II. FAILURE OF REGULATION AND
SUPERVISION
1
II. Failure of Regulation and Supervision
• Recurrence and severity of financial crises
• The 2007-09 financial crisis has a number of
lessons, many common to previous episodes
• No doubt there were market/private sector
failures; discussed in previous section
• But regulation is supposed to correct those
failures…also failed miserably!!!
• Monetary Policy also an important culprit
2
3
A Narrative of the crisis (cont.)
4
5
Immediate Causes of the Crisis
• Crisis was caused by an excessive expansion of
credit and a price bubble in the housing sector
• The expansion of credit/leverage happened
through the growth of secured lending and
structured products (not in M2!!!)
• Credit growth fuelled the housing price bubble,
leading to weak lending standards, and a large
misallocation of resources
Jorge Roldós
Causes of Crises
6
Causes of Crises
Jorge Roldós
7
Jorge Roldós
Causes of Crises
8
250
1000
900
200
Index or Interest Rate
700
150
600
Home Prices
500
100
400
Building Costs
300
Population
50
200
Interest Rates
0
1880
Population in Millions
800
1900
1920
1940
1960
1980
2000
100
0
2020
Year
Source: R. Shiller
Jorge Roldós
9
Deeper Fundamental Causes
• Why did this huge misallocation of resources
happen?
• Confluence of a number of forces/factors
• We organize the many causes into three
categories:
1. Monetary Policy Mistakes
2. Market/private sector failures
3. Regulatory Failures
Jorge Roldós
Causes of Crises
10
1. Monetary Policy Mistakes
• The crisis started after a period of low
macroeconomic volatility and very low interest
rates (dubbed the “Great Moderation”)
• Fed easing from 2001 until 2004 led to very low
short term interest rates (next chart)
• Low risk-premia (for both market and credit risk)
the so-called “connondrum” produced very low
longer term interest rates
• Prompted a “search for yield” by investors
worldwide
Jorge Roldós
Causes of Crises
11
Fed’s Easing Beyond Taylor Rule
Source: J. Taylor, 2007
Jorge Roldós
12
1. Monetary Policy Mistakes
• Difference between actual policy rates and “optimal” ones
is even larger if one adjusts for cyclically-low risk-premia
– Market risk
– Credit risk
• Emerging market central banks (especially Asia) reinforced
this by intervening in FX markets (to resist appreciation)
and accumulating large amount of int’l reserves
• Global imbalances also driven by U.S. financial system
intermediating needs of over-stimulated US consumers
and under-stimulated surplus countries’ consumers
Jorge Roldós
Causes of Crises
13
1. Monetary Policy Mistakes
• Monetary policy models ignored asset prices
[more in L-7]
• Difficulties diagnosing “bubble” [L-3], led to
policy of “cleaning-after-the-fact”
• Reinforced by “Greenspan put” (an implicit
“floor” for asset prices), an invitation not to
store enough liquidity for bad times (moral
hazard)
Jorge Roldós
14
2. Market/Private Sector Failures
• We can classify the main market/private sector
failures into three main classes:
a. Incentive problems (a result of imperfect
information/contracts)
b. Incomplete markets (say, for “liquidity” in some states
of the world, shorting housing)
c. Herding, coordination problems, and externalities
• Perfect financial markets would correct some of
these failures; regulation should take care of
others
Jorge Roldós
Causes of Crises
15
2a. Incentive problems (1)
• A number of incentive problems were created by
the shift in the financial system to an “originateto-distribute” (O2D) model
• Securitization segments the credit process, with
the originator of the loans selling them to an
arranger, who repackages them into securities
assessed by rating agencies
• “Distance” from investor to debtor, and lack of
transparency in some of the stages, weakens
ability to evaluate/monitor creditworthiness
Jorge Roldós
Causes of Crises
16
2a. Incentive problems (2)
• Rating agencies are paid for by issuer: incentive
to do “ratings shopping”
• Weaker lending standards also related to use of
credit scoring models (reliance only on a few
indicators, no “soft/character” information)
• Agency problems (shareholders versus
managers/traders/bankers) were aggravated by
compensation systems: one-sided bonuses linked
to short-term returns
Jorge Roldós
Causes of Crises
17
2a. Incentive problems (3)
• Product complexity and the associated lack of
