The Quest for the Financial System’s Ideal Structure: Efficiency v Stability

1. Professor CHRISTOS HADJIEMMANUIL University of Piraeus & London School of Economics The Quest for the Financial System’s Ideal Structure: Efficiency v Stability Asobancaria, XI Congreso de Derecho Financiero Hotel Hilton,Cartagena de Indias, 4 October 2012

2. Banking & finance, post-crisis • Banking in the wake of the Global Financial Cririsis (2007– ? ): the financial industry as an area of contention • An efficient, dynamic, self-correcting financial industry, servicing the real economy, in accordance with standard theory? or • Finance as a non-productive, parasitical set of activities, producing few and ambiguous benefits but severe risks for the real economy? • Mixed results of recent academic work on effects of financial innovation • More direct observation of experience of recent decades: • exponential growth of global financial markets and institutions, accompanied by • increasing instability, as evidenced by successive systemic (in many cases, regional or cross-national) crises, culminating in the Global Financial Crisis • Reasons: public policy-related, monetary, but also • related to the banks’ chaning business model and culture

3. Traditional relationship banking: a successful (& resilient?) business model • Principal functions of a traditional banking institution: • Deposit-taking and account-keeping services (depository institution) • Payment services (monetary financial institution) • Fractional reserve banking & lending activities (credit institution) • Economic logic of the traditional banking firm • Economies of scope in joint provision of traditional banking services • Bankers as expert financiers: lending, monitoring & collection • Banks as information producers (information from account servicing) • Banks as liquidity providers • Can traditional banking survive in the 21st century? • Financialization of the economy • Financial innovation / securitization of financial intermediation • New business models / different incentive structures!

4. Transformations of banking intermediation • Starting in the 1960s, new trends in banking: • Internationalization / removal of capital controls • Deepening of interbank market / facilitation of banks’ access to liquidity > active liability management • Technological revolution: telecommunications and IT • Liberalization (including denationalization) • Deregulation (including removal of structural / activity restrictions) • Prudential reregulation • Impact on the nature / structure of banking intermediation • Enormous scale of activity / intense competition / less secure profitability • Innovation: unbundling and repackaging of financial services; active asset management; off-balance-sheet financing; securitisation • Shift from interest to fee income: from relationship banking to the “originate-and-distribute” model

5. Perverse incentives & banking instability • Securitization of finance / “originate-and-distribute”: limited incentives for proper evaluation / continuing monitoring of debtors • Increasing significance of trading income: risk-proneness / short-termism • Compensation practices / current stock performance as benchmark of success: dissociation of rewards from true longer-term outcomes • Changing approaches to information gathering and risk-management: • “Actuarial” approach to risks and “market for lemons” in lending • Risk-modeling as key managerial tool – despite limitations of historical data sets and genuine uncertainty • Bureaucratic risk-management: reliance on credit-rating agencies • Complexity and opacity of products: no transparency / limited ability to appreciate all risks (e.g. systemic, legal or reputational risks) • Interbank linkages / interconnectedness: • Liquidity on a shoestring • Pyramiding of exposures in asset-backed and derivatives markets • False sense of security in the presence of common aggregate risks

6. Flawed public policies’ contribution to the crisis • Central banks: role of monetary policy in fuelling imbalances / asset bubbles in the years of the “Great Moderation” • Prudential regulators • Inappropriate approach (especially under Basel II): Complexity without resilience! Attempt to replicate/validate banks’ risk decisions, rather than set external limits to their risk-taking • Unquestioning belief in the beneficial effects of financial innovation • Misconceived reliance on “enforced self-regulation” • In certain cases: protectionism, supervisory forbearance • Continuing presence of public safety-net in era of ubiquitous risk-taking: • Increased moral hazard / mispricing of banks’ sources of financing, now also in relation to securities trading activities • Exacerbation of “too-big-to-fail” problem • Monetary easing / bailouts in response to the crisis: generally beneficial; but: prolongation of debt overhang / “zombie” banks / bad legacy assets

7. Regulatory responses to the crisis • After Lehman Brothers: widespread demand for regulatory reforms • Convergence of policy-makers on key “lessons” of the crisis, drawn especially from the US subprime / investment bank debacle • Key fora: G20/FSB, EU, US, UK • Parallel reform agendas: common general direction, but divergence in specifics / technique / form of implementation • Agenda-setting document at global level: FSB report to G20 Leaders, “Improving Financial Regulation” (25 Sep 2009) • Variety of reform proposals, addressing a motley of observed deficiencies of prior regime • Incentive and market-structure-related proposals • New (micro-)prudential requirements for banks (Basel III), accompanied by novel framework of macroprudential oversight • Special resolution regimes, with particular emphasis on systemically important banks

8. Compensation practices • Attempt to abolish perverse incentives, align incentives with prudent risk-taking in large banks, by regulating executive compensation practices • Principles for sound compensation practices set out by FSB in 2009 • Effective governance of the compensation system’s design and operation at BoD level, especially through non-executive directors / remuneration committee • For staff in the risk and compliance function, compensation must be adequate / determined independently from business areas they oversee • Variable compensation should take into account full range of current and potential risks • Employees who generate same short-run profits, but take different amounts of risk on behalf of the bank, should not be treated equally • Bonuses should diminish or disappear in the event of poor firm, divisional or business unit performance

