rate risk management. Much of what went wrong went wrong in activities which a commercial bank was free to perform even before Glass Steagall was dismantled. It is, I think, difficult to imagine applying a law which says that a commercial bank cannot hold fixed income securities in its Treasury portfolio, turn loans into securities for distribution but hold them until distribution is achieved, or use credit derivatives to manage credit risks. And you certainly cannot say that a commercial bank cannot take any proprietary positions, without making it impossible to perform necessary market-making functions in, for instance, foreign exchange and interest rate markets.

But once you have said that a commercial bank can do all of those functions, you have allowed it to do most of the activities which, pursued on a large scale and in a risky fashion, caused the crisis.

That is why my tentative conclusion in The Turner Review was that we could not proceed by a binary legal distinction – banks can do this but not that – but had to focus on the scale of position-taking and the capital held against position-taking. That is why the increases in trading book capital to which I referred earlier are so important. And such increases need to be applied to all trading activity by banks or non-banks, since even where those trading activities are performed by institutions which are not insured deposit-takers, large systemic risks can still result. That was the lesson of Bear Stearns and Lehman Brothers.

Where there may be a role for legal entity definitions, however, is in defining more clearly the separate legal entities in which core retail banking functions and investment banking type functions are performed, ensuring that the retail banking functions are adequately and independently capitalised, and making it clear to the market that in any future crisis there is at least the possibility that rescue might apply only to retail banking operations. Such ideas have been floated, for instance, by Philipp Hildebrand, Vice-Chairman of the Governing Board of the Swiss National Bank. They would not be straightforward to implement, but they deserve careful consideration.

Macro-prudential analysis and tools

In the years running up to the crisis – in, say, 2002 to 2007 – we needed an analytical approach would put together the dots of the macro-prudential picture. In the UK that picture was of a growing current- account deficit, rapid credit growth, rapidly rising house and commercial real estate prices, the rapid growth of securitised mortgages, rapidly growing banks dependent on wholesale funding, and extensive reliance on funding from abroad, both via interbank funding and via US purchases of securitised mortgages, a reliance on funding from abroad which in turn, of course, was the flip side of the current-account deficit. We needed to do that analysis, identify the emerging risks, and then take offsetting actions. But we had in place neither the analytical approach nor the regulatory tools. We need to put them in place for the future.

If the overall principle is clear, however, much work is still needed to define how precisely macro-prudential regulation will operate. There are important questions in respect to objectives, to tools, and to the choice between hardwired and discretionary approaches.

On objectives, a crucial issue is how ambitious we should be. Are we simply aiming to increase the resilience of the financial system, reducing the likelihood of bank failure? Or do we believe we can reduce the amplitude of economic cycles, more effectively leaning against the wind of asset price bubbles, using other instruments than the interest rate to take away the punch bowl before the party gets out of hand? The more the objective is the latter, the closer the required links to the conduct of monetary policy.

On tools, one clear priority is a countercyclical approach to capital at the institutional level. But it is also possible to envisage both the definition and then the through-the-cycle-variation of margin requirements in secured lending, and of loan to value (LTV) or loan-to-income (LTI) ratios in, for instance, residential mortgages. Such approaches are essentially ways of regulating leverage at the product specific rather than the institution specific level. But establishing and then varying maximum LTV or LTI ratios in mortgages, raises complex issues relating to consumer access, and overlaps with conduct of business concerns. The FSA will make a contribution to that debate in the Discussion Paper on the mortgage market, which we will issue in October.

Finally, there is the issue of whether macro-prudential tools, and in particular countercyclical capital adequacy, should be varied in a discretionary fashion or hardwired, through, for instance, a Spanish dynamic provisioning type approach. The issue of hardwired countercyclical rules is already being considered by the Basel Committee, and the conclusions they reach on that issue may in turn have implications for the balance between hardwired and discretionary elements within the UK approach.

GAO releases report on regulators’ use of systemic risk exception

On Thursday, the Government Accountability Office (GAO) released a new report on the regulators’ use of systemic risk exception entitled “Federal Deposit Insurance Act: Regulators’ Use of Systemic Risk Exception Raises Moral Hazard Concerns and Opportunities Exist to Clarify the Provision.”

The report reviews five potential emergency actions that were announced in 2008 and 2009 and that, to implement, would require a determination under the systemic risk exception of the Federal Deposit Insurance Act.

Treasury did not approve two of the requested determinations, but did approve three regarding Wachovia and Citigroup, each to avert the failure of an institution that regulators determined could exacerbate liquidity strains in the banking system, and to address disruptions to bank funding affecting all banks, which resulted in the FDIC’s establishment of the Temporary Liquidity Guarantee Program.

The GAO report examined:

  • steps taken by the FDIC, the Federal Reserve, and Treasury to invoke the systemic risk exception;
  • the basis of the determinations (including analysis of the FDIC’s legal authority to take the actions it took) and the purpose of resulting actions; and
  • the likely effects of the determinations on the incentives and conduct of insured depository institutions and uninsured depositors.

The GAO report noted that “Regulators’ use of the systemic risk exception may weaken market participants’ incentives to properly manage risk if they come to expect similar emergency actions in the future.” The GAO’s recommendations to Congress include:

  • where the FDIC, the Federal Reserve, and Treasury publicly announce intended emergency actions but Treasury does not make a systemic risk determination, consider requiring Treasury to document and communicate the reasoning for not making or delaying a determination;
  • consider enacting legislation clarifying the requirements and assistance authorized under the systemic risk exception; and
  • consider ensuring that systemically important institutions receive greater regulator oversight.

"Prefunding" systemic risk function

Source: All About Picking Losers as Winners: Interview With Bob Feinberg August 5, 2009

"Here's one sleeper issue: Senator John Warner (D-VA) has been saying that any systemic solution must be pre-funded like SIPC and previous industry self-insurance efforts. It has also been suggested by others that SIPC needs to be beefed up with some sort of FDIC-like examination function.

But obviously, if the markets believed that the industry would have to pay its way, we would never have seen the huge rally in banks stocks that occurred from the end of the first quarter until today. Even as we talk about Systemic Risk, the Fed and other authorities are working to create a new bubble in securities markets fueled with public money.

The confidence of the markets in this arrangement is badly misplaced, in my view, and is simply another case of Irrational Exuberance, courtesy of the authorities. Whenever the Fed decides to slip the Yield Curve again, they create a panic to get into financials. It actually damages the economy, because it distorts incentives and keeps the Zombie banks pumped up on steroids when they need to be shrunk to maybe a fraction of their bloated size.

A host on CNBC's "Squawk Box" observed recently that banks really don't do very much, and Greenspan once told Senate Banking that some people would say banks exist only to feed off of the yield curve. This strategy is described as, "Borrow short, buy anything."

One of the lessons Learned from the S&L crisis was supposed to be not to do this, but no less a personage than Bill Isaac told an SEC roundtable that this is what banks do. My way of formulating this is that we can have the zombie banks, or we can have the economy, but we can't have both..."


In this paper we propose a framework for measuring and stress testing the systemic risk of a group of major financial institutions. The systemic risk is measured by the price of insurance against financial distress, which is based on ex ante measures of default probabilities of individual banks and forecasted asset return correlations. Importantly, using realized correlations estimated from high-frequency equity return data can significantly improve the accuracy of forecasted correlations. Our stress testing methodology, using an integrated micro-macro model, takes into account dynamic linkages between the health of major US banks and macrofinancial conditions.

Our results suggest that the theoretical insurance premium that would be charged to protect against losses that equal or exceed 15% of total liabilities of 12 major US financial firms stood at $110 billion in March 2008 and had a projected upper bound of $250 billion in July 2008.

