Presentation on theme: "Professor CHRISTOS HADJIEMMANUIL"— Presentation transcript:
1 Professor CHRISTOS HADJIEMMANUIL University of Piraeus & London School of EconomicsThe Quest for the Financial System’s Ideal Structure: Efficiency v StabilityAsobancaria, XI Congreso de Derecho FinancieroHotel Hilton, Cartagena de Indias, 4 October 2012
2 Banking & finance, post-crisis Banking in the wake of the Global Financial Cririsis (2007– ? ):the financial industry as an area of contentionAn efficient, dynamic, self-correcting financial industry, servicing the real economy, in accordance with standard theory?orFinance as a non-productive, parasitical set of activities, producing few and ambiguous benefits but severe risks for the real economy?Mixed results of recent academic work on effects of financial innovationMore direct observation of experience of recent decades:exponential growth of global financial markets and institutions, accompanied byincreasing instability, as evidenced by successive systemic (in many cases, regional or cross-national) crises, culminating in the Global Financial CrisisReasons: public policy-related, monetary, but alsorelated to the banks’ chaning business model and culture
3 Traditional relationship banking: a successful (& resilient Traditional relationship banking: a successful (& resilient?) business modelPrincipal functions of a traditional banking institution:Deposit-taking and account-keeping services (depository institution)Payment services (monetary financial institution)Fractional reserve banking & lending activities (credit institution)Economic logic of the traditional banking firmEconomies of scope in joint provision of traditional banking servicesBankers as expert financiers: lending, monitoring & collectionBanks as information producers (information from account servicing)Banks as liquidity providersCan traditional banking survive in the 21st century?Financialization of the economyFinancial innovation / securitization of financial intermediationNew business models / different incentive structures!
4 Transformations of banking intermediation Starting in the 1960s, new trends in banking:Internationalization / removal of capital controlsDeepening of interbank market / facilitation of banks’ access to liquidity > active liability managementTechnological revolution: telecommunications and ITLiberalization (including denationalization)Deregulation (including removal of structural / activity restrictions)Prudential reregulationImpact on the nature / structure of banking intermediationEnormous scale of activity / intense competition / less secure profitabilityInnovation: unbundling and repackaging of financial services; active asset management; off-balance-sheet financing; securitisationShift from interest to fee income:from relationship banking to the “originate-and-distribute” model
5 Perverse incentives & banking instability Securitization of finance / “originate-and-distribute”: limited incentives for proper evaluation / continuing monitoring of debtorsIncreasing significance of trading income: risk-proneness / short-termismCompensation practices / current stock performance as benchmark of success: dissociation of rewards from true longer-term outcomesChanging approaches to information gathering and risk-management:“Actuarial” approach to risks and “market for lemons” in lendingRisk-modeling as key managerial tool – despite limitations of historical data sets and genuine uncertaintyBureaucratic risk-management: reliance on credit-rating agenciesComplexity and opacity of products: no transparency / limited ability to appreciate all risks (e.g. systemic, legal or reputational risks)Interbank linkages / interconnectedness:Liquidity on a shoestringPyramiding of exposures in asset-backed and derivatives marketsFalse sense of security in the presence of common aggregate risks
6 Flawed public policies’ contribution to the crisis Central banks: role of monetary policy in fuelling imbalances / asset bubbles in the years of the “Great Moderation”Prudential regulatorsInappropriate approach (especially under Basel II):Complexity without resilience! Attempt to replicate/validate banks’ risk decisions, rather than set external limits to their risk-takingUnquestioning belief in the beneficial effects of financial innovationMisconceived reliance on “enforced self-regulation”In certain cases: protectionism, supervisory forbearanceContinuing presence of public safety-net in era of ubiquitous risk-taking:Increased moral hazard / mispricing of banks’ sources of financing, now also in relation to securities trading activitiesExacerbation of “too-big-to-fail” problemMonetary easing / bailouts in response to the crisis: generally beneficial; but: prolongation of debt overhang / “zombie” banks / bad legacy assets
7 Regulatory responses to the crisis After Lehman Brothers: widespread demand for regulatory reformsConvergence of policy-makers on key “lessons” of the crisis, drawn especially from the US subprime / investment bank debacleKey fora: G20/FSB, EU, US, UKParallel reform agendas:common general direction, but divergence in specifics / technique / form of implementationAgenda-setting document at global level:FSB report to G20 Leaders, “Improving Financial Regulation” (25 Sep 2009)Variety of reform proposals, addressing a motley of observed deficiencies of prior regimeIncentive and market-structure-related proposalsNew (micro-)prudential requirements for banks (Basel III), accompanied by novel framework of macroprudential oversightSpecial resolution regimes, with particular emphasis on systemically important banks
8 Compensation practices Attempt to abolish perverse incentives, align incentives with prudent risk-taking in large banks, by regulating executive compensation practicesPrinciples for sound compensation practices set out by FSB in 2009Effective governance of the compensation system’s design and operation at BoD level, especially through non-executive directors / remuneration committeeFor staff in the risk and compliance function, compensation must be adequate / determined independently from business areas they overseeVariable compensation should take into account full range of current and potential risksEmployees who generate same short-run profits, but take different amounts of risk on behalf of the bank, should not be treated equallyBonuses should diminish or disappear in the event of poor firm, divisional or business unit performance