9. Payout schedules should be sensitive to time horizon of risks; accordingly, • substantial part of variable compensation to senior executives and other risk-taking employees, such as 40-60% or more, should be payable under deferral arrangements over a period of 3 or more years, depending on the nature of business and risks; and • significant portion should be in the form of shares or share-linked instruments • See now also, for the EU, the Liikanen report (2 Oct. 2012): banks should pay bonuses in “bail-in” bonds, which would be wiped out, if an institution failed, • Disclosure • Supervisory review of compensation practices

10. Structural separation of core banking from trading activities • Reasons for separation: • Insulation of deposit-taking and retail credit extension (low-risk, long-term-oriented) from trading activities (short-term, high-risk, potentially leading to concentrated exposures) • Increased transparency and minimization of conflicts of interest • Continuity of essential financial services, including retail banking and payments, in periods of crisis • Easier / less costly resolution of troubled banks • Separation may involve increased funding costs for banks, but this may be justified insofar as the lower funding costs of the past were attributable to the public safety-net (deposit insurance or expectation of bailout) • Distinct versions: • US, Volcker rule: prohibition on insured depository institutions to engage in “proprietary trading”, or invest in hedge funds • UK, Vickers Commission, Sep. 2011: ring-fencing of retail banking • EU, Liikanen report, 02 Oct 2012: ring-fencing of proprietary trading

11. Other market-related proposals • Redefining the perimeter of the regulatory system: identifying and controlling “shadow banking” • Imposing quantitative retention rules for originators of securitization deals, in order to counteract moral hazard in loan screening / monitoring • Reducing reliance on credit rating agencies • Ensuring global convergence of accounting standards • Improving standards on fair-value accounting and off-balance-sheet entities, making accounting valuations less procyclical and more informative • Enhancing access to information / transparency in OTC derivatives markets • Ensuring that standardized OTC derivatives are traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties

12. Basel III: key components • Dec 2010: two BCBS papers: • “Basel III: A global regulatory framework for more resilient banks and banking systems” (revised June 2011) • “Basel III: International framework for liquidity risk measurement, standards and monitoring” • Key components: • Review of Basel II system of minimum capital requirements • Two new capital buffers, on top of basic capital adequacy requirement • Non-risk-weighted capital requirements: leverage ratio • Measures to correct the pro-cyclicality of minimum capital requirements • Two new liquidity ratios: moving beyond capital adequacy! • Gradual implementation of new norms: • 1 Jan 2013 through 1 Jan 2019

13. Recast capital adequacy requirements • Recast of definition of own funds: • greater emphasis on common equity (“core Tier I” capital); • abolition of Tier III capital; • limit on inclusion of general provisions in Tier II capital: up to 1.25% of risk-weighted assets (“RWA”) • Enhanced risk coverage: inclusion of credit risks arising in the context of derivatives, repo agreements, etc • Revised minimum capital ratios: • 4.5% core Tier I capital / RWA; • 6% Tier I capital / RWA; • 8% total own funds (Tier I + Tier II) / RWA

14. Add-ons to the capital adequacy regime • New capital buffers, on top of basic requirements • Capital conservation buffer: 2.5% core Tier I capital / RWA, as first line of loss-absorption • Countercyclical buffer: 0% to 2.5% core Tier I capital / RWA, to be called at national supervisors’ discretion in times of excessive credit expansion & drawn down in recessions • Measures towards non-procyclical / countercyclical capital adequacy requirements • Correctives to excessive pro-cyclicality of capital requirements • Long-term data horizons to estimate probability of asset default • Downturn loss-given-default estimates • Forward looking provisioning: move towards expected loss approach • Stress tests • Minimum 3% leverage ratio (core Tier I capital / total gross nominal exposure): parallel, non-risk-weighted capital requirements

15. New risk-weighted capital adequacy ratios Source: BCBS 189

16. Liquidity requirements • New liquidity ratios: a first in international banking regulation • Details still under discussion • Liquidity coverage ratio (LCR): minimum 100% high-quality liquid assets / total net cash outlays of next 30 days • Regulators may allow banks to move below minimum LCR in times of stress • Net stable funding ratio (NSFR) as longer-term structural liquidity ratio: minimum 100% of available stable funding / funding needs, as defined • Supervisory observation of liquidity risk on the basis of: • contractual maturity mismatch; • concentration of funding; • available unencumbered assets; • LCR by significant currency; • market-related monitoring tools

17. Transition to Basel III Source: BCBS 189

18. Haldane’s critique • Is the Basel methodology both excessively detailed and inaccurate? • Robust call by key regulator for more parsimonious regulatory approach (Andrew Haldane, executive director for financial stability, BoE, speech of 31 Aug 2012) • Basel Accord (1988): • Brief (30 pages long), comprehensible • Covered credit risk only, based on five risk categories; • Operated as a backstop, not substitute for commercial risk decisions • Starting with the Market Risk Amendment (1996): • Highly detailed/complex regulatory framework • Covers credit, market and operational risks on the basis of a large number of estimated parameters and capital charges • Incorporates credit ratings • Incorporates banks’ own risk models, blurring the distinction between commercial and regulatory judgments