(Page 5)

"...Our main contribution is to propose to use a new indicator to assess the systemic risk of the banking sector: the price of insurance against large default losses in the banking sector in the coming 12 weeks. The new measure is economically intuitive, in that it is equivalent to a theoretical premium to a risk-based deposit insurance scheme that guarantees against most severe losses for the banking system. The new measure also has the property that it increases in both PDs and asset return correlations. In other words, an increase in the indicator, or a higher systemic risk, can reflect market participants’ perception of higher failure risk as well as their view that the probability of common failings is higher (see Das et al. (2007) and Duffie et al. (2008)).4 In addition, the new indicator reflects the various degrees of importance of different banks in contributing to the systemic risk, in that banks are treated heterogeneously based on their relative size...."

BIS on the effects on the supply of bank credit

Effects on the supply of bank credit

"The paper provides some background information which may be useful for assessing whether rescue measures are proving effective in supporting credit supply to the private sector, which is their ultimate objective.

This kind of assessment is fraught with conceptual and statistical pitfalls, related, inter alia, to the very short sample period available, to the difficulty of disentangling the effects of rescue measures from those of other factors at work (some of them policy-related) and to the fact that lending policies reflect several bank characteristics, only some of which are observable.

Subject to these caveats, evidence from aggregate credit data shows that, at the end of 2008 and in early 2009, bank lending to firms and households kept slowing both in the United States and in Europe. Evidence from lending surveys and from loan pricing would suggest that the slowdown reflects both supply and demand factors.

Credit conditions may have eased somewhat as of late, after the extreme tensions registered following the Lehman default, in terms of both credit standards and spreads on loans. It is, however, premature to conclude that the credit supply cycle has reached a turning point. In order to provide a more accurate assessment of the effect of rescue measures on bank credit, it will be necessary – and this is an avenue for further research – to look into the lending behaviour of individual institutions over a longer time span.

BIS on the need for an exit strategy

"Overall, it is fair to say that the rescue measures have contributed to an avoidance of “worst case scenarios”, in particular by reducing the default risk of major banks. Before the interventions, financial markets were not providing sufficient long-term funding to banks.

On a net basis, capital markets were subtracting resources from banks. The measures implemented since September 2008 have mitigated the effects of this anomaly. Governments have played the role that is usually played by capital markets, supplying long-term resources to banks at reasonable cost, thus contributing to the stabilisation of the financial system.

The fact that no major credit event took place after Lehman’s demise is certainly due, at least in part, to the implementation of the rescue measures.

At the same time, government intervention has not been sufficient, at least so far, to trigger a “virtuous circle” for banks, such as a mutually reinforcing increase in capital and borrowing on the one hand and lending and profits on the other. Indeed, between the first and the second quarter of 2009, the portion of overall bank funding provided or guaranteed by governments sharply declined – in the case of bank bond issuance, this portion dropped from 60% to 30% – but this increase in risk appetite may prove transitory and most banks continue to depend on government funds.

The rescue measures have been effective in stabilising the financial system, but this has come at a price, represented by the distortions and inefficiencies mentioned above. This is an example of the trade-off that exists between the stability and the efficiency of the financial system.

The existence of these distortions has two important implications.

First of all, the distortions induced by government intervention should be taken into account in the design of the rescue measures. For example, bond guarantee programmes generally expire at the end of 2009 but it cannot be ruled out that the authorities will decide to extend them into 2010.

In such a case, in order to ensure a level playing field across countries, the pricing of the guarantees on bank bonds could be modified in a way that takes into account country-specific factors. For instance, “weaker” countries could be allowed to charge lower fees to their banks, in particular in the euro area, in order to offset those large differences in the cost of issuing bonds which are unrelated to the issuer’s characteristics.

A second implication is that, in order to contain the distortions, governments should dismantle the rescue measures as soon as financial market conditions allow. Even if it may take some time until these conditions materialise, governments should start preparing an exit strategy right now.

A credible, quick-to-implement exit strategy is key to avoiding banks and other financial institutions devising their future strategies on the assumption that they will continue to benefit from government support for an extended period of time, possibly at the expense of their competitors.

The condition for dismantling the rescue measures without consequences for banks and for a successful exit strategy is to trigger the above-mentioned virtuous circle, in particular as far as funding is concerned. In this regard, a key ingredient for success is the resumption of the market for securitisation, which has represented a very important source of funding for banks until it dried up because of the financial crisis."

IMF panel - "Systemic risks still high"

  • Need for much better understanding of macro-financial linkages
  • IMF researching how the financial sector affects the broader economy
  • Global imbalances raise concerns about future stability

Governments need to rethink how the financial sector intersects with the broader economy if future crises are to be avoided, economists agreed at a panel discussion at the International Monetary Fund’s recently held Economic Forum.

Opening the November 5-6 research conference, IMF Managing Director Dominique Strauss-Kahn remarked on the positive effects of the timely and effective policy interventions at the global level that have helped stave off an even worse outcome to the recent global crisis.

Strauss-Kahn noted that macro-financial linkages are at the heart of the two-way interactions between the real economy and the financial system. “One of the most important lessons we painfully learned is that we need to have a much better understanding of macro-financial linkages,” he said. “At the IMF, we will utilize the results of recent research on macro-financial linkages in order to help our membership devise policies that promote global financial stability and economic growth.”

The Economic Forum, chaired by IMF Chief Economist Olivier Blanchard, wrapped up the 10th Jacques Polak Annual Research Conference in Washington, D.C. Since it was first launched, the research conference has become one of the major international forums for researchers and policymakers to exchange their views about issues related to the global economy.

Graceful exit

Around the world, discussions are under way on how to best move toward unwinding public sector support. Of all the measures of public support implemented thus far—fiscal and monetary policy, interventions to specific institutions, and government support programs—perhaps the one most delicate to unwind will be monetary policy.

Former Federal Reserve governor, Laurence Meyer, explained that exit for the United States will mean raising the federal funds rate; withdrawing the reserves that were put in by the various programs; and shrinking the balance sheet by selling previously purchased assets—such as, mortgage-backed securities—or letting short-term assets “run off” as the various facilities or programs are scaled back or shut down.

Meyer predicts the federal funds rate will not be increased until the middle of 2011, saying the Federal Reserve would, however, tighten earlier if another asset bubble developed. Despite having just emerged from a collapse in the housing market, Meyer believes, “we are already on bubble alert.” He points to market concerns of an emerging bubble in the corporate bond and other markets, noting credit spreads have disappeared, equity prices are increasing, and housing market prices are slowly rising.

Market concern over long-term inflation expectations might also lead to a tightening, as might a collapse in the dollar. “If there was freefall in the dollar, even if the short-term economic conditions weren’t very good, the Fed would have no choice but to raise rates,” he said.

Policy overhaul

When it comes to redesigning monetary policy, there is disagreement as to how this might best be accomplished. Wharton finance and economics professor Franklin Allen believes more checks and balances could be built into the Federal Reserve System. “We need to have a third mandate—a financial stability mandate,” he said.

But more importantly, he says, outsiders should be checking the Federal Reserve. Allen favors a financial stability board, which would be independent from the Fed, with members sitting on the Federal Open Market Committee, not with a majority, but perhaps a substantial minority, so that given a dissent in the Board, they would be able to provide a counter effect.

Allen sees quantitative easing as an extremely risky policy, and as something that has been undertaken with very little discussion in policy or academic circles: “The notion is that you print money and buy up long-term bonds, but what happens if inflation ticks up?” Selling the bonds and reversing the liquidity could be problematic and, he argues, central banks need a mechanism to check what is going on and prevent such risky moves.

On the other hand, both Meyer and former Federal Reserve governor, Randall Kroszner, believed this might compromise the widely cherished independence of central banks. “If you ask a central bank whether it should intervene directly in an asset bubble, they would say, ‘yes’, but we have additional tools to do that,” said Meyer “we don’t want to compromise monetary policy being supervised in regulatory policies.” Panel chair Blanchard summed up the essence of the discussion, asking, “How can you balance this central bank independence and avoid misbehavior? If you think of monetary policy as a set of tools, then it seems wrong to have two decision makers. The need for coordination and information means there can only be one institution using these tools optimally.”

