Building a More Resilient Financial System: Reforms in the Wake of the Global Crisis

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

3. 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 Global crisis exposed the existing cracks in the financial architecture

4. 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) • Infrastructureto deal w/ interconnected, complex, TBTF institutions • Focus on systemic risk and macro-prudential policies How to Fix the System Make failures (1) less likely & (2) less costly/messy

5. 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 ) Impact of the reforms on the industry

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

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

8. 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 Ultimate impact will depend on how banks will adjust

9. Health of Financial Institutions Depends on Many Factors:

10. Regulations Require Effective Supervision – But Supervision was Inconsistent (pre-crisis):

11. Main deficiencies reflected in FSAPs – areas of lowest compliance globally

12. “Good Supervision” is:

13. Getting to “Good Supervision”

14. Clear Mandate • Operational Independence Accountability Will to Act

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

16. 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 The Perimeter of Supervision & Regulation

17. 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 )  Enhanced transparency/disclosure complements…

18. 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 Effective resolution regimes

19. IMF Proposal for Resolution of Cross Border Financial Institutions

20. 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 What are CoCos for (tool for prevention & resolution)?

21. Contingent Capital is only one intervention tool Senior Secured / Covered Bonds / Others Loss sharing by all creditors Status Type of capital / debt affected Intervention mechanism Liquidation Resolution Bail-In of Senior Unsecured Regulatory discretion to impose conversion/losses on all creditors Gone Concern Regulatory Intervention Gone Concern “Bail-in Capital”: Regulatory discretion to convert to equity or write-off at point of non-viability New Style Hybrid Tier 1 Non-step cancellable coupons, with principal write-down or equity conversion Capital Conservation measures Going Concern Contingent Capital (Post Conversion ) Management Actions Losses Future Earnings Core Equity Common Shares and Retained Earnings Probability of occurrence 0 Profit

22. 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 Useful addition to the toolkit …

23. 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 …but carries risks…

24. 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 …that should be safeguarded against

25. 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 Bottom line

26. 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 How about living wills (Recovery Resolution Plans)?

27. 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 (1/3rd 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 Implementation has been very slow, however…

28. 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 Lack of progress for effective resolution regimes at the core of Too-Important-To-Fail (TITF) Problem

29. 57 bp 14 bp TITF funding/competitive advantage (US SIFIs)

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

31. Framework to Reduce SIFI Moral Hazard Internalizing systemic risks

32. 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 However, long before TITF is put to rest…

33. 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 actionsare 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 What should be done in the interim?

34. More direct approaches to address the TITF problem? Caps on future growth Deleveraging Breaking up banks 34

35. 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 Why re-scope business models?

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 Narrower banks

37. What do the proposals entail?

38. 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 Will re-scoping do the job?

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 Structuring banks as subsidiaries vs. branches ? ‹5›

40. 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 Pros and Cons…

41. One size does not fit all - neither branch nor subsidiary structure is obviously preferable • Organizational structures themselves cannot reduce the probability of cross-border bank failures • Imposing certain structures can be costly/inefficient for certain banks • 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 Bottom line ‹3›

42. 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 Where are we today in the reform efforts?

43. 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 Looking Ahead

44. 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 Key challenges and Key ingredients to stability Key conclusions?

45. Thank You…

46. Extra Slides

47. Enhancing Resilience: Individual institutions 47

48. Enhancing Resilience: System as a Whole • 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 Implementation over a gradual phase-in period till 2019 to allow smooth adj.

50. Basel III: Liquidity Rules: Higher liquidity & Stable Funding Implementation considerably phased out to allow smooth adjustment and calibration (2015 for LCR ; 2018 for NSFR)