Building a More Resilient Financial System:
Reforms in the Wake of the Global Crisis
Jonathan Fiechter
İnci Ötker-Robe
Ceyla Pazarbasioglu
Jay Surti
FPD Chief Economist Talk
The World Bank
May 15, 2012
Outline
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Brief background
Policy response to fix the system
Views on the reform proposals
Taking stock
Looking ahead
Conclusions
2
Global crisis exposed the existing cracks in the
financial architecture
Pre-Crisis global financial system was characterized by:
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Highly complex/interconnected financial systems in advanced
countries
Overleveraged financial institutions
Reliance on short-term wholesale funding
Incentives that encouraged excessive risk taking
Poor risk management practices
Inadequate regulation/supervision (individual/systemic level)
Insufficiently wide regulatory perimeter
Poor transparency/disclosure requirements
Lack of effective resolution regimes & infrastructure to deal with
failures of complex, interconnected institutions
3
How to Fix the System
Make failures (1) less likely & (2) less costly/messy
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Reduce incentives that encourage excessive risk taking
Tighten regulation (Basel 2.5, 3, SIFI framework)
Better supervision
Widen the regulatory/monitoring perimeter to cover shadow banks
Address data/information gaps to facilitate market
discipline/supervision
Establish effective resolution regimes (domestic and cross border)
Infrastructure to deal w/ interconnected, complex, TBTF institutions
Focus on systemic risk and macro-prudential policies
4
Impact of the reforms on the industry

Private sector ownership of the reforms key to successful
implementation

Business models and practices need to be aligned with
the new financial structure

But financial institutions will adjust business strategies
in response to tighter prudential requirements

Analyze the impact of regulatory reforms for ~60 LCFIs
◦ Basel 3 capital rules (higher and better quality capital)
◦ Liquidity requirements (NSFR—LT stable funding )
5
Capital requirements: Greater effect on investment &
universal banks
12
10
Core Tier 1 Ratio 2009
Basel III Core Ratio, 2012
8.8%
8
7.9%
7.1%
9.9%
2.9%
2%
6.8%
(1.9% RWA effect)
7%
6
4
2
0
Commercial Banks
Universal Banks
Investment Banks
6
NSFR: Greater effect on investment and
universal banks
180
Basel 3 requirement: NSFR ≧ 100 %
160
140
120
100
80
60
40
20
0
Commercial
Universal
‹15›
Investment
7
Ultimate impact will depend on how banks will adjust
• Basel 3 rules likely to affect investment and universal banks more
• Also targeted by other measures (derivatives and securitization measures;
SIFI measures, Volcker rule, other scope measures)
• But these banks have more flexible business models  adjust strategies to
mitigate the impact:


Some activities may shift to the unregulated shadow banking sector
Some businesses may move to less tightly regulated locations/sectors

Policy challenge: ensure adj’s in business models don’t generate systemic
risks through these shifts

Safeguards: - effective supervision
- supervisory/regulatory coordination
- extended regulation to nonbanking sector
- enhanced transparency/disclosure
8
Health of Financial Institutions Depends on
Many Factors:
Internal
Governance &
Risk
Management
Economic &
Market
Conditions
Market
Confidence/
Discipline
Financial
Sector
Performance
SUPERVISION
and
Regulation
9
Regulations Require Effective Supervision – But
Supervision was Inconsistent (pre-crisis):
Was not proactive in
dealing with emerging risks
Did not sufficiently
question business activities
of regulated institutions
In some cases,
supervision:
Did not keep up with the
changing business
environment
Did not follow through –
lacked skepticism
10
Main deficiencies reflected in FSAPs –
areas of lowest compliance globally
Banking Supervision
Insurance Supervision
Securities Regulation
Consolidated Supervision
Corporate Governance
Operational Independence
and Accountability
Country and Market Risk
Supervisory Authority
(Independence,
Accountability, Resources,
Powers, Protection)
Regulatory oversight of
SROs
Risk Management Process
Group-wide Supervision
Supervisory Powers,
Resources and Capacity
Operational Independence, Risk-assessment and
Accountability and
Management
Resources
Effective use of inspection,
enforcement and
compliance
11
“Good Supervision” is:
Intrusive
Comprehensive
Adaptive
Skeptical and
Proactive
Credible –
Follow-through
12
Getting to “Good Supervision”
The will
to act
High
Quality
Supervision
The
ability
to act
13
Will to Act
Clear Mandate
Operational
Independence
Accountability
14
Ability to Act
Strong
Authority
Adequate
Resources
Forwardlooking
Strategy
Internal
Organization
Interagency
Collaboration
15
The Perimeter of Supervision & Regulation