Too broad a mandate could also risk overloading central banks, particularly in emerging markets, a view held by Brookings Senior Fellow and Cornell professor, Eswar Prasad. Where a central bank has a well-defined mandate, he believes it could be possible to incorporate many of these issues within that mandate. “Although the world has changed in many ways,” he said, “we should not be throwing out everything that we thought we knew.”

What to watch for

Picking up and building on one of the potential risks referred to earlier by Meyer, Allen noted that while a run on the U.S. dollar might be less likely, there are other advanced economies where the risks are greater, particularly those that followed policies of quantitative easing and purchased large amounts of financial assets. “If there is a run on the currency, it is going to be very difficult for [the central bank] to sell these assets back into the market without substantially raising rates.”

Global imbalances are again beginning to raise concerns. Pressures remain in many economies around the world, says Prasad, where many economies, such as China, Japan and Germany, ride the coat-tails of the United States. In China, Prasad noted that just in the first six months of 2009 China’s state banks had pumped $1 trillion of lending into mostly state-owned enterprises.

But the huge stimulus could result in a problem of overproduction that would again lead to imbalances with the need to export surplus output. Both Prasad and Allen worry that the crisis may have also incentivized emerging markets to continue with a policy of amassing huge stocks of reserves.

Allen points to countries such as Korea and some others across Asia that may have come through the crisis in good shape and avoided the large decrease in GDP and increases in unemployment experienced by other export-oriented countries. He suggests these countries will conclude, rightly, that they need more reserves. Prasad says a number of countries thought to have had vast reserves saw them depleted very quickly during the height of the crisis. Here, they both agree that changes to the international architecture—through better Asian representation at the IMF—would be helpful, but these changes need to move more quickly than they are at present.

Emerging markets are moving out of the crisis with a new perspective, argues Prasad, where they now recognize better the importance of strengthening financial systems, but doing so in very limited contexts. Prasad sees a new path developing as emerging markets move forward with their financial development and broadening financial access, one that emphasizes the importance of regulation.

“Perhaps ultimately what we should hope for is a convergence of the emerging markets moving toward more sophisticated, but better regulated, financial systems and perhaps the United States move toward a less sophisticated, in some ways, but more stable financial system.” But with no agreement yet among experts on what are the optimal regulatory structures for less developed financial markets, he sees a need for a great deal of work to be done in the area.

Tensions in financial markets began to subside

"As tensions in financial markets began to subside in the first quarter of 2009, the contraction of banks' international balance sheets slowed. Banks still registered an $812 billion fall in their interbank positions comparable to that experienced in the fourth quarter of 2008, reflecting protracted funding pressures. However, the decrease in international credit to non-banks, at $258 billion, was only one fourth that seen in the previous quarter. Banks also trimmed their international credit to emerging markets, but their local lending from offices in emerging market host countries remained stable. For most major banking systems, local lending in local currency is at least as large as their international claims.

Continued government support of financial markets led to an increase in the issuance of international debt securities in the second quarter of 2009. Net issuance rose by 25% to $837 billion, but remained short of its level in the second quarter of 2007. The increase was mostly accounted for by bonds and notes issued by financial institutions, particularly in the euro area, and public sector borrowers. By contrast, money market borrowing stagnated further.

Activity on the international derivatives exchanges rebounded in the second quarter, but remained well below previous peaks. Total turnover based on notional amounts increased by 16% to $426 trillion, mainly reflecting higher activity in futures and options on short-term interest rates. Higher stock prices also drove up turnover of equity index derivatives measured by notional amounts, although the number of contracts traded went up only slightly."

Arguments about a systemic risk regulator

The purpose of a systemic risk regulator would be to address the failure of any entity of sufficient scale that a disorderly failure would threaten the financial system.

Such a regulator would be designed to address failures of entities such as Lehman Brothers and AIG more effectively.

Writing in the Financial Times of June 26, 2009 John Plender talks about the broader issues around large interconnected global banks which raise systemic risk:

"Perhaps most worrying of all, it looks as though the political will to secure a strong regulatory response to the crisis is waning. The Obama administration’s reform proposals last week shuffled institutional deckchairs and gave more power to the Federal Reserve despite its signal failure to do its regulatory stuff during the credit bubble. There were worthy plans for this and that. Yet the result of all the bail-outs and mergers is still a higher degree of concentration in banking, which does nothing to mitigate the systemic threat from outfits that are too big or too interconnected to fail.

The likes of JPMorgan Chase and Goldman Sachs will continue to reap fat profits from opaque over-the-counter trade in credit default swaps and other derivatives. The stronger banks, while preparing to release themselves, from government guarantees, are bent on pursuing business models that are not dramatically different from those they adopted before they foundered.

In the UK, Mervyn King, governor of the Bank of England, has strongly urged that the casino element of the banking system be separated from the conventional borrowing and lending business that enjoys the benefit of deposit insurance and the Bank’s support as a lender of last resort. Lord Turner, his counterpart at the Financial Services Authority, has a more nuanced position. In his recent review of the regulatory system, he said: “Serving the financial needs of today’s complex globally interconnected economy ... requires the existence of large complex banking institutions providing financial risk management products which can only be delivered off the platform of extensive market-making activities, which inevitably involve at least some position-taking.”

He also questions whether it is realistic to think that high-risk trading activity could exist outside the utility-type banking sector and be subject to pure market discipline in a world of interconnected markets. Bear Stearns had no utility-type business but the US authorities still recognised that it posed a systemic threat when it ran into difficulty.

Alistair Darling, the UK chancellor of the exchequer, appears to be on Lord Turner’s side in this argument. He is also proposing to pass some of the Bank of England’s responsibility for financial stability to the FSA. The outcome is that re-regulation in the UK will fall short of radical.

In the European Union, meanwhile, the regulatory response has been lopsided, directed as much at hedge funds and private equity firms, which posed little or no systemic threat in this crisis, as at banks. This no doubt reflects the perennial Franco-German desire to knock British finance.

Why is it that the bankers suddenly appear to be off the hook? One answer is that the monetary remedies for the financial crisis create the potential for trading profits by reducing the banks’ cost of funds. While this appears offensive to ordinary people, it is nonetheless desirable, because it recapitalises banks via the back door.

But the less-than-draconian regulatory response represents a triumph of lobbying power, especially in the US where investment banks have been highly persuasive in Washington and have made full use of a deeply flawed campaign funding system."

Please click on the image for a larger version. (Source: The New York Times)

For a systemic risk regulator

Fed Chairman Ben Bernanke stated there is a need for "well-defined procedures and authorities for dealing with the potential failure of a systemically important non-bank financial institution." Bernanke Remarks, 2008-12-01

He also argued in March 2009: "...I would note that AIG offers two clear lessons for the upcoming discussion in the Congress and elsewhere on regulatory reform. First, AIG highlights the urgent need for new resolution procedures for systemically important nonbank financial firms. If a federal agency had had such tools on September 16, they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate. That outcome would have been far preferable to the situation we find ourselves in now. Second, the AIG situation highlights the need for strong, effective consolidated supervision of all systemically important financial firms. AIG built up its concentrated exposure to the subprime mortgage market largely out of the sight of its functional regulators. More-effective supervision might have identified and blocked the extraordinarily reckless risk-taking at AIG-FP. These two changes could measurably reduce the likelihood of future episodes of systemic risk like the one we faced at AIG."Bernanke Testimony on AIG

Economists Nouriel Roubini and Lasse Pederson recommended in January 2009 that capital requirements for financial institutions be proportional to the systemic risk they pose, based on an assessment by regulators. Further, each financial institution would pay an insurance premium to the government based on its systemic risk. "Roubini and Pederson - Systemic risk capital & insurance regulations, 2009-01-29

British Prime Minister Gordon Brown and Nobel laureate A. Michael Spence have argued for an "early warning system" to help detect a confluence of events leading to systemic risk. PIMCO-Lessons from the Crisis, 2008-11-26

Against a systemic risk regulator

Libertarians and conservatives argue for minimal or no regulation, preferring to let markets regulate themselves. They argue that it was government intervention, such as requiring Fannie Mae and Freddie Mac to lower lending standards AEI-Wallison-The Last Trillion Dollar Commitment, that caused the crisis in the first place and that extensive regulation of banks was ineffective. AEI-Wallison-Regulation without Reason

Regulating the shadow banking system

Unregulated financial institutions called the shadow banking system play a critical role in the credit markets. In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President and CEO of the NY Federal Reserve Bank, placed significant blame for the freezing of credit markets on a "run" on the entities in the "parallel" banking system, also called the shadow banking system.

