Triggers for PCA

1. Triggers for PCA Financial Regulation Seminar June 9, 2008 Thorvald Grung Moe Norges Bank (Central Bank of Norway) The views presented are mine and should not be associated with Norges Bank

2. Outline • Background • Key features of PCA • PCA in Europe? • Design of PCA triggers • Policy issues • Way forward

3. Background

4. Definitions • PCA = Prompt Corrective Action • Rule-based intervention framework based on specific levels of bank capital • FDICIA = Federal Deposit Insurance Corporation Improvement Act of 1991 • SEIR = Structured Early Intervention and resolution (Benston and Kaufman, 1988) • Mandatory regulatory responses based on predetermined capital assets ratios that trigger structured actions by supervisors

5. Trigger event • How can we avoid another run? • Strengthen the financial system • Reducing likelihood of banks failing • Reducing the impact of failing banks

6. Renewed interest in PCA • The Treasury Committee: • … see great merit in the “prompt corrective action” approach adopted in the US and in other countries. • We recommend that the judgment of the relevant authority, supplemented by a set of quantitative triggers, be used to identify whether a bank is either “failing”, at risk or failing, or is just an outlier in the industry.

7. Tripartite report – more reserved • … the interventions and powers available to the FSA are already wide-ranging • there may be cases in which there are practical problems with implementing (intervention) OIVOP powers (*) • … the authorities judges that the FSA requires a small number of additional powers (*) Own Initiative Variation Of Permission

8. IMF support PCA type policy • … the regime of remedial measures to be applied against weak institutions crossing various thresholds established by the FSA could be further elaborated. Although the existing powers of the FSA to take action against weak institutions suffice, increasing clarity on the outcomes sought by regulators will lead to reduced ambiguity and would encourage early voluntary actions by weak financial institutions, for instance by reducing dividends and augmenting capital. IMF Article IV Concluding Statement; May 23, 2008

9. … there were a number of indicators emerging that could have prompted the supervisory team to re-assess its view of Northern Rock’s business risk much earlier (p. 42) Should FSA have spotted the crisis? • A number of signals were apparent that individually (and in aggregate) should have provided a trigger for a review of the structure of the balance sheet and the appropriateness of controls, … (p. 39)

10. FSA Internal Audit Report(March 2008) • Inadequate FSA resources • Lack of management attention • Last ARROW in march 2006 • Letter to NR board: “Risk to FSA: LOW” • No Risk Mitigation Process (RMP) • Supervisory period extended to 3 y • Weak Close & Continuous process • Liquidity review April 2007: • “No material weakness”

11. PCA Workshop in Norges Bank March 2008 • Issues for discussion • DO YOU THINK PCA REGULATION COULD BE USEFUL IN EUROPE? • HOW SHOULD PCA TRIGGERS BE DESIGNED AND USED? • WHICH REGULATORY ACTIONS SHOULD BE “TRIGGERED” - AND HOW FIXED SHOULD THE LINK BE BETWEEN TRIGGERS AND MANDATORY ACTIONS? • ANY OTHER RELEVANT ISSUES RELATED TO PCA TRIGGER IMPLEMENTATION IN EUROPE?

12. ConclusionNorges Bank workshop on PCA triggers, March 2008 PCA legislation is no panacea, but if implemented in a flexible and pragmatic manner, it could be a useful supplement to current EU regulations

13. PCA in context; related themes • Rules versus authority (Simons 1936) • Why prevention is better than cure (Goodhart 2007) • Banking regulation and PCA (Freixas and Pragi 2007) • Disclosure, volatility and transparency (Baumann 2004) • Formulas or supervision? (Estrella 1998) • The credit crisis and what it means (Soros 2008)

14. Key features of PCA

15. FDICIA -“Subtitle D”, Section 38 • Mandates that each appropriate Federal banking agency … to take prompt corrective action to resolve the problems of insured depository institutions by prescribing or rescinding, as appropriate, specified capitalization measures established according to statutory guidelines (including capital restoration plan requirements)

16. FDICIA (1991): Bank classification and related capital levels

17. Graduated supervisory response depending on capital category • Key provisions are [Sections 38 (d)–(i)] : • No institution can pay dividends that will lead it to be undercapitalized • Undercapitalized institutions will be monitored and have to provide a capital restoration plan; asset growth can also be restricted • Significantly undercapitalized institutions will (obviously) be subject to further restrictions • Critically undercapitalized institutions will be taken into receivership within 90 days

