A New Regulatory Environment: What can we Expect?

1. A New Regulatory Environment: What can we Expect? Arnoud W.A. Boot University of Amsterdam and CEPR FSA on Shadow Banking April 28, 2011

2. My remarks • Understanding the 2007-09 crisis and beyond • Regulation/supervision • What is wrong? • Dodd-Frank, EU, UK Independent Committee, Basel… What needs to be done? • Do we understand the economics of banking? New Regulatory Environment Arnoud W.A. Boot April 28, 2011

3. The crisis: Economic setting • How do you regulate an increasingly dynamic financial services industry? • Proliferation of financial markets with institutions and markets being increasingly intertwined • Rapid innovation in financial instruments, distribution channels and institutions • Blurring distinction between banks and other financial institutions Mushrooming of the financial sector… New Regulatory Environment Arnoud W.A. Boot April 28, 2011

4. Financial crisis... Much can go wrong in the financial sector • Modern banking suffers from extreme interconnectedness... • Existing regulation/supervision lacked macro-prudential focus • In euphoric times risk is underpriced and always too much capital... • When times are good no support for tough regulator…. • Where money is being earned rests control New Regulatory Environment Arnoud W.A. Boot April 28, 2011

5. Information technology key What did information technology really do to the financial sector? … Extreme tradability… and ‘changeability’… Risks via • Herding behavior • Power structure within financial institutions.. New Regulatory Environment Arnoud W.A. Boot April 28, 2011

6. How to look at financial innovations? • Extensive literature shows value of innovations • Spanning • Other direct benefits for real activities (e.g. commercial letter of credit) • Yet this literature may say little about more recent financial innovations • (Often?) creating opaqueness • Aimed at regulatory arbitrage only?  Opened up bank balance sheet: marketability and changeability key New Regulatory Environment Arnoud W.A. Boot April 28, 2011

7. Crisis? You can sleep soundly again... Amerikaanse Dodd-Frank Financial Reform Act: “[This Act] ends the possibility that taxpayers will be asked to write a check to bail out financial firms that threaten the economy, consumers, investors and businesses…” … really???? New Regulatory Environment Arnoud W.A. Boot April 28, 2011

8. Length of the bill not an issue... New Regulatory Environment Arnoud W.A. Boot April 28, 2011

9. New regulation? • Scope of regulation and supervision needs to be contained? How to limit systemic reach? • Cross-sector footprint • Cross-border issues • Most importantly (?) “seamless” integration of financial markets and institutions • Marketability has its limits…. • Complexity… Issue: all this obscures object of supervision New Regulatory Environment Arnoud W.A. Boot April 28, 2011

10. Greenspan… Can we accept Allen Greenspan’s statement that the financial system is like Adam Smith’s invisible hand …. some type of complex eco-system that is beyond anyone’s control or imagination, and is “unredeemably opaque” (Financial Times, March 31, 2011) New Regulatory Environment Arnoud W.A. Boot April 28, 2011

11. Fundamental reform • Will international coordination go far enough? • Role IMF, FSF/FSB and BIS (Basel) • EU-wide regulators, ESAs, ESRB, role ECB • Burden sharing • More capital… • Market discipline? Need more than that? • Structure of the banking sector • Limits on use of deposits? OTC? Etc. New Regulatory Environment Arnoud W.A. Boot April 28, 2011

12. Market discipline? • Sensible complementary ‘tool’. Idea behind third pillar Basel II • Complicated effect in crisis times: everyone may “head simultaneously for the exit” • Paradox in normal times… momentum in financial market may lead to opportunistic behavior of banks, yet same momentum driven markets would simultaneously have to impose discipline?  Market discipline effective for idiosyncratic differences between institutions, less for financial market driven strategies New Regulatory Environment Arnoud W.A. Boot April 28, 2011

13. Cost of capital fallacy We do not need to like M&M, nor believe M&M has relevance to banking, but to deny that “the cost of capital is affected by the risk that the capital is exposed to” is disturbing Implications: • Fixed cost of capital does not make sense • Maximizing ROE fundamental violation of corporate finance theory …. No free lunches, yes self-fulfilling prophecy… New Regulatory Environment Arnoud W.A. Boot April 28, 2011