He described the significance of this unregulated banking system: "In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion.

The combined balance sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion." He stated that the "combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles."Geithner-Speech Reducing Systemic Risk in a Dynamic Financial System

The FDIC has the authority to takeover a struggling depository bank and liquidate it in an orderly way; it lacks this authority for non-bank financial institutions that have become an increasingly important part of the credit markets.

For regulating the shadow banking system

Leverage Ratios of Investment Banks Increased Significantly 2003–2007
Leverage Ratios of Investment Banks Increased Significantly 2003–2007

Nobel laureate Paul Krugman described the run on the shadow banking system as the "core of what happened" to cause the crisis. "As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible—and they should have responded by extending regulations and the financial safety net to cover these new institutions.Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank." He referred to this lack of controls as "malign neglect." The Return of Depression Economics and the Crisis of 2008

The crisis surrounding the failure of Long-term Capital Management in 1998 was an example of an unregulated shadow banking institution that many believed posed a systemic risk.

Economist Nouriel Roubini has argued that market discipline, or free market incentives for depositors and investors to monitor banks to prevent excessive risk taking, breaks down when there is mania or bubble psychology inflating asset prices. People take excessive risks and ignore risk managers during these periods. Without proper regulation, the "law of the jungle" rules. Excessive financial innovation that is not controlled is "very risky." He stated: "Self-regulation is meaningless; it means no regulation."Roubini-Charlie Rose Interview

Former Chairman and CEO of Citigroup Chuck Prince said in July 2007: "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing."FT-Chuck Prince Interview

Market pressures to grow profits by taking increasing risks were significant throughout the boom period. The largest five investment banks (such as Bear Stearns and Lehman Brothers), were either taken over, liquidated, or converted to depository banks. These institutions had increased their leverage ratios, a measure of risk defined as the ratio of assets or debt to capital, significantly from 2003-2007.

Against regulating the shadow banking system

Banking regulations, some of the most restrictive of any industry, did not prevent banks from taking on significant risks, assuming high levels of leverage, or hiding certain obligations in off-balance sheet entities. Why then, should similar regulations that proved ineffective be extended to non-bank financial institutions? According to Peter J. Wallison of the American Enterprise Institute,"...the federal government had to commit several hundred billion dollars for a guarantee of Citigroup's assets, despite the fact that examiners from the Office of the Comptroller of the Currency (OCC) have been inside the bank full-time for years, supervising the operations of this giant institution under the broad powers granted by FDICIA to bank supervisors." He questions whether regulation is better than market discipline at preventing the failure of financial institutions, as follows: AEI-Regulation Without Reason

  • "The very existence of regulation—especially safety-and-soundness regulation—creates moral hazard and reduces market discipline. Market participants believe that if the government is looking over the shoulder of the regulated industry, it is able to control risk-taking, and lenders are thus less wary that regulated entities are assuming unusual or excessive risks.
  • Regulation creates anticompetitive economies of scale. The costs of regulation are more easily borne by large companies than by small ones. Moreover, large companies have the ability to influence regulators to adopt regulations that favor their operations over those of smaller competitors, particularly when regulations add costs that smaller companies cannot bear.
  • Regulation impairs innovation. Regulatory approvals necessary for new products or services delay implementation, give competitors an opportunity to imitate, and add costs to the process of developing new ways of doing business or new services.
  • Regulation adds costs to consumer products. These costs are frequently not worth the additional amount that consumers are required to pay.
  • Safety-and-soundness regulation in particular preserves weak managements and outdated business models, imposing long-term costs on society."

Market bubbles are not caused by failure of a free market to control manias — the market mechanism has been short-circuited by the Central Bank using its legal monopoly to create excessive amounts of new money. People seek to avoid the effects of inflation on their savings by investing in assets whose prices are being artificially increased. This aggravates the price rises, but this vicious cycle of phony capital gains eventually becomes unsustainable.

Levels of credit in the system can predict financial crisis

Source: Predicting Crises, Part I: Do Coming Crises Cast Their Shadows Before? Federal Reserve Bank of San Francisco, September, 2009

The ongoing financial crisis has been an extremely painful experience. The unemployment rate is up about 5 percentage points since the beginning of the recession and is widely expected to rise further. Real output has fallen by nearly 4% over the last four quarters, more than any previous four-quarter decline over the postwar period. This is not the first time that a financial crisis has had effects of this magnitude.

Among developed economies, the stock market crash of 1929 and the subsequent Great Depression is the first thing that comes to mind. The collapse of Japanese financial markets in the 1990s offers another example. One wonders if something could have been done to prevent these events or at least mitigate the losses.

The last public debate on this issue occurred after the collapse of technology stocks at the beginning of the decade. That debate was cast in terms of asset price bubbles. Many argued that monetary policy should not react directly to stock market bubbles because they are hard to detect. Moreover, even if correctly identified, bubbles can be difficult to deflate without imposing significant costs on the economy.

The implication is that, instead of leaning against a bubble while it was inflating, it would be better to clean up after it had burst. (There was general agreement, though, that policy should respond to the effects asset price movements have on key economic variables, such as output, employment, and prices.)

But the current crisis has prompted some to reconsider this view. “[O]bviously, the last decade has shown that bursting bubbles can be an extraordinarily dangerous and costly phenomenon for the economy, and there is no doubt that as we emerge from the financial crisis, we will all be looking at that issue and what can be done about it,” Federal Reserve Chairman Ben Bernanke said last year (Lahart 2008).

This Economic Letter takes up some of the issues related to the objection that bubbles are hard to identify, arguing that, while we may never be able to conclusively prove that a bubble exists, some simple indicators may provide evidence that the economy is facing heightened risk of a financial crisis.

The trouble with bubbles

Bubbles involve a departure of market values from fundamentals. Most economists would agree that they are not easy to detect. With equities, for example, it is hard to determine the fundamental value of a stock, let alone the value of the entire stock market. With fundamentals themselves hard to identify, trying to determine whether market values have departed from fundamentals is trickier still. But it is not clear that identifying bubbles is the key issue for policymakers. As Adrian and Shin (2008) point out, even if one were unable to say for certain that a bubble existed in real estate prices, for example, one might still answer yes if asked whether favorable credit conditions could reverse abruptly, with harmful effects on the economy. That is because we know more about how financial institutions react to changes in the market than we do about what the “fundamental” value of a house might be.

Others have pointed out that financial crises can occur even if no bubble exists. Bordo and Jeanne (2002) present a model in which an unexpected slowdown in the rate of productivity growth causes the value of business borrowers’ collateral to fall below what is required to cover outstanding debt. As a consequence, lenders try to reduce the amount of debt outstanding, leading to a financial crisis. Thus, the level of debt outstanding can play a role in determining whether a crisis occurs, and, more generally, in how the economy reacts to shocks (see Bernanke and Gertler 1989).

