Regulatory Reform following the
crisis
Too big to regulate?
• Nations cannot – the US aside perhaps –
regulate the banks.
• If the UK tried alone and a major bank said
OK, we leave the UK, the consequences for
the UK would be severe.
• Regulation either has to be international as
with the Basel series of standards, or by an
authority even bigger than the banks (the
EU?) laying down the law.
Basel III
• Basel I and Basel II set out rules and guidelines
for banks to follow, e.g. Capital ratios.
• These were theoretically voluntarily, but most
banks really have to follow them.
• But Basel II was inadequate to the task and
hence we now have Basel III
Basel III
Basel III provides for
• higher minimum capital requirements,
• better risk capture (i.e. to do a better job in
evaluating the risk of assets such as mortgage
backed securities,
• a stricter definition of eligible capital elements
with a particular focus on common shares
• greater transparency.
• The Basel III rules will be transposed into
national or European law
Basel III
• By 1 January 2015, the minimum capital
requirements for common equity Tier 1 and total
Tier 1 capital will gradually be raised up to a level of
4.5% and 6.0% of their risk bearing assets,
respectively.
• Note in some countries such as Sweden these
requirements are much tougher.
• Tier 1 capital is the core measure of a bank’s
financial position. It is composed of core capital
(e.g. common stock and reserves)
• tier 2 capital is composed of less core capital
Tier 2 Capital: examples:
• A revaluation reserve is a reserve created
when a company has an asset revalued (e.g.
Land bought 20 years ago, revalued at today’s
price).
• Provision for anticipated future losses which
have not yet occurred.
Different to the reserve ratios you
have met before.
• These capital requirements are totally
different from the reserve requirements a
central bank requires commercial banks must
hold of cash and deposits with the central
bank with respect to its lending.
Basel III also specifies
• Systemically important financial institutions
should have additional loss absorbing capacity
• i.e. financial institutions which if they go bust
will have substantial repercussions on the
financial system must have higher reserves.
• Work is currently underway on how to define
institutions that are ‘systemically important’,
and the appropriate capital surcharges, etc to
limit systemic problems.
Revising economics
• In the crisis risks in market returns were not
mainly exogenous, coming e.g. from the
stochastic variation in the real economy.
• They came from financial risk itself. The
financial structures that were thought to
assess, absorb and neutralise risk – they did
not.
Revising economics
• Key factors in creating this risk were opaque financial
structures, particular vulnerability to contagion and
domino effects, and pro-cyclicality in financial
markets.
• The role of distortions in economic incentives is fairly
well known even within neo-classical economics.
• But herd behaviour as a driver of pro-cyclical patterns
in financial markets still needs a thorough
explanation and integration into economic theories.
Two possible explanations for ‘herd
behaviour’:
1. the significance of a market player’s evaluation of his or her
performance relative to the rest of the market. Market
participants do not form their own opinions, but follow the
general mood prevailing among market participants.
Everybody seeks to follow general sentiment, hoping to
anticipate turning points in sentiment.
2. Global markets are in fact less atomistic (many small players,
none with influence) than thought. Hence one or two key
players can have substantial influence. For example,
derivatives activity in the US banking system is dominated by
a small group of large institutions. And the market for credit
ratings is dominated by three firms. Similar, copycat,
behaviour is much more likely than would be the case with
atomistic markets (i.e. Many players).
New Directions
• In general work is underway to incorporate into
economics new ideas and approaches including
insights from physics and biology which do not
necessarily rely only on the notions of
equilibrium, universal rationality and efficiency
which underlies much of economics.
• Could this be the beginning of the economics
revolution many are anticipating in the light of
the crisis?
Back to regulation: Macro-prudential
oversight
• As we have seen, major risks can emerge from
within the financial system itself. Endogenous
risks – risks that emerge from within the financial
sector – can have many causes.
• They may arise, for example, because large parts
of the system rely on the same sources of
funding, or because they have similar exposures –
to rising financial imbalances, to currency
mismatches and to widespread mis-pricing of
risk.
The European Systemic Risk Board
• For these reasons, we need a new framework
of macroprudential supervision e.g. The new
Financial Stability Oversight Council in the US
and the ESRB, the European Systemic Risk
Board:
http://www.esrb.europa.eu/home/html/index
.en.html
The ESRB (founded in December 2010)
• “shall contribute to the smooth functioning of
the internal market and thereby ensure a
sustainable contribution of the financial sector
to economic growth.”
The ESRB will do this by:
• identifying and prioritising systemic risks;
• issuing warnings where such systemic risks are deemed
to be significant and, where appropriate, make those
warnings public;
• issuing recommendations for remedial action in
response to the risks identified and, where appropriate,
making those recommendations public.
• In this way it is trying to anticipate future problems in
the financial system, much more than was previously
the case.
• In doing this it will co-operate with other European and
international agencies (e.g. The IMF and the newly
created Financial Stability Board, FSB).