More intensive bank supervision and regulation will push some
activities outside of banks

Leave risks in the system (ownership /funding links with banks)
Response: FSB/IMF/WB work on shadow banking risks
Greater transparency of off-balance sheet risk
Limit bank concentration risk to nonbanks
Prohibit nonbank deposit-taking activities
If non-bank credit intermediation (e.g., finance company), solution
less clear
 Greater transparency/reporting – no downside
 Greater consumer/investor literacy
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16
 Enhanced transparency/disclosure complements…
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Adequate data/information key to reducing info asymmetries

Increased transparency and disclosure essential to
◦ Enhance supervisors’ ability to capture risks on time
◦ Increase market ability to assess risks/impose market discipline

Aimed both at banks and shadow banks to limit regulatory
arbitrage

Progress made on addressing data gaps—BIS/FSB/IMF initiatives
(info on G-SIFI exposures, structure, interconnectedness etc)

But slow progress (subset of the data available by end 2014 )
17
Effective resolution regimes

Recovery and Resolution Plans (living wills)

Special national schemes for orderly and timely
resolution of financial institutions

Financial sector contribution (FSC) to cover costs

Arrangements for bailing-in creditors

Cross-border resolution and burden sharing
Resolving TITF institutions—requires
tough decisions
18
IMF Proposal for Resolution of Cross
Border Financial Institutions
Permit cooperation where
possible
Adherence to core standards
with non-discriminatory
treatment of domestic and
foreign creditors
Coordination
Agreement on procedures for
rapid and predictable
resolution
Framework for burden
sharing and allocation of
responsibilities
19
What are CoCos for (tool for prevention & resolution)?

Higher capital buffers to recapitalize a bank under
difficult market conditions
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Private sector involvement /more burden sharing
between creditors and equity holders
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Reduce debt level in times of stress / prevent firesale of assets
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Prudent risk management and monitoring
20
Contingent Capital is only one intervention tool
Status
Liquidation
Type of capital / debt affected
Senior Secured / Covered Bonds / Others
Loss sharing by all creditors
Intervention mechanism
Resolution
Bail-In of Senior Unsecured
Gone Concern “Bail-in Capital”:
Regulatory discretion to convert to equity or
write-off at point of non-viability
Non-step cancellable coupons, with principal
write-down or equity conversion
Contingent Capital
(Post Conversion )
Core Equity
Common Shares and Retained Earnings
Capital
Conservation
measures
Management
Actions
Future
Earnings
Profit Losses
New Style Hybrid Tier 1
Going
Concern
Regulatory
Intervention
0
Gone
Concern
Regulatory discretion to impose
conversion/losses on all creditors
Probability of occurrence
21
Useful addition to the toolkit …

Provide extra loss-absorbing capital at cheaper cost
than equity

May help SIFIs meet the capital surcharge

Facilitate automatic burden sharing with private
investors

May help prevent a bank failure or reduce the
severity of failure
22
…but carries risks…
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May complicate and obscure capital structures
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Negative signaling effects of conversion

Speculative investors may trigger a conversion; cause a
“death spiral” in stock prices

Domino effect on equity prices triggering one conversion
after another
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Significant risk transfer to institutional investors and
political economy considerations
23
…that should be safeguarded against

Supervisors need to be vigilant in monitoring
◦ the design and issuance of contingent capital instruments
◦ the implied transfer of risks within the financial system
◦ potential build-up of systemic risks, including liquidity risks.
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Circuit breakers to avoid potential “death spirals”
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Instrument standardization to maintain capital
transparency
24
Bottom line
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CoCos may work in support of the regulatory agenda
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to meet supplementary capital requirements (Pillar
2, SIFI surcharge)

provided suitable measures are taken to assure
convertibility when needed and guard against risk
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but some incentives may be necessary to garner
investor interest
25
How about living wills (Recovery Resolution Plans)?