Two pre-crisis indicators

Unfortunately, it is no easier to determine the right level of debt for the economy than it is to determine whether an asset bubble exists. Instead, researchers have proposed measures that attempt to determine whether credit or other relevant assets are growing too fast or are departing markedly from some easy-to-define reference levels. The logic is that fundamentals tend to change slowly, so sharp movements in asset volumes or values are unlikely to be sustained.

Borio and Lowe (2002) have proposed a measure that builds on pioneering work by Kaminsky and Reinhart (1999). In a multicountry study, Kaminsky and Reinhart showed that it was possible to define thresholds for growth rates of money, credit, and several other variables such that growth above these levels was likely to be followed by a banking crisis. Borio and Lowe use a data set of 34 relatively wealthy countries, looking at three different measures based on asset prices, credit, and investment. They find that the measure based on credit—which they call a credit gap—is the best predictor of banking crises.

Figure 1, Credit gap measure

The credit gap is based on the level of credit instead of the growth rate, because Borio and Lowe believe that the level of credit can become unsustainable even in the absence of rapid growth: a not-so-rapid increase in the growth rate of credit, for example, may persist for too long. More specifically, the credit gap is defined as the difference between the current ratio of credit to GDP and a slowly changing measure of the trend value of this ratio. When using this measure, a key issue is determining when the gap has become “too large.”

For instance, if we were to use a credit gap of 5% as a threshold and announce that a financial crisis would occur over the next three years whenever this threshold was exceeded, the data sample used by Borio and Lowe suggests that we would be able to predict 74% of the crises that occurred subsequently. Lowering the threshold to 4% would increase the number of crises accurately forecast but would also increase the number of false predictions. Thus, determining what value to use as a threshold remains a matter of judgment.

Figure 1 plots the credit gap since 1980, using annual U.S. data starting in 1955. The credit gap’s value for 1985, for instance, represents the difference between the ratio of total nonfinancial-sector credit in the economy to GDP multiplied by 100 and the trend value of that ratio calculated using data from 1955 to 1985.

This credit gap measure has exceeded 5% every year since 2001, though its highest recent value occurred last year. The all-time peak occurred in the mid-1980s, when it stayed above 5% for three years. According to Adrian and Shin (2009), one of the three significant financial crises of the past quarter century occurred in 1987.

Bank capital requirements & leverage restrictions

Nondepository banks (e.g., investment banks and mortgage companies) are not subject to the same capital requirements (or leverage restrictions) as depository banks.

For example, the largest five investment banks were leveraged approximately 30:1 based on their 2007 financial statements, meaning that only a 3.33% decline in the value of their assets could make them insolvent as explained above.

Many investment banks had limited capital to offset declines in their holdings of mortgage backed securities (MBSs), or to support their side of credit default insurance contracts. Insurance companies such as AIG did not have sufficient capital to support the amounts they were insuring and were unable to post the required collateral as the crisis deepened.

For stronger bank capital/leverage restriction

Nobel prize winner Joseph Stiglitz has recommended that the USA adopt regulations restricting leverage, and preventing companies from becoming "too big to fail". Stigliz Recommendations

Alan Greenspan has called for banks to have a 14% capital ratio, rather than the historical 8-10%. Major U.S. banks had capital ratios of around 12% in December 2008 after the initial round of bailout funds. The minimum capital ratio is regulated. Greenspan-Banks Need More Capital

Greenspan also wrote in March 2009: "New regulatory challenges arise because of the recently proven fact that some financial institutions have become too big to fail as their failure would raise systemic concerns. This status gives them a highly market-distorting special competitive advantage in pricing their debt and equities. The solution is to have graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage." He estimated that another $850 billion will be required to properly capitalize major banks. Greenspan - We Need a Better Cushion Against Risk

Economist Raghuram Rajan has argued for regulations requiring "contingent capital." For example, financial institutions would be required to pay insurance premiums to the government during boom periods, in exchange for payments during a downturn. Alternatively, they would issue debt that converts to equity during downturns or when certain capital thresholds are met, both reducing their interest burden and expanding their capital base to enable lending. Cycle Proof Regulation

Economist Paul McCulley advocated "counter-cyclical regulatory policy to help modulate human nature." He cited the work of economist Hyman Minsky, who believed that human behavior is pro-cyclical, meaning it amplifies the extent of booms and busts. In other words, humans are momentum investors rather than value investors. Counter-cyclical policies would include increasing capital requirements during boom periods and reducing them during busts. McCulley PIMCO-The Shadow Banking System and Hyman Minsky's Journey-May 2009

Against bank capital/leverage restriction

Higher capital ratios or requirements mean banks cannot lend as much of their capital base, which increases interest rates and theoretically places downward pressure on economic growth relative to freer lending regulations.

During a boom (before the corresponding bust begins), even most economists are unable to distinguish the boom from a period of normal (but rapid) growth. Thus officials will be unwilling or politically unable to impose counter-cyclical policies during a boom. No one wants to take away the punch bowl just when the party is warming up.

Breaking up "too big to fail" institutions

Regulators and central bankers have argued that certain systemically-important institutions not be allowed to fail, due to concerns regarding widespread disruption of credit markets.

Thomas Hoenig, President/CEO of the Federal Reserve Bank of Kansas City, calls for a process of taking over financial firms that are failing letting them know they won't get a government guarantee. (Bloomberg News video running time = 1:30 minutes). March 6, 2009 speech by Federal Reserve Bank President Hoenig called "Too Big Has Failed".

For breaking-up large financial institutions

Economists Joseph Stiglitz and Simon Johnson have argued that institutions that are "too big to fail" should be broken up, perhaps by splitting them into smaller regional institutions. Dr. Stiglitz argued that big banks are more prone to taking excessive risks due to the availability of support by the federal government should their bets go bad. (WSJ-Economists Seek Breakup of Big Banks)

Various Wall Street special interests would likely be weakened if major financial institutions are broken-up or no longer allowed to make campaign contributions. Further, restrictions could be placed more easily on the "revolving door" of executives between investment banks and various government agencies or departments. (Simon Johnson-The Quiet Coup) Similar rules regarding conflicts of interest were placed on accounting firms and the corporations they audit as part of the Sarbanes-Oxley Act of 2002.

The Glass-Steagall Act was enacted after the Great Depression. It separated commercial banks and investment banks, in part to avoid potential conflicts of interest between the lending activities of the former and rating activities of the latter. Joseph Stiglitz criticized the repeal of key provisions of the Act. He called its repeal the "culmination of a $300 million lobbying effort by the banking and financial services industries...spearheaded in Congress by Senator Phil Gramm." He believes it contributed to this crisis because the risk-taking culture of investment banking dominated the more conservative commercial banking culture, leading to increased levels of risk-taking and leverage during the boom period. Stiglitz - Vanity Fair - Capitalist Fools

Against breaking-up large financial institutions

Some corporate customers may be inconvenienced by having to work with separate depository and investment banks, through the re-enactment of a law such as the Glass-Steagal Act.

Senior Supervisors Group recommendations

Source: Observations on Risk Management Practices During the Recent Market Turbulence Transmittal Letter from the Senior Supervisors Group to the Financial Stability Forum, March 6, 2008

"First, we will use the results of our review to support the efforts of the Basel Committee on Banking Supervision to strengthen the efficacy and robustness of the Basel II capital framework by:

• reviewing the framework to enhance the incentives for firms to develop more forward-looking approaches to risk measures (beyond capital measures) that fully incorporate expert judgment on exposures, limits, reserves, and capital; and

• ensuring that the framework sets sufficiently high standards for what constitutes risk transfer, increases capital charges for certain securitized assets and asset-backed commercial paper liquidity facilities, and provides sufficient scope for addressing implicit support and reputational risks.

