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Building a More Resilient Financial System: Reforms in the Wake of the Global Crisis Jonathan Fiechter İnci Ötker-Robe Ceyla Pazarbasioglu Jay Surti FPD.

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Presentation on theme: "Building a More Resilient Financial System: Reforms in the Wake of the Global Crisis Jonathan Fiechter İnci Ötker-Robe Ceyla Pazarbasioglu Jay Surti FPD."— Presentation transcript:

1 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

2 Outline Brief background Policy response to fix the system Views on the reform proposals Taking stock Looking ahead Conclusions 2

3 Global crisis exposed the existing cracks in the financial architecture Pre-Crisis global financial system was characterized by: 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

4 How to Fix the System How to Fix the System Make failures (1) less likely & (2) less costly/messy 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

5 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

6 Capital requirements: Greater effect on investment & universal banks 6 2% 2.9% (1.9% RWA effect)

7 NSFR: Greater effect on investment and universal banks ‹15› 7 Basel 3 requirement: NSFR ≧ 100 %

8 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

9 Health of Financial Institutions Depends on Many Factors: Financial Sector Performance Economic & Market Conditions Internal Governance & Risk Management Market Confidence/ Discipline SUPERVISION and Regulation 9

10 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 Did not keep up with the changing business environment Did not follow through – lacked skepticism In some cases, supervision: 10

11 Main deficiencies reflected in FSAPs – areas of lowest compliance globally Banking SupervisionInsurance SupervisionSecurities Regulation Consolidated SupervisionCorporate GovernanceOperational Independence and Accountability Country and Market RiskSupervisory Authority (Independence, Accountability, Resources, Powers, Protection) Regulatory oversight of SROs Risk Management ProcessGroup-wide SupervisionSupervisory Powers, Resources and Capacity Operational Independence, Accountability and Resources Risk-assessment and Management Effective use of inspection, enforcement and compliance 11

12 “Good Supervision” is: IntrusiveAdaptive Credible – Follow-through Skeptical and Proactive Comprehensive 12

13 Getting to “Good Supervision” The will to act The ability to act High Quality Supervision 13

14 Will to Act Clear Mandate Operational Independence Accountability 14

15 Ability to Act 15 Adequate Resources Strong Authority Internal Organization Forward- looking Strategy Interagency Collaboration

16 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 16

17  Enhanced transparency/disclosure complements… 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

18 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

19 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 Agreement on procedures for rapid and predictable resolution Framework for burden sharing and allocation of responsibilities Coordination 19

20 What are CoCos for (tool for prevention & resolution)? Higher capital buffers to recapitalize a bank under difficult market conditions Private sector involvement /more burden sharing between creditors and equity holders Reduce debt level in times of stress / prevent fire- sale of assets Prudent risk management and monitoring 20

21 Contingent Capital is only one intervention tool Senior Secured / Covered Bonds / Others Loss sharing by all creditors Resolution Bail-In of Senior Unsecured Regulatory discretion to impose conversion/losses on all creditors Gone Concern “Bail-in Capital”: Regulatory discretion to convert to equity or write-off at point of non-viability Regulatory Intervention New Style Hybrid Tier 1 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 Losses Profit 0 Probability of occurrence Going Concern Gone Concern Liquidation StatusIntervention mechanismType of capital / debt affected 21

22 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

23 …but carries risks… May complicate and obscure capital structures 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 Significant risk transfer to institutional investors and political economy considerations 23

24 …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. Circuit breakers to avoid potential “death spirals” Instrument standardization to maintain capital transparency 24

25 Bottom line CoCos may work in support of the regulatory agenda to meet supplementary capital requirements (Pillar 2, SIFI surcharge) provided suitable measures are taken to assure convertibility when needed and guard against risk but some incentives may be necessary to garner investor interest 25

26 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  Valuable contribution to effective resolution frameworks 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

27 Implementation has been very slow, however… Very limited progress in preparing living wills by 29 G-SIFIs (recent Ernst & Young survey) Only 1/19 institutions completed a draft RRP European and Japanese banks particularly lagged behind US/UK Resolution part of RRPs: least progress made (1/3 rd not started) Cross-border differences among regulators  biggest hurdle Further highlights the need to establish effective cross-border regimes for cooperation, information-sharing, decision-making 27

28 Lack of progress for effective resolution regimes at the core of Too-Important-To-Fail (TITF) Problem Share in the global financial system doubled during the crisis … likely to have grown further TITF problem SIFIs Difficult to manage, supervise, resolve High capacity to disrupt the entire system / economy: ◦ Large size ◦ Interconnectedness & complexity ◦ Limited substitutability  Too Important To Fail Bailing out generates moral hazard  influence over regulatory process  competitive funding advantage 28

29 TITF funding/competitive advantage (US SIFIs) bp 57 bp

30 Greater challenge for countries with large financial systems 30 Systemically important bank assets  multiples of home GDP (%) (In percent)

31 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 Effective resolution regimes (national/globally) Recovery and resolution plans (Living wills) Creditors share losses (CoCos, Bail-in) 31 Internalizing systemic risks

32 However, long before TITF is put to rest… Methodology to identify SIFIs and scope of application (for D-SIFIs) Level/composition/coverage of the capital surcharge (for D-SIFIs) Translating SIFI supervision recommendations to national practices Enhancing disclosure and closing data gaps Understanding/monitoring/regulating the shadow banking system Obstacles to national and cross-border resolution frameworks Compensation policies to limit incentive for excessive risk taking 32

33 What should be done in the interim? 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

34 More direct approaches to address the TITF problem? 34 Preventing institutions from becoming systemic Limits on size Absolute size (assets, liabilities) Relative size (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

35 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

36 Narrower banks 36 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

37 What do the proposals entail? 37

38 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

39 “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 ‹5› 39 Structuring banks as subsidiaries vs. branches ?

40 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

41 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) 1 st 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 ‹3› 41

42 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

43 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

44 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

45 Thank You… 45

46 Extra Slides

47 Enhancing Resilience: Individual institutions 47 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 Prudential regulation (probability of failure) More intensive supervision Proactive and adaptive to changing conditions Capacity and willingness to act Mandate, resources, independence, accountability Better supervision (probability of failure) 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) Effective resolution (cost of failure) 47

48 Enhancing Resilience: System as a Whole 48 Systemic capital and liquidity surcharges Systemic levies (for banks and non-banks) More intensive supervision of SIFIs in line with systemicness Regulation/ supervision (probability of failure) 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) Resolvability (cost of failure) 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) Market infrastructure (impact of failure) Countercyclicality (impact on economy) Countercyclical capital charges Forward looking loan-loss provisioning Fair-value accounting Macro-prudential policies against cycles and systemic risk 48

49 Basel III: More and Better Quality Capital 49 Implementation over a gradual phase-in period till 2019 to allow smooth adj.

50 Basel III: Liquidity Rules: Higher liquidity & Stable Funding High quality liquid assets to meet short-term stresses Enough liquidity to last 30 days without new borrowing Liquidity coverage ratio (LCR) Reducing maturity mismatches More long-term funding; less reliance on volatile and ST wholesale funding sources Net stable funding ratio (NSFR) 50 Implementation considerably phased out to allow smooth adjustment and calibration (2015 for LCR ; 2018 for NSFR)


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