18. Restrict dividends No management fees Capital restoration Restrict asset growth Prior approvals for branching etc. No brokered deposits Require new capital Restrict affiliate transactions Restrict rates on new deposits Restrict activities Replace management Require divestiture Mandatory – Discretionaryprovisions for undercapitalized banks

19. Arguments in favour of a rule based approach to intervention • Increased credibility of supervisor • Reduce scope for regulatory forbearance • Reduce danger of undue political interference • Beneficial impact on bank behavior • Reduce probability of future insolvency Llewellyn & Mayes (2004)

20. Preconditions for PCA in Europe(*) (*) See Nieto and Wall (2007) for details

21. Philosophy of SEIR/PCA • Minimize deposit insurance loss • Forbearance should be limited • Banks should be closed at positive capital levels

22. Institutional preconditions • Supervisory independence and accountability • Adequate authority • Adequate resolution procedures • Adequate and timely financial information

23. Discussion • CRD (and B II) have PCA elements • Supervisory architecture different • Supervisors prefer “broader” approach • Elements of discretion even in FDICIA • Discretion due to uncertain information => Reluctance to embrace rule based intervention, but emerging support for early resolution features of PCA

24. CRD/B II have PCA elements • B II/Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored. • CRD/Article 136: Competent authorities shall require any credit institution that does not meet the requirement of this Directive to take the necessary actions or steps at an early stage to address the situation.

25. Different supervisory architecture Systemic concern Safety and soundness Least cost resolution Europe NCB incl. supervision DGS Pay box

26. US Federal Reserve: Regulators imposed formal action on banks long before their capital became undercapitalized. PCA legislation may fill a few gaps, but may have been oversold. Peek and Rosengren (1996) Canada’s FSA (OSFI): FDICIA was influential in shaping OSFI’s approach to intervention, but there was no direct importation. Rather, the framework was rejected in its existing form. Hard financial indicators were argued to be trailing rather than leading indicators of the financial health of an institution. Black (2004) Supervisors prefer “modified” PCA approach

27. OSFI: “Soft indicators” • The Guides to Intervention therefore incorporate ‘soft’ indicators, such as the strength of internal controls, internal policies on risk management and whether or not these were being followed, as well as figures on business growth in assessing financial health.

28. Broader supervisory approaches FSA: The ARROW risk model FED: CAMELS Capital Asset Quality Management Earnings Liquidity Sensitivity to market risk ARROW = Advanced, Risk-Responsive Operating Frame-Work

29. Even some discretion in FDICIA Section 38 (g): • If an insured depository institution is in an unsafe or unsound condition, … the agency may … • Reclassify the institution (“downgrade”) … • Require the institution to comply with (certain) provisions related to that capital category

30. Uncertain information => discretion • PCA encourage, but is not reliant on market value accounting • Paradox: PCA “rely on” effectiveness of supervisory examinations (Wall and Nieto 2007) • PCA ratings are lagging indicators of bank health (Peek and Rosengren 1996) • Interaction between accounting practices and financial crisis (Goodhart 2006) • Greater volatility => Stronger buffers

31. Emerging support for early closure • Special Resolution Regime (SRR) • … to ensure that a range of tools are available to take greater control of a failing bank • Special Resolution Regime (SRR) • … should be based on regulatory triggers, in line with principles in EU law governing the reorganization and winding-up of banks (!) • [= based on regulatory judgment by the FSA after consultation with BoE and HMT]

32. IMF support for SRR • We support the aim of early intervention of distressed institutions in the proposed SRR. • It is not possible to identify in advance all circumstances under which an institution should be put into the SRR process, but a definition of the circumstances likely to give rise to such a judgment would support this aim. • An approach whereby the regime is presumed to be triggered when a bank meets this definition strikes an appropriate balance between regulatory forbearance and unnecessary actions. • As thresholds for liquidity are hard to identify, discretion remains essential in this context. IMF Article IV Concluding Statement; May 23, 2008

33. The problem of “signal error” • Banking crisis do not appear out of the blue • A high proportion were anticipated by our best leading indicators • There is a problem, however, of too many “false alarms” • ~ one false for every 2-5 true signals Goldstein (2000): Early warning system for financial crisis

34. Design of PCA triggers

35. Design of PCA triggers • 10, 8, 3 or 0 %? • Alternative triggers? • Liquidity triggers? • Link to Early Warning Systems • Can we predict banking crises?