transparency impeded market and regulatory
discipline on the financial system
• Excessive leverage magnified the above
incentive problems, with FIs engineering and
undertaking a large amount of “tail risk”
• The fact that they kept a large share of that
risk—directly or indirectly—on their balance
sheets is a sign that they expected a (too-bigto-fail, TBTF) bailout (moral hazard)
Jorge Roldós
18
2a. Incentive problems (4)
• Fannie Mae and Freddie Mac were privatelyowned companies with a public-policy objective
• When asked to increase their share of lowincome house-finance, bought subprime-ABS
– Some estimate that, adding the FHA, gov’t mandated
loans amount to almost 2/3 of all junk mortgages
• Some pension funds and foreign banks based
their investment decisions purely on ratings,
with out further due diligence
Jorge Roldós
Causes of Crises
19
2.b Incomplete Markets
• When short-term creditors do not roll-over funds (“run” on
the FI), or require higher margins, FIs have to raise funds
when markets are closed to them
• In other words, markets for liquidity insurance in “bad times”
are non-existent
• Fire-sale externalities can be damaging to FI balance sheets
• Counterparty or network externalities
• Few opportunities to short housing market means prices
have tendency to rise excessively (bubbles? [L-3])
• Limits to arbitrage could lead to persistent mispricing of
assets (bubbles?)
Jorge Roldós
Causes of Crises
20
Bottom line:
• Financial institutions and markets are supposed
to correct/control information problems
• Since they are likely to be unable to correct all
incentive problems and externalities, there is a
role for regulation
• But regulation may also fail—and may even
aggravate some of the incentive problems it is
meant to solve
Jorge Roldós
Causes of Crises
21
3. Regulatory Failure
• Regulations failed for a number of reasons:
1. Lack of resources to understand LCFI strategies
and incentive problems, to extend regulation to all
relevant parties, and to enforce the existing ones
2. Regulatory “capture” by the industry or politicians
3. Regulatory mistakes or gaps
• Examples from the 2007-09 crisis:
Jorge Roldós
Causes of Crises
22
3.a Lack of regulatory resources
• The regulatory “perimeter” (L-8) in the U.S. was
restricted, in part because of lack of resources, in
part because of underestimation of linkages
– Some states did not license mortgage brokers, much less
monitor their behavior
– Finance companies largely unregulated
• The complexity of products and business strategies
could not be understood by a few regulators
checking the balance sheets of LCFIs
– Explicit recognition of head of the OCC
Jorge Roldós
23
3.a Lack of regulatory resources
• 1992 legislation allowed Fannie&Freddie to
hold less capital than other FIs
• Also determined that their new regulator, an
office within HUD with little financial sector
experience, was subject to congressional
appropriation
Jorge Roldós
Causes of Crises
25
3.b Regulatory “capture”
• LCFIs lobbied U.S. authorities to repeal GlassSteagall Act, allowing commercial banks into
investment banking activities
• Investment banks lobbied the SEC to have a
voluntary “net-capital” rule, using own risk models;
allowed for unrestricted leverage
• Fannie&Freddie mandate to fund low-income
mortgages expanded during Clinton (“Affordable
Housing”) and Bush (“Ownership Society”)
administrations
Jorge Roldós
Causes of Crises
26
3.c Regulatory gaps/mistakes
• Basel rules allowed for regulatory arbitrage
between the banking and trading books, using
guarantees or reducing RWA (L-2)
• A number of explicit and implicit guarantees
were underpriced
– Deposit insurance
– Too-big-to-fail
• Lack of an orderly resolution mechanism for
LCFI and other non-bank FIs
Jorge Roldós
Causes of Crises
27
3. c Regulatory gaps/mistakes
• Lack of regulation on liquidity mismatches (L-2/3)
• OTC derivatives markets were allowed to grow
without transparency or central clearing
• Regulation focused on individual institutions
rather than on systemic risk contribution [L-6]
• Regulators did not internalize that risk-taking is
endogenous
Jorge Roldós
Causes of Crises
28
Deeper “Fault Lines” (R. Rajan)
• Political-economy arguments: facilitate credit
to buy houses when politicians cannot solve
problem of stagnant middle-class