Second, our observations support the need to strengthen the management of liquidity risk, and we will continue to work directly through the appropriate international forums (for example, the Basel Committee, International Organization of Securities Commissions, and the Joint Forum) on both planned and ongoing work in this regard.

Third, based on our shared observations from this review, individual national supervisors will review and strengthen, as appropriate, existing guidance on risk management practices, valuation practices, and the controls over both.

Fourth and finally, we will support efforts in the appropriate forums to address issues that may benefit from discussion among market participants, supervisors, and other key players (such as accountants). One such issue relates to the quality and timeliness of public disclosures made by financial services firms and the question whether improving disclosure practices would reduce uncertainty about the scale of potential losses associated with problematic exposures. Another may be to discuss the appropriate accounting and disclosure treatments of exposures to off-balance-sheet vehicles. A third may be to consider the challenges in managing incentive problems created by compensation practices."

EU plans three bodies to regulate finance

Three new pan-European supervisory agencies will draw up and help enforce a common rulebook for banks, insurers and securities markets under laws to be unveiled by the European Commission on Wednesday.

The plans for the long-awaited overhaul of the EU’s patchy system of financial supervision are expected to follow a two-tier approach first outlined in the De Larosière report in February and subsequently endorsed by heads of governments.

The circulation of the draft in Brussels has ignited a push by the European Commission to extract the broadest possible backing among member states for a new common set of rules.

“The Commission is walking a very tight line – and in the Council [among member states] it may find some opposition,” said Karel Lannoo, chief executive of the Centre for European Policy Studies, a Brussels-based think-tank.

The Commission, he pointed out, has traditionally been involved in regulation. “Now it is being involved indirectly in supervision.”

The proposals will include the creation of a new “European Systemic Risk Board”, made up of representatives of central banks and financial supervisory groups across the 27-country bloc, to track and analyse financial stability issues.

They will also propose the establishment of pan-EU supervisory bodies in the banking, insurance and securities areas, to augment day-to-day supervision by national authorities. The bodies will have more powers and resources than three existing EU committees, which now play only a co-ordinating role.

Final details of the legislation were still being hammered out on Monday but the new authorities were likely to be given the task of drawing up common rules in a wide range of financial services areas, from technical insurance standards to short-selling. Under the legislation, their rules would still have to be endorsed by the Commission before coming into effect but this could become a largely “rubber-stamping” exercise.

The principle of “fiscal responsibility” would be formally recognised in the legislation, meaning that the new supervisory structure should not intrude on states’ finances.

Bank of England recommendations for system stability

Source: Financial Stability Report, Bank of England, June 2009, pages 37-38

This section sets out five areas where the Bank believes change is needed, though it is by no means an exhaustive list of all reforms that are required. The Bank will continue to develop this thinking in future Reports and in speeches.

Stronger market discipline

  • Richer, more consistent and more timely disclosure, including intra-period data and more granular information on balance sheet risks;
  • Creating a credible threat of closure/wind-down for all financial firms; and
  • Risk-based, pre-funded deposit insurance.

Greater self-insurance

Financial institutions’ own resources should be the first line of defence against financial pressures and need strengthening (Section 3.2) through:

  • Larger, higher-quality capital buffers consisting of common equity;
  • Larger liquidity buffers comprising high-quality government bonds;
  • Realistic and tested contingent funding and capital plans;
  • Firms developing wind-down plans; and
  • More effective cross-border co-operation on crisis management

Reduce and monitor inconnectness

Improved management of risks arising from interactions among firms and with the real economy (Section 3.3) through:

  • Better information on connections between firms in the financial network;
  • Capital and liquidity buffers gauged to firms’ systemic importance;
  • More realistic stress testing that factors in feedback effects from firms’ responses to shocks;
  • Expansion of the use of central counterparties for the clearing of vanilla over-the-counter (OTC) instruments;
  • Strengthening the structure of critical markets, including through more trading on exchange or on similar platforms;
  • Use of countercyclical prudential policy in order to limit the growth of financial imbalances; and
  • Developing an international monetary system that limits the build-up of international imbalances.

Reduce "too big to fail"

Banks should not be too big or complex: The size and structure of the financial system needs to be compatible with maintaining financial stability (Section 3.4) through:

  • Simpler, more transparent legal structures that are capable of being supervised and resolved;
  • Potential changes to the structure or size of the banking system.

Clearly defined public backstops

Clear principles for public safety nets: Where self-protection fails, a safety net is needed that encourages prudent behaviour and contains risks to the public finances (Section 3.5) through:

  • Clear principles guiding the authorities’ interventions in financial markets; and
  • Principles for public sector provision of capital support.

All of these initiatives are designed to improve the resilience of the financial system as a whole, not just individual firms. This systemic perspective has perhaps not always shaped policy around the world sufficiently in the past. It needs appropriate weight and influence in decision-making going forward.

Taken together, these initiatives will mean additional costs for the financial system. But these must be weighed against the costs of financial instability, in terms of its adverse impact on public finances, on wealth and on economic growth. These measures are for the medium term and must not compromise economic recovery.

Financial Services Authority (FSA) new approaches

"... So the FSA, on behalf of society, must consider whether the financial services industry is delivering its vital services in an efficient and risk-controlled fashion. That does not mean we can define precisely how large the financial system should be. It doesn’t mean that we know how much trading and liquidity creation is optimal, nor that we can easily define some products as beneficial and others as harmful. But it does imply an important and profound shift in regulatory philosophy.

In the past, in the years running up to the crisis, it was the strong mindset of the FSA – shared with securities and prudential regulators and central banks across the world, it was almost part of our DNA – that we assumed that financial innovation was always beneficial, that more trading and more liquidity creation was always valuable, that ever more complex products were by definition beneficial because they completed more markets, allowing a more precise matching of instruments to investor demand for liquidity, risk and return combinations.

And that mindset did affect our approach – and the approach of the whole world regulatory community – to the setting of capital requirements on trading activity; it affected our willingness to demand risk reduction in the CDS market; and it influenced the degree to which we could even consider short-selling bans in conditions of exceptional market volatility.

We have had to change that mindset and we have now done so. And that has profound implications for the regulation and supervisory approaches which will be imposed at UK and global level.

The world’s financial regulators, led by the new International Financial Stability Board, will require the global banking system to be more prudent, operating with larger shock-absorbing buffers of capital and liquidity, and if as a result bank equity becomes a more boring investment – lower average return but lower risk – we should not regret that. After the last year, there’s a lot to be said for being boring.

And we will impose much higher capital requirements against many riskier trading activities, where the past approach was woefully inadequate, while recognising that market making in many core markets – such as FX or government bonds or equities – is both relatively low risk and an essential lubricant of a complex market economy.

We will have a bias to conservatism in our capital requirements for trading in complex and potentially risky products where the benefit to the economy is unclear. And if that means trading activity and liquidity in these specific markets shrinks, that too we should not regret.

And we are imposing at firm level a far more assertive style of supervision, no longer willing to assume that market discipline and incentives will always lead bank management to make optimal decisions; more willing to make judgements on whether business models and business strategies create undue risks for the whole financial system.

This reform programme amounts to a radical change in direction. But it poses for regulators the challenge of complexity, because it involves rejecting an intellectually elegant but also profoundly mistaken faith in ever perfect and self-equilibrating markets, ever rational human behaviours; but it leaves us with no equally simple alternative philosophy.

It is much easier to proceed in life on the assumption that either all markets are axiomatically good, or all speculation evil. The reality is more complex and requires us to make trade-offs and judgements. But there is no alternative to that complexity.

But if regulators need to change and face complex challenges, so too do bankers. And one of their biggest challenges is to regain public trust, to rebuild public understanding that banks and financial markets perform not only socially useful but vital functions, linking savers to productive investments, allocating capital to efficient use, lubricating the flows of capital and trade in a global economy which, for all its faults, is a better system than any available alternative for delivering prosperity in a free society."