Blueprints (contingency plans) jointly developed by firms/regulators

Guide smooth orderly resolution of a failed bank to stem contagion
to the broader financial system 
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Valuable contribution to effective resolution frameworks
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Global SIFIs required to prepare RRPs to improve “resolvability”
(drafts by June 2012; finalized by end-2012), to:
 show how they would recover under stress & unwind if they fail
 provide information on firm’s structure, commitments, exposures, A&L
 expected to facilitate recovery, supervision and resolution efforts
 encourage/force firms to simply their structure to facilitate R&R
26
Implementation has been very slow, however…

Very limited progress in preparing living wills by 29 G-SIFIs
(recent Ernst & Young survey)
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Only 1/19 institutions completed a draft RRP
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European and Japanese banks particularly lagged behind US/UK
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Resolution part of RRPs: least progress made (1/3rd not started)
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Cross-border differences among regulators  biggest hurdle
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Further highlights the need to establish effective cross-border
regimes for cooperation, information-sharing, decision-making
27
Lack of progress for effective resolution regimes at the core
of Too-Important-To-Fail (TITF) Problem
TITF problem
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Difficult to manage, supervise, resolve
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High capacity to disrupt the entire
system / economy:
◦ Large size
◦ Interconnectedness & complexity
◦ Limited substitutability
 Too Important To Fail

Share in the global financial system
doubled during the crisis … likely to
have grown further
SIFIs
40
35
30
2000
2009
25
20
15
10
Bailing out generates moral hazard
5
 influence over regulatory process
 competitive funding advantage
0
Systemic Other banks Institutional Others 1/
banks in the
investors
sample
28
TITF funding/competitive advantage (US SIFIs)
1.4%
(Difference in Cost of Non-deposit Liabilities between insured US
banks with assets over $100 bn compared to those with assets
$10-100 bn)
1.2%
1.0%
80 bp
0.8%
57 bp
0.6%
0.4%
14 bp
0.2%
0.0%
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010Q1
2010Q2
2010Q3
2010Q4
29
Greater challenge for countries with large
financial systems
Systemically important bank assets  multiples of home GDP (%)
(In percent)
30
Framework to Reduce SIFI Moral Hazard
Market-based approach
Reducing probability/consequences of “systemicness”
More stringent
capital and liquidity
requirements
Consistent with
SIFI’s contribution to
systemic risk
Intensive and
proactive
supervision
Consistent with
complexity and
riskiness of the
institutions
Enhanced
transparency and
disclosure
Facilitate risk pricing
Capture emerging
risks in the system
Internalizing systemic risks
Effective resolution
regimes
(national/globally)
Recovery and
resolution plans
(Living wills)
Creditors share
losses
(CoCos, Bail-in)
31
However, long before TITF is put to rest…
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Methodology to identify SIFIs and scope of application (for D-SIFIs)
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Level/composition/coverage of the capital surcharge (for D-SIFIs)
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Translating SIFI supervision recommendations to national practices
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Enhancing disclosure and closing data gaps
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Understanding/monitoring/regulating the shadow banking system
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Obstacles to national and cross-border resolution frameworks
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Compensation policies to limit incentive for excessive risk taking
32
What should be done in the interim?
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Growing pressure at the national level to take immediate
action to limit the risk posed by SIFIs

Reaching a consensus internationally more difficult
 Credible and visible actions are needed in the interim:
 Require SIFIs to hold significantly more loss-absorbing capital
 Subject them to enhanced and intensive supervision
 Globally coordinate these actions to maintain a level playing field
 Provide a reasonable transition period
33
More direct approaches to address the TITF problem?
Preventing institutions
from becoming systemic
Limits on size
Absolute size
Relative size
(assets, liabilities)
(GDP or system
aggregates)
Limits on scope
Narrow banking
Volcker rule
Swap push out
Limits on
structure
Organizing groups
as a set of separate,
self-sufficient
subsidiaries
Caps on future growth
Deleveraging
Breaking up banks
34
34
Why re-scope business models?