14. Complexity • Simplifying structure of financial institutions of paramount importance for alignment market forces and prudential concerns • But existing complexity itself makes it also difficult to act on structural measures. • No readily available prescriptions on how to simplify • Difficult to grasp interlinkages and intralinkages New Regulatory Environment Arnoud W.A. Boot April 28, 2011

15. Dealing with complexity i. Complex institutions difficult to manage and supervise (problem of opaqueness); ii. A complex financial institution has many, difficult to discern linkages with the financial system at large; TBTF, too-interconnected-to-fail concerns; iii. As a consequence systemic concerns might become more prominent; iv. Complexity puts supervisors in a dependent position, e.g. how to intervene (timely)? New Regulatory Environment Arnoud W.A. Boot April 28, 2011

16. Dealing with complexity – 2 • Living will idea aimed at mitigating this • Only effective if dealt with ex ante • How to disentangle businesses? • Separate legal structures, no recourse? • Would it work, and does market accept it? • UK Banking Committee? • Breaking-up banks? (Volcker Rule and beyond…) New Regulatory Environment Arnoud W.A. Boot April 28, 2011

17. You ain’t seen nothing yet…. ‘Anyone who deals in the financial markets knows that anticipating trends is difficult at best. But he or she also realizes that not to try is tantamount to accepting the most unlikely scenario of all: no change’ (Sandford, 1994) New Regulatory Environment Arnoud W.A. Boot April 28, 2011

18. Appendix:Structure EU banking sector supervision Elaborate EU coordination being implemented…. New Regulatory Environment Arnoud W.A. Boot April 28, 2011

19. History of EU banking regulation 19 System of home-country control –2nd Banking Directive 1988 Lamfallusy framework Larossiere report New Regulatory Environment Arnoud W.A. Boot April 28, 2011

20. European Systemic Risk Board (ESRB) • Steering Committee (12 persons) • 7 ESCB members • 3 chairs of ESAs • Member of the European Commission • EFC President • General Board (at least 62 persons) Macro-prudential supervision Report to ECOFIN Early risk warning and recommenda-tions to governments Early risk warning and recommendations to supervisors Micro-prudential information • European System of Financial Supervisors (ESFS) Steering Committee: Chairsof 3 ESAs Micro-prudential supervision European Securities Markets Authority (ESMA) European Banking Autority (EBA) European Insurance and Occupational Pensions Autority (EIOPA) New Regulatory Environment Arnoud W.A. Boot April 28, 2011

21. Macro-prudential policy “Macroprudential policy focuses on the interactions between financial institutions, markets, infrastructure and the wider economy. It complements the microprudential focus on the risk position of individual institutions, which largely takes the rest of the financial system and the economy as given.” “[Systemic risk is defined by the IMF, FSB and BIS for the G20] as a risk of disruption to financial services that is caused by an impairment of all or parts of the financial system and has the potential to have serious negative consequences for the real economy” [Committee on the Global Financial System, emphasis added] New Regulatory Environment Arnoud W.A. Boot April 28, 2011

22. Characteristics of systemic risk to address • Excess credit growth to private sector • Widespread maturity mismatches • More opaque chains of intermediation • Cross-exposures and contagion • Massive undervaluation of risk • Procyclicity • Bubbles • Market freezes/ fire sales New Regulatory Environment Arnoud W.A. Boot April 28, 2011

23. Implications for Basel II Note: Basel II was just being implemented, thus not the direct cause of current problems …But… • Induces herding behavior via use of models • VAR not just ignores tail risks but ignores systemic issues • Induces low capitalization in general and particularly in good times… procyclicality… New Regulatory Environment Arnoud W.A. Boot April 28, 2011

24. BIS III … (Basel III) What does it seek to do?? • Level of capital • Quality of capital • Leverage ratio and timely intervention • Liquidity New Regulatory Environment Arnoud W.A. Boot April 28, 2011

25. Other issues.. • Contingent capital?? • What does it seek to address? • More capital for systemically relevant institutions? New Regulatory Environment Arnoud W.A. Boot April 28, 2011

26. Economics of banking • Government involvement lasting... • Regulation has a cost too.. • Regulatory arbitrage • Level playing field • What is optimal for banks? • ERM perspective, risk appetite  Implications for business model New Regulatory Environment Arnoud W.A. Boot April 28, 2011

27. New Regulatory Environment Arnoud W.A. Boot April 28, 2011