19. A flawed framework? • Opacity, reliance on great number of estimated parameters • Non-comparability across banks, raising issues of competitive equality • Supposed “accuracy” of risk estimations flounders due to the lack of sufficiently large and accurate series of historical data • Low predictive power: simple leverage ratio found to yield better results • Subsidises complexity! Distinct advantage to large/complex financial institutions (although this is now reversed, due to the resolution requirements for SIFIs, to be discussed next) • Haldane: appeal for resort to simple rules of thumb (heuristics) / supervisory discretion / market discipline • Leverage should play a greater role: • 3% ratio in Basel III: first ever internationally consistent ratio • But is it sufficient?

20. Macroprudential oversight • Belief that certain problems do not arise / are not observable at individual firm level, lead to high correlation of risk across banks • Macroprudential regulation: aimed at early identification, prevention, mitigation of such risks, e.g. bubbles, affecting the whole financial system • Establishment of new institutions with specific mandate to oversee systemic risk / prevent procyclicality in operation of the financial system • Globally: transformation of FSF into FSB (FSB), with much wider mandate as coordinator of standard-setting bodies / monitor of systemic risk • US: Financial Stability Oversight Council (FSOC), chaired by Secretary of the Treasury • UK: Financial Policy Committee (FPC), as a committee of the BoE • EU: creation of European Systemic Risk Board (ESRB), as part of the European System of Financial Supervision (ESFS); multimember college, comprising central bankers and regulators

21. Approach: • observation of system-wide and macro-economic developments; • use of quantitative and qualitative indicators to identify and measure systemic risk; issuing of warnings and recommendations; • directing the taking of remedial action • Generally: “softer” mandate than microprudential regulators, limited ability to take direct action (e.g., ESRB lacks direct enforcement power); more political • Open question: how effective / powerful macroprudential bodies may prove to be? • Successful implementation: contingent on the ability to identify and estimate systemic risk in real time; is this possible? • Use of controversial indicators / models, e.g. stress tests: legally ambiguous, but highly pervasive / consequential use of discretionary power, unconstrained by the legal controls of standard microprudential regulation?

22. Special Resolution Regimes for failed banks • Trend towards SRRs for troubled banks (UK, Germany, EU proposals), following the US example (FDICIA of 1991) • Specific FSB requirements relating to global and domestic systemically important financial institutions (SIFIs) • Objective: orderly resolution (including in the form of reorganization), prioritizing public interest objectives (financial stability, continuity of essential services, protection of retail depositors) • Requirement of prior “recovery and resolution planning” (“living wills”) by large banks and their supervisors, setting the ground for effective and expeditious resolution in the event of failure • Possibility of early regulatory intervention at the pre-insolvency stage, if weakness is detected • Regulatory assumption of control once the resolution trigger is crossed: in addition to management, power to exclude / expropriate old shareholders, forcibly dispose of the bank or its business • Possibility of bridge financing with public money to enable reorganization / transfer of control to new owners

23. The end of TBTF & moral hazard? • SRRs are supposed to ensure that no bank is “too big to fail” • Resolvability ensured through prior planning and arrangements ensuring loss-absorbency • Higher capital requirements for large-complex banks • SRRs designed to combat moral hazard, by imposing ex post cost on shareholders and bondholders • Mandatory expropriation of shareholders • Imposition of haircuts on junior and senior bondholders, in the form of write-downs in case of liquidation, or of “bail-in” to facilitate reorganization (statutory debt-to-equity conversions, issuance of contingent convertible bonds or CoCos) • The end of moral hazard? • How credible is the “no bailout” threat? • The system preserves some failed banks, and shelters at least some stakeholders (i.e. the depositors) from losses • Saving large, systemic banks (even if there is change of control) has significant competitive implications

24. Regulatory dynamics & uncertain effect of the reforms • Agreement in principle on a reform agenda does not guarantee agreement on the detailed arrangements • See, e.g., macroprudential arrangements, or the proposed systems of separation of banking from trading activities • International convergence hampered by differences in national approach • EU accused by BCBS inspection team of “non-compliant” application of Basel III in two key areas:looser definitions of core capital in at least sevenways;and loophole, allowing banks to treat sovereign debt holdings as risk-free! • More generally: Strong popular demand for radical reforms during crisis results in bold / sweeping legislative changes, • But these are watered down, and eventually reversed, over time, as the issues loose their political salience and lobbying by banks affects the technical details of implementation • See, e.g., implementation of the Volcker rule in US

25. Thank you for your attention CHRISTOS HADJIEMMANUIL Professor of Monetary and Financial Institutions, University of Piraeus Visiting Professor of Law, London School of Economics Attorney at law, Athens Bar Association e-mail: c.hadjiemmanuil@ablaw.com, c.hadjiemmanuil@lse.ac.uk tel: +30 6936 161770