• Intersection of politics and finance: although
some housing subsidies are OK, when you give
a “wall of money” to financiers…
• Global imbalances are a result of
overconsumption/financial deepening in US,
opposite in surplus countries
Jorge Roldós
Causes of Crises
29
III. SYSTEMIC RISK REQUIRES NEW
INSTRUMENTS AND INSTITUTIONS
Jorge Roldós
30
III. Systemic Risk Requires New
Instruments and Institutions
• Improvement in Supervision and Regulation
(Sup&Reg) framework requires a definition of
macro-prudential policies and systemic risk
• More fundamental diagnosis of Sup&Reg failures
suggest new, improved instruments
• Central issue: regulation has to focus on system
(macro-pru), not just institutions alone (micro-pru)
• Sup&Reg framework also requires new institutional
arrangements
31
A. Definition and Objectives
• The objective of macro-prudential policy is to
promote financial stability by limiting systemic
risk
• Financial stability means a stable provision of
financial intermediation services, i.e. a stable
supply and cost of credit, insurance, others
• Realistic: cannot expect to eliminate credit
cycles and/or target asset prices
Systemic Risk
• Systemic risk can be defined as “the risk of
disruption to financial services that is caused by
an impairment of all or parts of the financial
system and has the potential to have serious
negative consequences for the real economy”
(FSB, IMF, BIS, 2009)
• The sources of systemic risk are basically the
ones that we identified as causes of the current
crisis in the previous section (also BoE, 2009)
B. Macro-Prudential Instruments
• Micro-Prudential regulation based on deposit
insurance (DI) and capital regulation [L-2]
• Goal: internalize losses on bank assets to
minimize moral hazard and protect DI fund
• Key element: prompt-corrective-action (PCA)
to restore capital adequacy ratio (CAR)
• Next we provide two examples of why this
framework proved inadequate in last crisis
34
An example from Morris and Shin
(2008)
• Bank 2 in the next Figure is a very safe bank by
Basel I-II standards:
1. Assets are reverse repos, collateralized
2. Liabilities (repos) are matched with assets
• Bank 2 could increase its leverage beyond 30X
• However, Bank’s 2 assets are systemically
important, because they mirror Bank 1 liabilities
An example from Morris and Shin
(2008)
An example from Morris and Shin
(2008)
• If Bank 2 does not rollover reverse repo with
Bank 1 (a prudent policy for B2), and B1 assets
are illiquid, then B2’s prudent decision is like a
run on B1 and causes a fire-sale of assets
• Bank 2 assets are safe (requiring low CAR
under Basel for the individual bank) but are
systemically important: they should NOT have
a low risk weight
An example from Morris and Shin
(2008)
• This example shows the importance of
interconnectedness of the different Financial
Intermediaries (FI), not just banks, in the system
• One tool to identify this interconnectedness is the
network approach (to be discussed in L-4 and W-1
of the course)
• Another approach is through the measurement of
Co-VaR, co-movement of bank portfolio returns
whenever another bank is under stress (a “tail risk”
event, L-5 and W-2)
38
An example from Hanson, Kashyap,
and Stein (2011)
• Financial intermediaries (FI) amplify or
magnify business cycles
• In the boom phase, asset values increase and
so does equity (by a multiple), inducing procyclical behavior (as in the FA + Firesales)
• Pro-cyclicality means borrowing more to take
advantage of the higher value of assets (or
quality of loans): the endogenous response of
risk-taking is important
increase in
value of
securities
assets
equity
debt
initial
balance sheet
assets
increase in
equity
equity
debt
Final balance
sheet
assets
equity
debt
After q shock
new purchase new borrowing
of securities
An example from Hanson, Kashyap,
and Stein (2011)
• Hanson, Kashyap, and Stein (HKS, 2011) argue that
the problem is not just with capital adequacy ratios
(CAR) at the individual level per se
=
CAR
Equity
=
Assets
E
A
• The problem with the micro-prudential approach is
with prompt corrective action (PCA): regulator does
not care whether bank adjusts via the numerator
(raise equity) or the denominator (lower assets)
An example from Hanson, Kashyap,
and Stein (2011)
• If bank adjusts by shrinking assets, causes firesale and/or reduction in lending to real economy