Banking  leveraged intermediation managed by agents with
profit-sharing & limited liability
 Assumption of risk excessive from capital suppliers’ perspective

Incentive problem significantly magnified in case of SIFIs
Presumption of diversification  size and complexity at low capital cost
SIFIs are TITF  presumption of wide (implicit) public backstop
Complexity prevents use of appropriate resolution options in a crisis

Ways forward?
 Goal  ensure continuity of retail business + protect retail deposits
 Approach  reduce leverage, risky investments, complexity
 Side-benefits  credibly reduce perimeter of public guarantees 
increase incentives for market discipline
35
Narrower banks

General idea
 Reversion of deposit funded banks to payments function outfits
 Lending restricted to mortgages, retail cards, etc.
 Securitization, trading, risky investments shipped out to stand-alone
finance companies
 Only narrow banks receive public backstop / deposit insurance

Concrete policy proposals
 Volcker Rule of the U.S. Dodd-Frank Act
 U.K. Retail Ring-fence
36
What do the proposals entail?
Volcker rule
Prohibited businesses
 Proprietary trading
 Investments in hedge
funds, private equity funds
Application of prohibition to To all levels, including:
group structure
 parent bank
 all affiliates
 holding company
Geographic reach
Impact severity
Applies to:
 U.S. banks globally
 Foreign banks’ U.S.
businesses/transactions
More on IBs
U.K. retail ringfence
 All IB business
 All non-EEA business
Only applies to retail
business that must:
 be subsidiarized
 be subject to solo
capital/liquidity standards
Applies to:
 U.K. banks globally
 Foreign banks’ U.K. retail
businesses
More on IBs
37
Will re-scoping do the job?

Proposals are, in principle, structured carefully to address key
objectives

However, implementation is made challenging because
 Complex business models
 Desirable / risky transactions sharing same markets and counterparties
 Incentives to push risky activity into shadow banks

Prohibiting trading via structural constraints—is it overkill?
 Could Basel’s trading book fundamental review already do the job?

Success will depend on a number of complementary measures
38
‹5›
Structuring banks as subsidiaries vs.
branches ?

“Subsidiarization” as a way to reduce financial stability concerns

Distressed affiliates can leave home/host authorities with heavy
financial obligation  burden sharing issues

“To minimize financial stability risks from distressed foreign
banks” affiliates must be:
◦ under the regulatory oversight of local supervisors and
◦ Hold self sufficient levels of capital and liquidity

Easier to ensure under a system of host-supervised subsidiaries
39
Pros and Cons…
 Subsidiary structure can:
•
•
Shield an affiliate from losses in other parts of the group (reduced
interconnectedness)
•
Easier to spin off /restructure businesses and affiliates individually
•
Facilitates living wills by simplifying structure of a group
But: imposing self-sufficiency regardless of business models:
• Limits advantages of a given structure to a particular business model
• Undermines ability to manage risks given the intra-group constraints
• Leaves affiliates alone under stress, if local markets are shallow
40
‹3›
Bottom line
1)
One size does not fit all - neither branch nor subsidiary structure is
obviously preferable
2)
Organizational structures themselves cannot reduce the probability of
cross-border bank failures
3)
Imposing certain structures can be costly/inefficient for certain banks
4)
1st BEST: a combination of policies and practices that involves:


Harmonized resolution regimes and coordinated supervision
Adequate buffers and risk management capacity
 Home/Host can be more indifferent between different legal structures
 Banks can choose a structure that fits best their business focus
41
Where are we today in the reform efforts?

