The Fundamental Principles of Financial
Regulation
Geneva Report
by
Brunnermeier, Crockett, Goodhart, Persaud and Shin
1
Background
• We have observed a cycle of financial leverage and then
deleveraging (asset price bubble and bust)
• We argue that
– The regulatory framework of Basel II and IFRS amplified this
cycle, producing ‘procyclicality on stilts’.
– This occurred because Basel regulation is too focussed on
micro-prudential oversight: improving the condition of the
individual bank
– It is a fallacy of composition to believe that, if each individual
institution behaves ‘prudently’, the system as a whole will be
safe.
2
Endogenous risk
Indeed most systemic crises arise because of the
responses of the banks, and other financial
intermediaries, to exogenous shocks, not just from such
latter shocks.
Two main such self-amplifying mechanisms are the loss
spiral and the margin spiral.
3
4
Repo Haircuts
Securities
U.S. treasuries
Investment-grade bonds
High-yield bonds
Equities
Senior leveraged loans
Mezzanine leveraged loans
Prime MBS
ABS
April-07 August-08
0.25
3
0–3
8–12
10–15
25–40
15
20
10–12
15–20
18–25
35+
2–4
10–20
3–5
50–60
Source: IMF GFSR
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Capital requirements for systemic risk
Our theme is that the Basel approach (Basel I and II)
has focussed excessively on the risks of individual
banks;
•
•
Micro-prudential rather than macro-prudential
Valuable but insufficient.
Measures of systemic cyclical variation:1) Leverage (FDICIA; SNB)
2) Credit expansion (Banco de Espana)
3) Maturity Mismatch
We suggest all three.
6
Applying capital requirements for
systemic risk
How applied :• Provisions (Spain)
• Separately to capital (FDICIA; SNB)
• Interactive with Basel II (US) (Helps to avoid ‘gaming’)
But which Basel ratio?
• Details and coefficients to be estimated.
• Absolute need for precommitment/rule, and graduated
ladder of responses.
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To whom should such capital
requirements apply?
Taxonomy
(a)
Individually systemic (identify in advance, if possible)
(b)
‘Systemic as part of a herd’
(c)
Non-systemic, but large
(d)
Tinies
Main problem is (b), largely hedge funds. Macro-prudential,
but also micro-prudential?
Home/host issues: Cycles differ from country to country. Also
cross-border banks are “international in life, but national in
death”.
8
Liquidity
Financial risk arises from a combination of asset price
volatility and maturity mismatch.
Both the asset and liability structure are crucial.
Crisis arose from excessive confidence in continued ability
to fund, or roll-over, in short-term wholesale financial
markets.
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Proposed liquidity regulation
• Need for liquidity regulation based on maturity mismatch, enforced by explicit capital charges
• Proposal on ‘Mark to Funding’
• The ability to hold to maturity depends on funding
structure
• Problem: incentives to finance potentially illiquid assets
on the basis of short-term debt, both in good and bad
times
• We need to counter-balance that
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Other regulatory issues
(a) Remuneration
Supervisor should set higher capital charges for
more risk-promoting remuneration schemes
(b) Loan-to-Value Ratios in Mortgages
(c) Credit Rating Agencies
(d) Year-end Spikes
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The structure of regulation
We advocate enhancing macro-prudential regulatory requirements to
support and to accompany existing Basel micro-prudential
requirements.
The two involve a different ethos and professionalism:• Macro-prudential
Central Bank
• Micro-prudential
FSA
Cross-border, home/host issues
• Cycles differ between countries
• Common Principles, differing application
Europe?
FSF
Problems
(1) Democratic legitimacy
(2) G7 representation
(3) Warning procedure
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