Lecture 8. FINANCIAL REGULATION Economics 1490 THE WORLD ECONOMY: GROWTH OR STAGNATION? with Professor Dale W. Jorgenson Lecture 8. FINANCIAL REGULATION September 26, 2017 Harvard University Department of Economics Fall 2017

THE WORLD ECONOMY: GROWTH OR STAGNATION? A. Comparing Economies B. U.S. Crisis and Recovery C. European Slowdown D. Asian Economic Miracles E. Sustainability of Economic Growth F. World Economic Outlook

B. U.S. CRISIS AND RECOVERY 6. U.S. Financial Crisis 7. Monetary Policy  8. Financial Regulation 9. Fiscal Policy  10. Secular Stagnation

SUPPLEMENTARY READINGS ON FINANCIAL REGULATION: The Official Documents Basel Committee on Banking Supervision (2011, 2013), International Regulatory Framework for Banks (Basel III), Basel, Switzerland, Bank of International Settlements. See: http://www.bis.org/bcbs/basel3.htm   Board of Governors, Federal Reserve System (2013), “Federal Reserve Board Approves Final Rule to Help Insure Banks Maintain Strong Capital Positions,“ Washington, DC, Board of Governors, Federal Reserve System, Press Release,” July 2. See: https://www.federalreserve.gov/newsevents/pressreleases/bcreg20130702a.htm Janet Yellen (2017), “Financial Stability a Decade after the Onset of the Crisis,” Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 25. See: https://www.federalreserve.gov/newsevents/speech/yellen20170825a.htm

DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT OF 2010 Re-organized Regulatory Agencies to Elimination Overlapping Jurisdictions Undertook Comprehensive Regulation of Financial Markets Provided a Resolution Mechanism for Insolvent Financial Institutions Greatly Extended Consumer Protection

WHAT IS BASEL III? “Basel III” is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector. These measures aim to: improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source; improve risk management and governance; strengthen banks’ transparency and disclosures.

WHAT IS THE PURPOSE OF BASEL III? The reforms target bank-level, or microprudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress, and macroprudential, system wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time. These two approaches to supervision are complementary as greater resilience at the individual bank level reduces the risk of system wide shocks.

PILLAR 1: CAPITAL Quality and Level of Capital Capital Loss Absorption at the Point of Non-Viability Capital Conservation Buffer Countercyclical Buffer

PILLAR 1: RISK COVERAGE Securitizations Trading Book Counterparty Credit Risk Bank Exposures to Central Counterparties

PILLAR 1: CONTAINING LEVERAGE Non-Risk-Based Leverage Ratio Backstop to Risk-Based Capital Requirement Contains Build-Up of System-Wide Leverage

PILLAR 2: RISK MANAGEMENT AND SUPERVISION Firm-Wide Governance and Risk Management Includes Off-Balance Sheet and Securitization Managing Risk Concentration

PILLAR 3: DISCLOSURE REQUIREMENTS Market Discipline Requirements for Securitization and Off-Balance Sheet Vehicles Disclosures on Components of Regulatory Capital Requirements

LIQUIDITY Liquidity Coverage Ratio Net Stable Funding Ratio Liquidity Risk Management and Supervision Supervisory Monitoring

SYSTEMICALLY IMPORTANT FINANCIAL INSTITUTIONS Identify Global SIFI’s Higher Loss Absorbency Capacity Progressive Common Equity Tier Additional Loss Absorbency

BASEL III PHASE-IN ARRANGEMENTS Leverage Ratio: 2013-2017 Minimum Common Equity Capital Ratio: 2013-2019 Minimum Total Capital Ratio: 2013 Liquidity Coverage Ratio: 2015-2019

U.S. IMPLEMENTATION July 2, 2013: The Federal Reserve Board approved a final rule to help ensure banks maintain strong capital positions that will enable them to continue lending to creditworthy households and businesses even after unforeseen losses and during severe economic downturns. The rule will implement in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

THE VOLCKER RULE “Volcker Rule” requirements of section 619 (of the Dodd-Frank Wall Street Reform and Consumer Protection Act) generally contains two prohibitions. First, it prohibits insured depository institutions, bank holding companies, and their subsidiaries or affiliates (banking entities) from engaging in short-term proprietary trading of any security, derivative, and certain other financial instruments for a banking entity's own account, subject to certain exemptions. Second, it prohibits owning, sponsoring, or having certain relationships with, a hedge fund or private equity fund, subject to certain exemptions.

NEW FORMS OF FINANCIAL INTERMEDIATION The greatest change to intermediation in the history of finance has been spurred by advances in information technology (IT) that have enabled, among other things, better and faster processing of information and trading in a wider range of financial instruments. Over the past 10 years, these changes have allowed more financial intermediation to take place in markets instead of through bilateral negotiations.

RISING SYSTEMIC RISKS Size and Complexity of Financial Institutions Concentration, Interconnectedness, and Procyclicality   Wholesale Funding and Market Discipline Nonbanks and New Financial Products

SIZE OF THE GLOBAL FINANCIAL SYSTEM Sources: Bank for International Settlements; Bankscope; Bloomberg L.P.; and World Federation of Exchanges.

RELATIVE SIZE OF TRADITIONAL TO TOTAL BANKING ACTIVITIES

SHARE OF TOTAL LOANS AND BONDS BY NON-BANK INSTITUTIONS

GLOBAL SECURITIZATION

OUTSTANDING OVER-THE-COUNTER CREDIT DERIVATIVES

OTC DERIVATIVES Counterparty Risk: The AIG Rescue Central Clearing Mandates Minimum Margin Requirements Data Reporting Requirements

HAS THE STRUCTURE OF THE FINANCIAL SYSTEM BECOME SAFER? Market-Based Financial Intermediation Remains Important Financial Systems Remain Dependent on Wholesale Funding Globalization Has Not Been Much Affected Official Interventions Have Made “Bail-In’s” Less Credible

RESOLUTION OF GLOBAL SIFI’S Core Elements of a Resolution Framework Statutory Authority to Convert Claims into Equity Recovery and Resolution Plans Crisis Management Groups

GLOBAL POLICY RESPONSE Capital Requirements for Global SIB’s Counter-Cyclical Capital Buffers Liquidity Rules Multiple Channels for Reform

FINANCIAL REGULATION: SUMMARY Macro-Prudential versus Micro-Prudential Regulation Basel III U.S. Implementation Resolution of GSIFI’s

CONCLUSION The recent crisis showed that some financial innovations, over time, increased the system's vulnerability to financial shocks that could be transmitted throughout the entire economy with immediate and sustained consequences that we are still working through today. Some of these vulnerabilities were a consequence of innovations that increased the complexity and interconnectedness of aspects of the financial system. In response to the crisis and the weaknesses it revealed, governments around the globe are acting to improve financial stability and reduce the risks posed by a highly interconnected financial system.