Adair Turner, Chairman, FSA spoke to the British Bankers' Association annual conference on 30 June 2009 about new approaches to regulation.

A new supervisory approach

We are now involved to a much greater extent than a year ago in the granular analysis of balance sheets, accounting practices and valuation approaches.

  • We are analysing the maturity mismatches of banks with hugely increased intensity.
  • We are now willing to challenge business models and strategies, rather than rely on the assumption that if a bank has appropriate systems and procedures in place, and is operating within the defined capital rules, that its strategy is therefore acceptable.
  • We are now conducting interviews of key personnel – significant influence functions – to assess competence as well as simply probity.
  • And we have dramatically intensified our use of detailed stress tests to assess – looking forward over five years and using adverse economic parameters – whether banks or building societies can meet our capital adequacy standards, and if not whether they have convincing strategies for meeting possible shortfalls.

Radical change in regulation required

We need to get on with implementing the obviously required changes. But we must also use the various reviews as stimuli to further thinking, recognising that it is impossible for anyone to get all the answers right first time. The Turner Review and its associated Discussion Paper were intended to stimulate a major debate. We have now received responses from over 75 organisations and individuals, including of course a major and thoughtful response from the BBA, and we will be considering these over the summer. And debates with international colleagues, and observation of financial industry developments over the last six months, continue to suggest new ideas and approaches which were not considered in the initial review and Discussion Paper. Moreover the Bank of England, in its Financial Stability Review published last week, has put forward some ideas which my Review did not consider, but which may well be required parts of a sensible package of reform.

It is therefore quite possible that there are some specific recommendations of The Turner Review which in retrospect will look not quite right; and it is certain that further reflection will argue for changes not proposed in the initial review. The FSA’s next step will be to produce another document, responding to the feedback and fine tuning our proposals, in the autumn, while getting on with the detailed design and then implementation of the clearly essential reforms.

Clearly essential reforms

We need to run the banking system of the future with higher capital ratios, higher capital quality capital, and more loss absorbing equity. And the capital regimes which have been introduced in the course of the crisis – the UK’s Core Tier One 4% ratio and the US’ 4% Tier 1 Commons Capital - already require considerably higher capital levels then set out in past global agreements.

We also need to make capital to a degree countercyclical – with capital buffers built up in good times to be drawn down in bad times – and we need that approach to be reflected in some way in published accounts, with provision or reserve movements which reflect future possible losses. The Basel Committee is now working on the possible details of a countercyclical regime, and the International Accounting Standards Board (IASB) is committed to considering expected loss approaches to provisioning.

More capital, trading books concerns, reduce reliance on VAR, enhance liquidity

But for reasons which The Turner Review noted, and which were also noted last week in the Bank of England’s Financial Stability Review – both drawing on the insights of Modigliani and Miller – it is unclear whether significantly higher capital ratios do impose a long-term macroeconomic cost, even if they clearly have firm-level consequences, and even if any transition to significantly higher ratios would have to be gradually introduced to avoid harmful procyclical effects. We need to get on with immediate improvements to the capital adequacy regime, but also go back to fundamentals to design the best possible long-term system.

A similar balance between immediate action and long-term thinking is required in relation to the capital held against trading books, the area where the existing regime is most clearly and dramatically inadequate, but where the Basel II reforms left the VAR-based approaches, developed in the mid -1990s, almost entirely unchanged. Those VAR approaches are based on over-simplistic maths, they are procyclical, they fail to consider tail events or cross-system risks, and they allowed the explosion of balance sheets and of proprietary risk-taking by banks and shadow banks which played a major role in the origins of the crisis.

Capital requirements against trading books need to be significantly increased, and the already agreed Basel Committee changes, to be implemented by end 2010, will themselves produce a very significant change – increases of several times. But beyond those immediate fixes, as with the overall capital level, we need to go back to basics – looking at the different risk characteristics of different elements of the trading book, and thinking through appropriate approaches from first principles. Input from the industry to that long-term debate will be vital.

These changes in capital regime must be matched by major changes in the approach to the liquidity, another area where regulators across the world took their eye off the ball, amid all the complex debates over the Basel II banking book capital reform. The issue of how much this crisis was one of solvency or of liquidity will probably provide material for academic papers for many years to come. But it is certainly the case that the changed nature and scale of liquidity risks, changed patterns of maturity transformation, played a crucial role, and that the regulators failed to see the importance of the changes, and failed to develop either supervisory approaches or new rules to offset them. There was too much reliance on liquidity through marketability, including in off balance sheet vehicles –long-term contractual assets financed by a short-term debt. There was too much reliance on wholesale interbank funding, including in the UK case funding from abroad. In future we need larger buffers of undoubtedly liquid assets, primarily government bonds; and we need tighter controls of overall maturity mismatches. The FSA has already introduced major changes, and the Basel Committee is now working to agree new international approaches.

Three issues for further consideration:

  • 1. Too-big-to-fail

The first is resolution arrangements defined in advance which would make it possible to impose haircuts on at least some of the non-insured creditors of a large bank in failure. And there are certainly attractions in warning the non-insured creditors of even the largest banks that there is no certainty of bail-out in failure; and if a very large bank did fail idiosyncratically – i.e. failed when the rest of the system was stable – then such haircuts might in reality be applied. But if it is highly likely that the circumstances in which a very large bank gets into trouble are ones of systemic fragility, then it remains probable that the priority in large bank rescue will be to preserve systems’ stability, which is likely to mean keeping creditors whole.

A second option is simply to make banks smaller, to break them up, and that option should not be excluded from debate. But we might have to make banks very much smaller before we could really accept failure with equanimity. And we must not iconise small banks systems – the 1929-1933 bank failure wave in the US was one of multiple small banks falling like dominos. Finally it is unclear that absolute limits on bank size can be practically agreed at a European or global level.

The third option, and perhaps the best, is therefore simply to demand that larger banks have higher capital requirements, so as to reduce to extremely low levels the probability that they will ever fail; and to focus in particular on high levels of equity capital, since equity capital can be allowed to suffer loss without systemic danger, has indeed suffered losses in the present crisis, and would do so in any future resolution procedure. High equity capital levels are, I think, an answer to the moral hazard problem which also recognises systemic realities. Proposals put forward by US Treasury Secretary Tim Geithner include the possibility of higher capital requirements for what are labeled ‘Tier 1 financial holding companies’. The Basel Committee agenda, strongly supported by the FSA, now includes discussion of a potential capital surcharge for systemically important banks – where systemically important might be defined simply by size, but might also include considerations of interconnectedness.

  • 2. Too big and too cross-border to save

We can and certainly should intensify global supervisory cooperation as much as possible through the development of effective colleges of supervisors; but we must also be realistic about what any amount of intelligent cooperation can achieve. The more important response to the problem lies again I suspect in capital and liquidity requirements, but in this case looking not just at the group level but at the capital and liquidity residing in national entity balance sheets.

Measures of total bank liabilities as a percent of home country GDP can highlight the issue at the most general level, but they also gloss over an extremely important distinction between the liabilities of a bank’s overseas branches unmatched by ring-fenced assets (the Landsbanki case in the UK) and the position of those banks whose foreign operations are fully capitalised subsidiaries, with host supervisors looking not to the group and to the home country supervisor for assurances of sustainability but primarily to the local entity’s prudential standards. One possible way forward therefore is that across the world we will see an increasing focus on local legal entities, making large global banks essentially holding companies of stand-alone national banks, and perhaps making possible overt agreement that in conditions of failure there is no one country responsible for rescue but rather different nations responsible for rescue of the specific legal entities.

Such a system would tend to mean that large cross-border banks would have to hold even more capital than a capital surcharge regime would require from a too-big-to-fail but purely national bank. But if there are additional systemic risks arising from their cross-border operation that may be appropriate.