9 Payout schedules should be sensitive to time horizon of risks; accordingly, substantial part of variable compensation to senior executives and other risk-taking employees, such as 40-60% or more, should be payable under deferral arrangements over a period of 3 or more years, depending on the nature of business and risks; andsignificant portion should be in the form of shares or share-linked instrumentsSee now also, for the EU, the Liikanen report (2 Oct. 2012):banks should pay bonuses in “bail-in” bonds, which would be wiped out, if an institution failed,DisclosureSupervisory review of compensation practices
10 Structural separation of core banking from trading activities Reasons for separation:Insulation of deposit-taking and retail credit extension (low-risk, long-term-oriented) from trading activities (short-term, high-risk, potentially leading to concentrated exposures)Increased transparency and minimization of conflicts of interestContinuity of essential financial services, including retail banking and payments, in periods of crisisEasier / less costly resolution of troubled banksSeparation may involve increased funding costs for banks,but this may be justified insofar as the lower funding costs of the past were attributable to the public safety-net (deposit insurance or expectation of bailout)Distinct versions:US, Volcker rule: prohibition on insured depository institutions to engage in “proprietary trading”, or invest in hedge fundsUK, Vickers Commission, Sep. 2011: ring-fencing of retail bankingEU, Liikanen report, 02 Oct 2012: ring-fencing of proprietary trading
11 Other market-related proposals Redefining the perimeter of the regulatory system: identifying and controlling “shadow banking”Imposing quantitative retention rules for originators of securitization deals, in order to counteract moral hazard in loan screening / monitoringReducing reliance on credit rating agenciesEnsuring global convergence of accounting standardsImproving standards on fair-value accounting and off-balance-sheet entities, making accounting valuations less procyclical and more informativeEnhancing access to information / transparency in OTC derivatives marketsEnsuring that standardized OTC derivatives are traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties
12 Basel III: key components Dec 2010: two BCBS papers:“Basel III: A global regulatory framework for more resilient banks and banking systems” (revised June 2011)“Basel III: International framework for liquidity risk measurement, standards and monitoring”Key components:Review of Basel II system of minimum capital requirementsTwo new capital buffers, on top of basic capital adequacy requirementNon-risk-weighted capital requirements: leverage ratioMeasures to correct the pro-cyclicality of minimum capital requirementsTwo new liquidity ratios: moving beyond capital adequacy!Gradual implementation of new norms:1 Jan 2013 through 1 Jan 2019
13 Recast capital adequacy requirements Recast of definition of own funds:greater emphasis on common equity (“core Tier I” capital);abolition of Tier III capital;limit on inclusion of general provisions in Tier II capital: up to 1.25% of risk-weighted assets (“RWA”)Enhanced risk coverage: inclusion of credit risks arising in the context of derivatives, repo agreements, etcRevised minimum capital ratios:4.5% core Tier I capital / RWA;6% Tier I capital / RWA;8% total own funds (Tier I + Tier II) / RWA
14 Add-ons to the capital adequacy regime New capital buffers, on top of basic requirementsCapital conservation buffer: 2.5% core Tier I capital / RWA,as first line of loss-absorptionCountercyclical buffer: 0% to 2.5% core Tier I capital / RWA,to be called at national supervisors’ discretion in times of excessive credit expansion & drawn down in recessionsMeasures towards non-procyclical / countercyclical capital adequacy requirementsCorrectives to excessive pro-cyclicality of capital requirementsLong-term data horizons to estimate probability of asset defaultDownturn loss-given-default estimatesForward looking provisioning: move towards expected loss approachStress testsMinimum 3% leverage ratio (core Tier I capital / total gross nominal exposure): parallel, non-risk-weighted capital requirements
15 New risk-weighted capital adequacy ratios Source: BCBS 189
16 Liquidity requirements New liquidity ratios: a first in international banking regulationDetails still under discussionLiquidity coverage ratio (LCR):minimum 100% high-quality liquid assets / total net cash outlays of next 30 daysRegulators may allow banks to move below minimum LCR in times of stressNet stable funding ratio (NSFR) as longer-term structural liquidity ratio:minimum 100% of available stable funding / funding needs, as definedSupervisory observation of liquidity risk on the basis of:contractual maturity mismatch;concentration of funding;available unencumbered assets;LCR by significant currency;market-related monitoring tools
18 Haldane’s critiqueIs the Basel methodology both excessively detailed and inaccurate?Robust call by key regulator for more parsimonious regulatory approach (Andrew Haldane, executive director for financial stability, BoE, speech of 31 Aug 2012)Basel Accord (1988):Brief (30 pages long), comprehensibleCovered credit risk only, based on five risk categories;Operated as a backstop, not substitute for commercial risk decisionsStarting with the Market Risk Amendment (1996):Highly detailed/complex regulatory frameworkCovers credit, market and operational risks on the basis of a large number of estimated parameters and capital chargesIncorporates credit ratingsIncorporates banks’ own risk models, blurring the distinction between commercial and regulatory judgments
19 A flawed framework?Opacity, reliance on great number of estimated parametersNon-comparability across banks, raising issues of competitive equalitySupposed “accuracy” of risk estimations flounders due to the lack of sufficiently large and accurate series of historical dataLow predictive power: simple leverage ratio found to yield better resultsSubsidises complexity! Distinct advantage to large/complex financial institutions (although this is now reversed, due to the resolution requirements for SIFIs, to be discussed next)Haldane: appeal for resort to simple rules of thumb (heuristics) / supervisory discretion / market disciplineLeverage should play a greater role:3% ratio in Basel III: first ever internationally consistent ratioBut is it sufficient?
