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MBF-705 LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION

Session: TWENTY THREE. MBF-705 LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION. OSMAN BIN SAIF. Summary of previous Session. Corrective actions for weak Banks General principles for corrective action Guiding principles for banks resolution policy Resolution techniques

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MBF-705 LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION

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  1. Session: TWENTY THREE MBF-705LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION OSMAN BIN SAIF

  2. Summary of previous Session • Corrective actions for weak Banks • General principles for corrective action • Guiding principles for banks resolution policy • Resolution techniques • Conclusion: Dealing with Weak Banks

  3. Summary of this session • Lender of Last Resort • Classical Theory • LOLR and Bank closure Policy • Solvent banks and Insolvent Banks; LOLR • Systemic Risk • Contagion • Panic of 2008 crisis • Liquidity in a non functioning interbank market • LOLR policy as part of the banking safety net • Lessons for the LOLR’s role • Case Example: The State Bank of Pakistan

  4. Lender of Last Resort • The discretionary provision of liquidity to a financial institution (or the market as a whole) by the central bank in reaction to an adverse shock which causes an abnormal increase in demand for liquidity which cannot be met from an alternative source.

  5. Lender of Last Resort (Contd.) • This means that the central bank is the lender (provider of liquidity) of last resort (if there is no other way to increase the supply of liquidity when there is a lack thereof). • The function has been performed by many central banks since the beginning of the 20th century. • The goal is to prevent financial panics and bank runs spreading from one bank to the next due to a lack of liquidity.

  6. Lender of Last Resort (Contd.) • Since the creation of the first central banks in the 19th century, the existence of a lender of last resort (LOLR) has been a key issue for the structure of the banking industry. • Banks finance opaque assets with a long maturity with short-lived liabilities – a combination that is vulnerable to sudden loss of confidence.

  7. Classical Theory • To avoid avoidable disasters when confidence evaporates, the classical view (Thornton 1802 and Bagehot 1873) is that the central bank should lend to illiquid but solvent banks, at a penalty rate, and against collateral deemed to be good under normal times.

  8. Classical Theory (Contd.) • With the development of well-functioning financial markets, this view has been considered obsolete. • Goodfriend and King (1988) in particular argue that the central bank should just provide liquidity to the market and leave to banks the task of allocating credit and monitoring debtors.

  9. Classical Theory (Contd.) • On account of extensive research by both Thornton’s and Bagehot’s works, their main proposals are as follows: • (1) protect the money stock instead of saving individual institutions; • (2) rescue solvent institutions only;

  10. Classical Theory (Contd.) • (3) let insolvent institutions default; • (4) charge penalty rates; • (5) require good collateral; and

  11. Classical Theory (Contd.) • (6) pre-announce these conditions before a crisis so that the market knows exactly what to expect. • Many of these points remain controversial today but it seems to be accepted that the Bank of England strictly followed these rules during the last third of the 19th century.

  12. LOLR and bank closure policy • LOLR is thus connected with the efficient bank closure policy and, more generally, with the costs of bank failures and of the safety net.

  13. LOLR; Solvent Banks and Insolvent Banks • In cases of illiquidity, the LOLR is channelling liquidity and improving the efficiency of the monetary policy framework. • In insolvency cases, the LOLR acts as part of a safety net and thus is directly related to the overall regulatory framework.

  14. LOLR; Solvent Banks and Insolvent Banks (Contd.) • Clearly, the design of an optimal LOLR mechanism has to take into account both the banking regulation context and the monetary framework that is intended to cope not only with inflation but also with the management of aggregate liquidity.

  15. Systemic Risk • These issues are compounded by the fact that financially fragile intermediaries are exposed to the threat of systemic risk.

  16. Systemic Risk (Contd.) • Systemic risk may arise from the existence of a network of financial contracts from several types of operations: • the payment system, • the interbank market, and • the market for derivatives.

  17. Contagion • The tremendous growth of these operations in recent decades has increased the interconnections among financial intermediaries and among countries. • This has greatly augmented the potential for contagion (Allen and Gale 2000 and Freixas, Parigi and Rochet 2000).

  18. The panic of 2008 and subprime crisis of 2007 • The panic of 2008, originating with the subprime crisis of 2007, offers key insights into systemic risk and illustrates vividly the new role of a lender of last resort.