The FSB
• The FSB has been established to coordinate at the
international level the work of national financial
authorities and international standard setting bodies
and to develop and promote the implementation of
effective regulatory, supervisory and other financial
sector policies
• It was established in April 2009 as the successor to the
Financial Stability Forum (FSF).
• Following the crisis, as announced in the G20 Leaders
Summit of April 2009, an expanded FSF was reestablished as the Financial Stability Board with a
broadened mandate to promote financial stability.
The FSB’s mandate
• Assess vulnerabilities affecting the financial system
and identify and oversee action needed to address
them;
• promote co-ordination and information exchange
among authorities responsible for financial stability;
• monitor and advise on market developments and
their implications for regulatory policy;
• manage contingency planning for cross-border crisis
management, particularly with respect to
systemically important firms; and
• collaborate with the IMF to conduct Early Warning
Exercises.
Apart from the ESRB:
• Three pan-European micro-prudential
supervisory authorities have been
• the European Banking Authority (EBA),
• the European Securities Markets Authority
(ESMA)
• the European Insurance and Occupational
Pensions Authority (EIOPA).
• Regulation is back in fashion
Foresight
• The foresight activities of these bodies are
important and supervision needs to keep pace with
a changing environment
• The world is continually changing and the
authorities will need new regulatory instruments to
keep pace with the impact of new technologies –
including high frequency trading, algorithmic
trading and the new universal trading platforms
• that is today, but then there is tomorrow.
In the shadows
• But there is a risk that in regulating part of the
financial system, agents are pushed into other parts
– the shadow banking sector, which is less
regulated.
• The activities in the shadow banking sector and the
over-the-counter business have contributed
tremendously to the creation of uncertainties and
opaque transmission channels for risks.
• Therefore, a central goal for any future regulatory
action should the improvement of market
transparency.
• The crisis has shown that the exclusive focus on
banks has proven insufficient as contagion has
also occurred across different types of financial
intermediaries, such as insurance companies and
money market funds.
• Therefore, looking forward it will be crucial that
the cross border cooperation between authorities
be further strengthened. In this respect the work
of the newly created European Supervisory
Authorities will be key.
In the UK
• Prudential Regulation Authority
• The Government is creating a new Prudential
Regulation Authority (PRA) as a subsidiary of
the Bank of England (the Bank) to conduct
prudential regulation of sectors such as
deposit-takers, insurers and investment banks.
• The PRA will be chaired by the Governor of
the Bank (of England).
And.......
• In addition to the PRA, there will be a new
Consumer Protection and Markets Authority
(CPMA), separate from the Bank, to regulate
the conduct of all financial firms, including
those prudentially regulated by the PRA.
And................
• Financial Policy Committee
• A Financial Policy Committee (FPC) in the Bank,
which will be placed in charge of macroprudential
regulation.
• It will have responsibility to look across the
economy at macroeconomic and financial issues
that may threaten stability and will be given tools to
address the risks it identifies.
• It will have the power to require the new PRA to
implement its decisions by taking regulatory action
with respect to all firms.
The Financial Stability Report
• http://www.bankofengland.co.uk/publications/fsr/i
ndex.htm
• The Financial Stability Report is published halfyearly by Bank staff under the guidance of the
Bank’s Financial Stability Executive Board.
• It aims to identify the major risks to UK financial
stability and to stimulate debate on policies needed
to manage and prepare for these risks.
Thus the response to the crisis
• The beginnings of a revolution in economic theory
which help us understand the financial system and
its links with the real economy.
• Greater regulation of the banks at national and
international levels with stronger capital
requirements
• A particular focus on large institutions who pose a
particularly severe problem of systemic risk
• An emphasis on foresight
• All accompanied by the creating of a whole host of
new institutions at national and international level.
Will it work?
• Yes
• For a time, but eventually the memory will fade.
Politicians and bankers, journalists and
academics (some) will forget the lessons of
2008, just as we forgot those of 2009.
• Then, say in another 30 years time crisis will hit
us again.
Financial crises are not new
• During the early Roman Empire substantial revenues
allowed the state was able to undertake a substantial
public works.
• A new emperor, Tiberius, cut back on the building
program and hoarded large sums of cash.
• This led to a financial crisis in 33 A.D. A severe shortage
of money. and the reduction of state expenditures led
to a sharp downturn in economic activity.
• Zero interest rates once more saved the day, with the
state making large loans in order to provide liquidity
The Glass–Steagall Act
• The Banking Act of 1933 established introduced
banking reforms in the US, which in part were
introduced to control speculation.
• The Depository Institutions Deregulation and Monetary
Control Act of 1980 repealed part of lass Steagel
• The Gramm-Leach-Bliley Act of 1999 repealed
provisions that prohibited a bank from owning other
financial companies.
• This effectively removed the separation that previously
existed between Wall Street investment banks and
deposit banks.
• This was a factor in the severity of the crisis