Considerable progress has been made in correcting the
weaknesses that led to the crisis, especially in
◦
◦
◦
◦

banking regulation
framework for effective supervision
frameworks to identify and deal with SIFIs
infrastructure to deal with OTC derivative markets
But important challenges remain with respect to
◦
◦
◦
◦
◦
resolving the TITF problem
agreement on resolution regimes—esp. for cross border banks
implementation of new Basel standards
implementation of agreed frameworks: SIFI policies, supervision, …
understanding and overseeing shadow banking system
42
Looking Ahead

Rapid progress remains crucial to complete the unfinished agenda

Regulatory uncertainty weighs on the financial system and economy
 not conducive to lending

Potentially large shocks may still be upcoming (euro area tensions)

Financial system is not sufficiently resilient with pockets of
weaknesses in advanced countries

New regulatory framework not yet complete to protect the system
from future crisis

EMDEs need a benchmark to limit a build up of financial imbalances

There is less policy and political room to maneuver across the board
43
Key conclusions?

Current reforms are moving in the right direction—towards building
a more resilient financial system to support sustainable growth

Progress has been made in some areas

Some novel ideas put forward (living wills, CoCos, bail-ins..)

But implementation lagged in many areas and

Disagreements over some others
 Policy/regulatory coordination
 Cross border resolution frameworks
 Information gaps
 Adequate cushions sized up to risks
 Realigning incentives
44
Thank You…
45
Extra Slides
Enhancing Resilience: Individual institutions
Prudential
regulation
(probability of failure)
Better supervision
(probability of failure)
Effective resolution
(cost of failure)
•
•
•
•
•
More and better quality bank capital (greater loss absorption)
Better risk recognition for market/counterparty risk
Capital conservation buffer
Non-risk based leverage ratio
More bank liquidity and stable funding
•
•
•
•
More intensive supervision
Proactive and adaptive to changing conditions
Capacity and willingness to act
Mandate, resources, independence, accountability
• Special resolution regimes for orderly wind down, at national and
global levels
• Recovery and resolution plans (living wills)
• Arrangements for burden sharing by creditors (CoCos/Bail-in)
47
47
Enhancing Resilience: System as a Whole
Regulation/ supervision
(probability of failure)
Resolvability
(cost of failure)
Market infrastructure
(impact of failure)
Countercyclicality
(impact on economy)
• Systemic capital and liquidity surcharges
• Systemic levies (for banks and non-banks)
• More intensive supervision of SIFIs in line with systemicness
•
•
•
•
•
Effective national resolution schemes for SIFIs
Cross-border resolution-burden-sharing regimes for global SIFIs
Living wills (resolution plans to wind-down SIFIs if they fail)
Bail-in’able debt at a point of nonviability
Structural measures (subsidiarization/size-scope limits)
• OTC derivatives clearance through central counterparties (CCPs) to limit
contagion
• Repo markets (collateral, margining practices)
• Credit rating agencies (greater oversight, less mechanistic use of ratings)
•
•
•
•
Countercyclical capital charges
Forward looking loan-loss provisioning
Fair-value accounting
Macro-prudential policies against cycles and systemic risk
48
48
Basel III: More and Better Quality Capital
12
Higher Level of
Capital
10
8
6
4%
2%
7%
4
Higher Quality
of Capital
Tier 2
4.5%
2
Other Tier 1
2%
Common Equity
0
Basel II
Basel III minimum
ratio
Basel III
minimum +
conservation
buffer
Implementation over a gradual phase-in period till 2019 to allow smooth adj.
49
Basel III: Liquidity Rules: Higher liquidity & Stable Funding
Liquidity
coverage
ratio (LCR)
High quality liquid assets
to meet short-term
stresses
Enough liquidity to last
30 days without new
borrowing
Net stable
funding
ratio
(NSFR)
Reducing maturity
mismatches
More long-term
funding; less reliance on
volatile and ST
wholesale funding
sources
Implementation considerably phased out to allow smooth adjustment and
calibration (2015 for LCR ; 2018 for NSFR)
50