  19. The panic of 2008 and subprime crisis of 2007 (Contd.) • Years of accommodating monetary policy, regulatory arbitrage to save capital, and waves of financial innovations – which by definition tend to escape traditional prudential regulation – have created the conditions for slack credit standards and rating agencies that fail to call for adequate risk premia.

  20. The panic of 2008 and subprime crisis of 2007 (Contd.) • The opacity of the assets of the banks and of the financial vehicles they created to hold mortgages resulted in a dramatic and sudden reappraisal of risk premia.

  21. The panic of 2008 and subprime crisis of 2007 (Contd.) • As with a thin market typical of the Akerlof lemons problem (Freixas and Jorge 2007), financial intermediaries have become reluctant to lend to each other if not for very short maturities.

  22. The panic of 2008 and subprime crisis of 2007 (Contd.) • The fear that the interbank market might not work well and might fail to recycle the emergency liquidity provided by the central banks around the world in various and coordinated ways has induced banks to choose the rational equilibrium strategy of hoarding some of the extra liquidity instead of recycling it to the banks in deficit.

  23. The panic of 2008 and subprime crisis of 2007 (Contd.) • The resulting equilibrium closely resembles the gridlock described by Freixas, Parigi and Rochet (2000), where the fear that a debtor bank will not honour its obligations induces the depositors of the creditor bank to withdraw deposits, thus triggering the liquidation of assets in a chain reaction.

  24. The panic of 2008 and subprime crisis of 2007 (Contd.) • This is the modern form of a “bank run” – financial intermediaries refuse to renew credit lines to other intermediaries, thus threatening the very survival of the system.

  25. Liquidity in a non-functioning interbank market • Clearly channelling emergency liquidity assistance through the interbank market will not work if the interbank market is not functioning properly.

  26. Liquidity in a non-functioning interbank market (Contd.) • Thus, to limit the systemic feedbacks of the sudden deleveraging of financial institutions, the Fed has taken the unprecedented steps of both increasing the list of collateral eligible for central bank lending and extending emergency liquidity assistance to investment banks, government sponsored entities, money market mutual funds, and a large insurance company (AIG).

  27. Liquidity in a non-functioning interbank market (Contd.) • The panic of 2008 has showed that LOLR role should be limited to the funding of illiquid but solvent depository institutions, while capital injections should be the Treasury’s responsibility.

  28. Liquidity in a non-functioning interbank market (Contd.) • To understand the interventions of the lender of last resort in the current crisis, the view of its role has to be a broad one encompassing the closure or bail-out decision defining the lender of last resort as an agency that has the faculty to extend credit to a financial institution unable to secure funds through the regular circuit.

  29. LOLR policy as part of the banking safety net • Once we establish that the lender of last resort policy has to be part of the overall banking safety net, the interdependence of the different components of this safety net becomes clear. • First, the existence of a deposit insurance system limits the social cost of a bank’s bankruptcy, and therefore, reduces the instances where a LOLR intervention will be required.

  30. LOLR policy as part of the banking safety net (Contd.) • Second, capital regulation reduces the probability of a bank in default being effectively insolvent, and so has a similar role in limiting the costly intervention of the LOLR. • Third, the procedures to bail-out or liquidate a bank, determined by the legal and enforcement framework will determine the cost-benefit analysis of a LOLR intervention.

  31. LOLR policy as part of the banking safety net (Contd.) • Adopting a perspective of an all-embracing safety net does not mean that the safety net has to be the responsibility of a unique agent. Often several regulatory agencies interact, because different functions related to the well functioning of the safety net are allocated to different agents.

  32. LOLR policy as part of the banking safety net (Contd.) • It is quite reasonable to separate monetary policy from banking regulation, and the separation of the deposit insurance company from the central bank makes the cost of deposit insurance more transparent.

  33. Lessons for the LOLR’s role • First, an additional aggregate liquidity injection is not a sufficiently powerful instrument to solve the crisis. • The illiquidity of financial institutions around the world is, in fact, directly linked not only to their solvency but also to asset prices.

  34. Lessons for the LOLR’s role (Contd.) • Second, central banks around the world have been much more flexible in providing support to the banking industry than initially expected.

