How to Avoid Another Financial Crisis Central European Perspective Andrzej Raczko

Capital flows before financial crisis Major Net Exporters and Importers of Capital in 2007

Factors of foreign capital flows Risk of country - emerging market Reputable monetary policy (independent central bank) Long-term fiscal stabilization Structural reforms boosting international competitiveness (labor market) Free float of capital Good business climate Domination of private financial sector

Factors of foreign capital flows Macroeconomic environment Accumulation of huge global imbalances (exchange rate rigidity) Ample liquidity (global saving glut) - negative experience from former financial crisis – growing F/X reserves of central banks, - corporate saving, - high commodity prices and financial accumulation (oil countries) Low interest rates (easy monetary policy in the USA) Widespread growth of price assets (housing bubble) Low personal saving in the USA

Wholesale financial market development Interaction between mark-to-market pricing and liquidity Searching for higher return on equityIncrease in financial leverageOvervaluation of financial assetsHistorically very low risk premium Financial sector failure Credit risk (under-pricing of risk) Liquidity risk (excessive leverage)

- Complicated credit risk supervision (standardization & GSE) - ABS financing Sub-prime mortgage Financial system - elements of vulnerability US mortgage originate-to-distribute model

- Complex CDOs (CDO squared) - Risk valuation models (based on historical delinquencies data) - Over-reliance on rating systems - Sensitiveness for risk correlation effects Leads to mispricing of risk Financial system - elements of vulnerability Collateralized Debt Obligation (securitization)

- Avoidance of capital requirements - Maturity mismatch and roll-over risk - Guaranteed credit lines by banks (reputation risk for banks) - Sensitive to market sentiment (valuation of assets) - Illiquid assets (spillover effect of distressed sales of assets) - High leverage and off-balance sheet risk - Systemic liquidity risk Financial system - elements of vulnerability Structured Investment Vehicle (SIV)

- CDS – illusion of risk dispersion - Clearing system derivatives and counter-party risk - Wholesale financing system – repo operation - Difficult identification of ultimate risk holders - Illusion of negligible liquidity risk Financial system - elements of vulnerability OTC market and wholesale financing system

Reduction of pro-cyclicality (amplitude of credit cycles) Automatic countercyclical mechanism vs. discretionary interventions Scope of banking operations (the Volckers Rule) Systemic important institution (requirements and costs) Taxation of banking sector Consumer protection law Bank capital Liquidity Risk management International cooperation New framework for financial regulations Macro-prudential framework Too big to fail Micro prudential policies

Trading book capital Securitization risk weights Improvement of guidance on management and supervision Compensation system Concentration of risk Principles of cooperation (G-20, FSB – Standard Setters, BIS, IMF, EU) Supervisory colleges EU attempts to strengthen supervision New framework agreed elements Bank capital Liquidity International cooperation Risk management

Quality and transparency of capital base Reduction of Basel II build-in pro-cyclicality Counter cyclical capital buffer Capital conservation buffer Leverage ratio Forward looking provisioning New liquidity measures New framework – proposals

Revision of Code of Conduct Fundamentals Revision of Code of Conduct Fundamentals Differentiated ratings on structured products Differentiated ratings on structured products Conflict of interests Minimum standards Systemic monitoring New framework - proposals Credit rating agencies Hedge funds

Standardization of products Integrated clearing system Alternative approach to mark-to-market system standards for off-balance sheet vehicles Transparent standards for off-balance sheet vehicles New framework - proposals OTC derivatives Accountancy standards

Originate-to-distribute model Collateralized Debt Obligation (securitization) Structured Investment Vehicle (SIV) OTC market and wholesale financing system Abrupt outflow of foreign saving Long-term assets denominated in foreign currency Finance innovation (F/X options) Key elements of risk Advanced financial markets Emerging market countries

Quality and transparency of capital base Fair competition (based on risk not reputation) Hybrid capital (subordinated debt in foreign currency) Subsidiary vs. branch model Reform of Basel II Risk weights(standardized vs. internal rating-based approach) Pro-cyclicality (F/X sensitivity) Counter cyclical capital buffer Flexibility of automatic stabilizers definition Reform framework – emerging markets Harmonization of regulations

Capital conservation buffer Specific risks - role for domestic supervisor Leverage ratio Domination of standardized approach Forward looking provisioning System based on domestic risk assessment New liquidity measures Phasing-in mechanism Reform framework – emerging markets Harmonization of regulations

European Systemic Risk Board Domination of central banks (monetary policy vs. financial stability function) Early warning system (practical solution?) Communication (via non-binding recommendations) European System of Financial Supervisors (ESFS) Structure (built on Lamfalusy structures) Sectoral vs. national supervisors (balance of powers) Reform framework – emerging markets European supervisory framework

European Supervisory Authorities Single rule book (binding technical standards) Interpretation of regulations Mediation (even addressing individual financial institution) Colleges of Supervisors Supervision of cross-border groups (day-to-day supervision) European systemic institutions Reform framework – emerging markets European supervisory framework

Crisis resolution Cross-border insolvency Selection of institutions (financial viability criterion?) Models of resolution (bad bank, guaranty of price of assets, transfer of assets) Pan-European Deposit Guarantee Scheme Structure (domestic vs. Pan-European) Coverage (cross-border operation) Funding (ex-ante contribution) Membership (compulsory) Fiscal responsibility of last resort Potential arbitrage (subsidiary vs. branch) Reform framework – emerging markets European supervisory framework