36. Markets will react negatively if banks even approach regulatory minimum Which type of crisis? Slow asset burn or sudden liquidity crunch? “90 days notice” if critically under-capitalized – realistic? “… weakness leading to failure are often evident and addressed … well before the PCA capital triggers are met.” Brunnmeir and Willardson (2006) When to intervene? At 10, 8, 3 or 0 risk weighted capital?

37. Perhaps not such a big issue?Very few banks are actually undercapitalized Distribution of US banks along PCA and CAMEL categories Source: FDIC (2001)

38. RBI will initiate structured action if banks break any of these triggers: Capital to risk-weighted assets ratio (CRAR) Non-performing assets (NPA) Return on Equity (ROE) Wider set of triggers? Source: Reserve Bank of India (2000)

39. Perhaps also liquidity triggers? • FSA (2007): Liquidity is hard to predict! • Liquidity risk can grow very rapidly • One suggested liquidity trigger: • Request for emergency support facility • Other suggestions: • Funding mismatch • Short-duration liquidity shock • Which corrective action to associate? • Close link with central bank ELA

40. Link to Early Warning Systems • New risk index estimated by Norges Bank gives strong and early signals of 1990-93 crisis banks • The risk index includes six indicators: • The capital adequacy ratio • Ratio of residential mortgages to gross lending • An expected loss measure • A concentration risk measure • Return on assets • Norges Bank’s liquidity indicator

41. Early Warning Systems: Fantasy or Reality? • ECOFIN (2008) • Considerations should be given to the further development of early warning systems on individual (financial) institutions. • FSF (2008) • Authorities must do all they can to identify emerging problems so as to be able, if necessary, to take prompt appropriate action to mitigate them.

42. Core set RWC NPL Sector % of loans ROA ROE Interest margin Cost ratio Liquid assets Net open FX position Encourage set -additional data on: Deposit takers Other financial institutions Non-financial companies Households Market liquidity Real estate markets IMF Financial Soundness Indicators

43. Can we predict banking crises? • There are two traditional views of banking panics • Crisis is generated by random events (sunspots)=> bank run not due to any exogenous shock, or • Crisis is generated by fluctuations in fundamentals of the economy • Our theory … makes firm predictions about the conditions under which crisis will occurAllen & Gale (2002)

44. But Goodhart’s law would kick in • It is highly unlikely that a set of indicators could be identified that could detect future crises sufficiently early and with a high degree of certainty, while not giving false signals. • Indeed, if such indicators could be identified they would likely lose their usefulness because they would change behavior; markets would take them into account and, by anticipating crises, precipitate them earlier, or policymakers would take actions to prevent crises from occurring. Consequently, the indicators would lose their ability to predict crises. IMF (1998): Economic Outlook

45. … it is essential that optimal risk-sensitive capital requirements be complemented by a capital floor that does not depend on the riskiness of banks’ activities. Bichsel & Blum, April 2005 Reducing the leverage ratio would undermine our whole system of prompt corrective action which is the foundation stone of our system of supervision… Former Comptroller of the Currency John Hawke, April 2004 Something simple might do the trick: The leverage ratio

46. PCA policy issues

47. Early intervention Write down share capital ELA conditions Early resolution Closing a bank and depositor payout Bridge bank solution 1996 Act on Guarantee Schemes for Banks and Public Administration etc. Chapter 3: Payment and capital adequacy difficulties Chapter 4: Public Administration Current PCA policy issues in Norway

48. Triggers for SEIR in the 1996 Act

49. 1) Write down triggers in the Act • Write down possible according to the Act • However, write down may come too late? • Require new audited statement • Could take some time • How to protect shareholders right when time is short? • Chapter 4 (PA) + going concern may be better option? Based on large bank with Tier 1=8% and Tier 2=11,2%

50. 2) ELA policy issues (2004 – 2008) • Current financial crisis has highlighted: • Classic LLR case again • Illiquid, but solvent • ELA despite RWC > 10% • ELA only for systemic banks with collateral • But, obvious need for CORRECTIVE ACTION • Need to coordinate ELA conditions with FSA • Strengthen capital position • Engage shareholders 2008 2007 2004 ELA policy issues 2006 2005