• Macro-prudential sup&reg objective then is to
minimize the social costs of balance-sheet
shrinkage (“fire sales” and “credit crunches”)
• This alternative theory of regulation does not
rely on the existence of deposit insurance and
suggests it has to be applied to more than just
deposit-taking institutions
A Set of Macro-prudential Tools
• In line with their proposal to focus the
regulatory system in restricting socially
excessive balance-sheet shrinkage, HKS(2011)
discuss six sets of tools that can be useful:
1. Time-varying capital requirements (in L-3)
 Higher (lower) in good (bad) times
 Exceed the market-imposed standard in bad times
2. Higher-quality capital (in L-2)
 Common equity better than preferred stock
A Set of Macro-prudential Tools
3. PCA targeted at dollars of capital (not CAR)
 Relative to lagged assets
 As in the U.S. Supervisory Capital Assessment Program
4. Contingent Capital (in L-2)
 Contingent Convertibles
 Capital Insurance
 Economize on equity, requires regulatory “blessing”
A Set of Macro-prudential Tools
5. Regulation of Debt Maturity and Asset Liquidity (L-2)
 Limit runs
 Contain fire-sale externality
6. Regulation of the Shadow Banking System (in L-8)
 Collapse of ABS market very damaging in this crisis
 Any institution that acquires ABS and funds them with
short-term debt
 Avoid “margin spirals”
 Impose similar capital requirement on a type of credit
exposure/asset (Geanakoplos, 2010)
Other Macro-Prudential Instruments
• There are a number of other macro-prudential
instruments to be adopted
– In the time dimension (in L-3)
– In the cross-section dimension (in L-4, L-5)
• Also a number of different taxonomies (by BIS,
IMF, others)
• We will discuss issues related to the effectiveness
of some of these instruments, which have been
already used in many EMs
Cross-border Bank Resolution
• Problem: LCFI operate globally but resolution
regimes are guided by local legal framework
• “Living wills” would be very useful tool
• IMF recently proposed a framework of
“enhanced coordination” to deal with problem
• Ideally countries with major financial centers
would agree to the enhanced framework in
the near future (in L-6)
C. Framework for Macro-Prudential
Regulation and Supervision
• Macro-Prudential Sup&Reg is much harder in
practice than in principle
• If somebody has to do it, is central banks
• This may complicate monetary policy and
require broader objectives; models (in L-7)
• Different countries are setting up different
institutional “architectures” to carry out this
important function (in L-6)
Framework for Macro-Prudential
Regulation and Supervision
• U.S. and E.U. have already established their
systems, led by a “Financial Stability Oversight
Council” (FSOC) and the “European Systemic
Risk Board” (ESRB); others in EMs
• Both gather main regulators/supervisors with
central bank officials
• In case of U.S., Office of Financial Research
(OFR) has authority to request info from FI
AThe
E.U. new financial architecture
ESRB in charge of macro-prudential policy recommendations
Macro-prudential oversight
Micro-prudential supervision
European Systemic Risk Board
European System
of Financial Supervision
ECB
National
central banks
European
Supervisory
Authorities
European
Commission
National
Supervisors
(non-voting)
Representative
of EU finance
ministries
(non-voting)
European Banking Authority
European Insurance and Occupational
Pensions Authority
European Securities
and Markets Authority
National supervisors
(including supervisory colleges)
Risk warnings
EU-wide technical supervisory standards
Macro-prudential recommendations
Coordination of supervisors (also in crises)
51
Rules versus Discretion
• Rules are desirable, especially to provide
support in application during upswing and visà-vis powerful LCFI
• However, constrained discretion is probably
the maximum one will be able to achieve
• To be successful, will need to be transparent
and accountable
Final Thoughts
• Transparency can go a long way towards
reducing systemic risk
• Tightening of micro-prudential is likely to push
activities to non-bank financial intermediaries:
macro-prudential policy needs flexibility and
authority to regulate and supervise them
• International harmonization and cooperation
(including info sharing) are critical
Thank you