  35. Lessons for the LOLR’s role (Contd.) • In other words, that central bank cannot credibly commit to a bail-out policy. Indeed, the arguments regarding the bail-out of banks only if their closure could have a systemic impact (too-big-to-fail), that were intended for an individual bank facing financial distress were soon discarded in favour of a more realistic approach.

  36. Lessons for the LOLR’s role (Contd.) • A third point is that, in a systemic crisis, the safety net is extended to non-bank institutions. • This may be the result of financial innovation. Yet, because AIG had been issuing credit default swaps, its bankruptcy would have affected the fragility of the banking industry by leading to losses and a lower capital.

  37. Lessons for the LOLR’s role (Contd.) • Fourth, regulators around the world have a mandate to protect the interests of their national investors. • The international coordination of regulators, and in particular, the European coordination has been helpless when faced with the real cost of the Icelandic crisis.

  38. Case Example: The State Bank of Pakistan • The State Bank of Pakistan is the lender of last resort for the Pakistani commercial banks. • It at any time the banks are short of cash reserves, the State Bank of Pakistan comes to their rescue.

  39. Case Example: The State Bank of Pakistan (Contd.) • It provides cash to commercial banks by rediscounting bills of exchange and treasury bills. • The State Bank of Pakistan thus helps and maintain liquidity ad solvency of the commercial banks.

  40. Principal role and Objective of SBP • A principal role of SBP is to provide liquidity to the banking system in times of systemic illiquidity problems. • SBP’s principal objective as LOLR is to maintain liquidity in the banking system as a whole and ensure the smooth functioning of the payments system.

  41. Principal role and Objective of SBP (Contd.) • Another objective is to ensure that solvent banks do not fail due to temporary illiquidity. • At present, SBP provides liquidity for solvent banks facing temporary liquidity problems using different instruments. • With its off-site monitoring mechanisms and on-site inspections of banks SBP has a good idea of banks’ solvency situation.

  42. SBP ACT • The SBP Act must be changed to better specify SBP‟s role and powers as LOLR. Under existing law the SBP has very limited scope to function as LOLR: the SBP Act calls for all lending to be secured. • SBP can provide liquidity to the overall market but has limited capacity for providing liquidity to individual banks. • Once individual banks have run out of un-encumbered government securities, SBP has no other effective instruments with which to meet banks’ liquidity shortfalls.

  43. SBP ACT • When a bank runs out of collateral and becomes illiquid, SBP would need to close it. Recent liquidity problems in the market have tested SBP’s ability to manage the stress situation, which SBP has managed successfully through its monetary tools

  44. SBP ACT (Contd.) • The SBP needs broader legal authority to deal with illiquid banks. The law should define what institutions are eligible for SBP support, including guarantees of different kinds, and what assets qualify as collateral.

  45. SBP ACT (Contd.) • It is proposed that only scheduled banks, including branches of foreign banks, be eligible counterparts for LOLR support and that all NBFIs be excluded from access. • All support should be short-term.

  46. Internal Rules and Criteria • SBP has developed a set of internal rules and criteria, which helps it make consistent decisions and better justify its actions and facilitate accountability afterwards. • It should seek to make its decisions consistent both among classes of banks and over time. • New LOLR operating rules distinguish between bank-specific and systemic problems.

  47. Internal Rules and Criteria (Contd.) • These rules are based on different policy scenarios but also leave sufficient room for tweaking and policy changes in view of different economic and financial realities of each situation. • SBP has sought legal powers to make all LOLR support conditional on corrective actions by the borrowing bank.

  48. Internal Rules and Criteria (Contd.) • LOLR policies and rules are closely coordinated with bank exit policies. • LOLR rules are for internal use and it will be up to the SBP to determine what general rules and criteria it may wish to make transparent. • Details of corrective actions by individual banks using LOLR facilities will remain confidential.

  49. Internal Rules and Criteria (Contd.) • Unsecured LOLR lending would have to be guaranteed by the government. Such lending should be considered potential solvency support, and take-over of the institution for an eventual resolution strategy.

  50. Summary of this session • Lender of Last Resort • Classical Theory • LOLR and Bank closure Policy • Solvent banks and Insolvent Banks; LOLR • Systemic Risk • Contagion • Panic of 2008 crisis • Liquidity in a non functioning interbank market • LOLR policy as part of the banking safety net • Lessons for the LOLR’s role • Case Example: The State Bank of Pakistan

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