20 Macroprudential oversight Belief that certain problems do not arise / are not observable at individual firm level, lead to high correlation of risk across banksMacroprudential regulation: aimed at early identification, prevention, mitigation of such risks, e.g. bubbles, affecting the whole financial systemEstablishment of new institutions with specific mandate to oversee systemic risk / prevent procyclicality in operation of the financial systemGlobally: transformation of FSF into FSB (FSB), with much wider mandate as coordinator of standard-setting bodies / monitor of systemic riskUS: Financial Stability Oversight Council (FSOC), chaired by Secretary of the TreasuryUK: Financial Policy Committee (FPC), as a committee of the BoEEU: creation of European Systemic Risk Board (ESRB), as part of the European System of Financial Supervision (ESFS); multimember college, comprising central bankers and regulators
21 Approach:observation of system-wide and macro-economic developments;use of quantitative and qualitative indicators to identify and measure systemic risk; issuing of warnings and recommendations;directing the taking of remedial actionGenerally: “softer” mandate than microprudential regulators, limited ability to take direct action (e.g., ESRB lacks direct enforcement power); more politicalOpen question: how effective / powerful macroprudential bodies may prove to be?Successful implementation: contingent on the ability to identify and estimate systemic risk in real time; is this possible?Use of controversial indicators / models, e.g. stress tests: legally ambiguous, but highly pervasive / consequential use of discretionary power, unconstrained by the legal controls of standard microprudential regulation?
22 Special Resolution Regimes for failed banks Trend towards SRRs for troubled banks (UK, Germany, EU proposals), following the US example (FDICIA of 1991)Specific FSB requirements relating to global and domestic systemically important financial institutions (SIFIs)Objective: orderly resolution (including in the form of reorganization), prioritizing public interest objectives (financial stability, continuity of essential services, protection of retail depositors)Requirement of prior “recovery and resolution planning” (“living wills”) by large banks and their supervisors, setting the ground for effective and expeditious resolution in the event of failurePossibility of early regulatory intervention at the pre-insolvency stage, if weakness is detectedRegulatory assumption of control once the resolution trigger is crossed: in addition to management, power to exclude / expropriate old shareholders, forcibly dispose of the bank or its businessPossibility of bridge financing with public money to enable reorganization / transfer of control to new owners
23 The end of TBTF & moral hazard? SRRs are supposed to ensure that no bank is “too big to fail”Resolvability ensured through prior planning and arrangements ensuring loss-absorbencyHigher capital requirements for large-complex banksSRRs designed to combat moral hazard, by imposing ex post cost on shareholders and bondholdersMandatory expropriation of shareholdersImposition of haircuts on junior and senior bondholders, in the form of write-downs in case of liquidation, or of “bail-in” to facilitate reorganization (statutory debt-to-equity conversions, issuance of contingent convertible bonds or CoCos)The end of moral hazard?How credible is the “no bailout” threat?The system preserves some failed banks, and shelters at least some stakeholders (i.e. the depositors) from lossesSaving large, systemic banks (even if there is change of control) has significant competitive implications
24 Regulatory dynamics & uncertain effect of the reforms Agreement in principle on a reform agenda does not guarantee agreement on the detailed arrangementsSee, e.g., macroprudential arrangements, or the proposed systems of separation of banking from trading activitiesInternational convergence hampered by differences in national approachEU accused by BCBS inspection team of “non-compliant” application of Basel III in two key areas: looser definitions of core capital in at least seven ways; and loophole, allowing banks to treat sovereign debt holdings as risk-free!More generally: Strong popular demand for radical reforms during crisis results in bold / sweeping legislative changes,But these are watered down, and eventually reversed, over time, as the issues loose their political salience and lobbying by banks affects the technical details of implementationSee, e.g., implementation of the Volcker rule in US
25 Thank you for your attention CHRISTOS HADJIEMMANUILProfessor of Monetary and Financial Institutions, University of PiraeusVisiting Professor of Law, London School of EconomicsAttorney at law, Athens Bar Associationtel:
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