Australia's "twin peaks" approach

Source: Regulatory Issues Arising From the Financial Crisis for ASIC and for Investors and Financial Consumers Australian Securities and Investments Commission speech

"...Let me therefore expand on my answer on why ASIC is not in the position to prevent the failure of business models:

First a little history … the implementation of significant features of the Campbell Report by the Hawke-Keating Government had far reaching implications for the banking system in Australia, such as removal of interest rate and lending controls and the floating of the Australian dollar.

In 1996 the Wallis inquiry was set up to examine the deregulation which had followed the Campbell Report. The Wallis Inquiry produced a report that made a series of recommendations concerning the operation of the financial markets including what was to become known as the ‘twin peaks policy’. The Howard–Costello Government implemented significant aspects of this ‘twin peaks policy’.

The first peak, APRA, regulates ADI’s, important systemic institutions, which Government believe need to have their business models prudentially regulated.

The second peak, ASIC, regulates securities and investments. Let me say a little more on this second peak. Unlike intermediaries (banks and insurance companies)the policy (reflected in the Wallis Report) was that financial markets did not need prudential regulation.

As was said by commentators at the time, at the centre of the Wallis Report was the view that efficiency of the capital markets would be enhanced by the absence of capital backing regulation and these markets only needed disclosure and transparency and enforcement of proper market conduct for their operation (e.g. the development of the securitization markets is a good example of the working of that policy). They did not need prudential standards.

This policy behind this second peak is reflected in the Corporations Act and in ASIC’s role and powers. The US certainly applied this policy which economists, I think, call the Efficient Markets Theory.

Our Corporations Act is self-executing. That is, it is left to the market participants to comply with the law. Rules are around disclosure and preventing market abuse.

ASIC, unlike APRA, is an oversight and enforcement body. We are not a prudential authority.

Several things flow from this difference:

Inevitably ASIC will come in after a collapse has occurred. We are there, as an oversight body, to see if the law was complied with and, as such, we will arrive ‘at the scene of the accident’ (i.e. after the accident to see who caused it!).

Our powers to act ahead of time are limited. For example, we do not have power to regulate capital adequacy or to prohibit certain business models.

ASIC was simply not designed or equipped to regulate the financial markets to, for example, ensure capital adequacy. Indeed, the underpinning policy behind the legislation (Corporations Act) does not do that.

This is why the answer to the question of whether ASIC could have prevented these flawed business models is clearly ‘no’.

Now you will be thinking, we can probably accept that these collapses or near collapses are a feature of the current policy settings. Nevertheless, is ASIC enforcing market conduct and disclosure rules as intended or required to do by the Corporations Act? Could ASIC have done more to minimize the damage?

This brings me to my third point which is that while collapses or near collapses were essentially business model failures, ASIC is acting decisively in exercising its powers to regulate market conduct and improve disclosure and fulfilling its mandate on regulating market conduct and improving disclosure.

It is part of the work we are doing to rebuild and maintain confidence in the integrity of our markets.

Following a strategic review in 2007, ASIC set up 12 stakeholder teams (by and large based on industry groupings). The thinking behind this restructure is that it facilitates ASIC getting closer to the market to better understand the specific sectors. This in turn improves the ability of our teams to work with entities to identify potential issues early (the benefit translating into better consumer protection). Each stakeholder team is led at the Senior Executive Level and has around 30 front line staff supported by Shared Services staff across ASIC. Our real economy teams provide additional support (e.g. complaints and breach reporting).

Australian Prudential Regulation Authority's "Resilience reserves"

Source: The Australian, June 30, 2009

Also see the Letter to the Editor of the APRA to clarify several points in The Australian article.

"With governments worldwide weighing how to prevent a repeat of the subprime collapse that morphed into the global financial crisis, the Australian Prudential Regulation Authority (APRA) believes it is better placed than the Reserve Bank to regulate the growth of credit in the economy.

The prudential regulator wants banks to adopt the methods used in the life insurance industry to manage their "resilience reserves", which protect against adverse movements in asset markets.

APRA's views, set out in a speech by its general manager, David Lewis, last week, are that banks should be required to make provisions for losses that might occur throughout the life of a loan.

"A more forward-looking approach to reserving offers considerably more hope of better positioning bank balance sheets to cope with inevitable expansions and contractions in economic activity," Mr Lewis said.

He suggested this would take account of "macro-prudential" indicators in the same way that life insurers did with their resilience reserves.

These reserves are based on the sharemarket -- when markets are high, they must hold more in reserve.

In the case of banks, reserves would be based on a number of indicators, such as credit growth and sharemarket levels.

APRA's approach is directly contrary to the international financial reporting standards adopted in Australia four years ago. These expressly prevent banks from making forward-looking loan loss provisions.

Before IFRS, banks made specific provisions against loans that were not performing and general provisions against the possibility of future losses. However, the latter were seen to be penalising current shareholders for the benefit of future shareholders.

Under IFRS, banks can make provisions only against losses they are actually incurring. It is the role of their tier-one and tier-two capital levels to provide a buffer against unexpected losses. However, a number of international inquiries had established that this method of regulation meant that during the boom, banks ran down their provisions against loss. Capital ratios also declined during the boom.

While many have argued that central banks need to use monetary policy to puncture asset bubbles, raising interest rates at times of asset booms even when there is no inflation, Mr Lewis said the use of interest rates was a very "blunt instrument".

Mr Lewis said it was easier to deal with pro-cyclicality in the economy at the "micro-prudential" level -- controlling excessive credit growth on the balance sheet."

Stabilizers within financial markets

  • "Trading and clearing venues across Europe have agreed a set of standards to cover the electronic exchange of trade information between competing market infrastructures.

The Trading 2 Clearing (Trade2Clear) working group comprises representatives from Burgundy, Chi-X Europe, Equiduct, London Stock Exchange, Nasdaq OMX Europe and Turquoise, alongside clearers such as EMCF, EuroCCP, LCH.Clearnet, Monte Titoli and SIX x-clear.

The group, co-ordinated by financial messaging network Swift, has issued a set of market practice guidelines for creating standard links between exchanges and clearing houses. The network neutral proposals recommend the adoption of either Financial Information eXchange (FIX) or ISO 15022 syntaxes for the streamlined transportation of securities data between exchange venues and their preferred clearers." Source: Finextra, July 2, 2009


"...The plan also would create the Financial Services Oversight Council, chaired by the Treasury, to identify emerging risks in firms and market activities. But, Zubulake contends, creating an additional layer of bureaucracy to detect systemic risks is not the solution. "Promoting robust supervision sounds great, but they want to create another bureaucracy," he says.

What's missing from the plan, Zubulake argues, are details on what technologies the regulators will need to monitor the financial institutions. "To me the biggest type of problem is what type of technology is going to be used to gather the information -- again, no one is talking about how are they going to handle the job that they are going to be creating," he comments.

"They're developing a council to identify the systemic risks. In theory you would want to consolidate the regulatory agencies as a first step and to streamline them and get them on the same technology," Zubulake continues. "The issue is: How do you get a consolidated risk position for a regulator to observe, and how is that going to progress and how long is that going to take?"

For example, Zubulake says, the report lacks any specifics on systems that regulators would need to view OTC derivatives transactions along with positions in the listed markets. "You can have a large listed position that may look like you have huge risk, but you have an OTC position against it," he notes. "In reality you have no risk."

Under the plan, however, obtaining a consolidated view of risk is going to be a challenge as the administration is not proposing a merger of the two major financial markets regulatory agencies. According to the white paper released by the administration, the Securities and Exchange Commission, which regulates securities and equity options, and the Commodity Futures Trading Commission (CFTC), which oversees futures, would maintain their current responsibilities and authorities as market regulators..."

Paying for systemic regulation


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