Andrew Haldane: On counterparty risk (A paper appearing in the May 2012 Journal of Risk Management in Financial Institutions)
The financial crisis demonstrated the inadequacy of the management of counterparty credit risk and the vulnerability of financial structures to counterparty concerns.
Three possible solutions are proposed to mitigate such risks in the future:
Time will tell whether the new Basel capital levels will be enough to absorb losses from risks we understand and those risks we may not understand, “but if we are to err at all, surely it should be on the side of too much rather than too little capital.”
Uses a simple macroeconomic model to study the extent to which capital adequacy requirements and interest rates might be substitutes in meeting the objective of stabilising the economy.
The G20’s solution proposal for new SIFI rules are built on two pillars:
The likelihood of a SIFI failing has to be reduced, meaning that SIFIs are to be more resilient, mainly through specific capital surcharges that go beyond the requirements of Basel III.
The restructuring or resolution of a SIFI is to be made possible in future without jeopardising financial stability and without having to resort to taxpayers’ money.
Progress report on global planning for resolution regimes aimed at addressing the problem of Too Big To Fail.
Stresses that a robust, credible resolution regime “... can lead to a much better financial system, with stronger market discipline and so less stability-threatening imprudence.”
Examines the issue of the trigger for resolution, which some have criticised for being unclear, adding uncertainty to the resolution process.
The EU directive on resolution regimes will be “…crucial in giving us all the tools we need”; with Dodd-Frank already in place, “…it will help set the tone for the world.”
The level of a bank‘s capitalization can effectively transmit information about its riskiness and therefore support market discipline, but asymmetry information may induce exaggerated or distortionary behavior: banks may vie with one another to signal confidence in their prospects by keeping capitalization low, and banks‘ creditors often cannot distinguish among them - tendencies that can be seen across banks and across time.
Likens the connection between the economic policy making of different countries to “the Prisoner’s Dilemma—a non-cooperative approach will lead to inferior results for both players compared to a cooperative approach in which each side foregoes the chance for highest potential payoff in exchange for the payoff that maximizes returns jointly.”
Observations on the regulatory side:
“Essential that regulations be harmonized internationally to a much greater degree than in the past.”
“Critical that the harmonized regulations produce something that is coherent and effective on an international level, and that the different regimes in specific jurisdictions add up to a workable whole.”
“Regulatory harmonization and cooperation, by necessity requires trust and a willingness to share relevant information across jurisdictions.”
“We live in a globalized world both with respect to the macro-economy and the financial system. But too often we set macroeconomic policy and regulatory policy at a national level, and miss important opportunities to coordinate and make the global economic and financial system stronger overall.”
“We need to understand where greater global perspective is required and we need to apply that perspective consistently across jurisdictions in a timely manner. If we don’t do this, we won’t achieve all the benefits that are possible from global specialization and we will continue to run significant risks with respect to financial stability.”
In “hindsight” the Bank could have done more to warn of the dangers to financial stability prior to the crisis, but most of the blame should be laid at the door of the banks, the government of the day and the general “regulatory approach” of the time for the failure to head off the crisis.
The current crisis is “far from over” , and the Bank will play an important role with its new responsibilities in ensuring a recovery from the current “bad banking situation”.
Points to the “three Rs”: regulation, resolution, and restructuring. These refer, respectively, to the return of regulatory responsibility to the Bank, the creation of a resolution framework for managing the failure of banks, and the restructuring of banks through the implementation of the Vickers’ recommendations.
Calls on the UK Government to implement the recommendations of the Independent Commission on Banking “sooner rather than later”.
Its economic and financial statistics are currently not detailed enough to allow for a full understanding of the risks posed by ‘shadow banking’, or credit intermediation conducted outside of the regulated banking system.
The paper investigates the extent of shadow banking and its structure across the euro area.
More micro-economic data and qualitative information are needed to identify maturity and liquidity transformation and thereby assess the case for regulatory intervention.
With the European Commission currently consulting on potential regulatory measures for shadow banking, this paper serves as a reminder that understanding of the issue is still developing.
EU finance ministers fail to agree position on bank capital despite talks reported to have lasted over 15 hours
Disagreements persist over so-called ‘maximum harmonisation’, whereby capital levels would represent not only a minimum, as explicitly envisaged by the Basel Committee on Banking Supervision (BCBS), but also a maximum.
Some countries, notably the UK and Sweden, want the power to impose higher capital ratios on their own banks as part of their macroprudential toolkits.
There are also reports that ministers failed to agree on a common definition of regulatory capital. Competing definitions could lead to variations in capital requirements of up to 300 basis points, some reports suggest.
The ministers postponed the target date for a deal to May 15.
A financial ‘arms race’ led banks to pursue excessive leverage in the decades before the financial crisis, fuelling extreme increases in returns on equity and remuneration.
He uses an evolutionary analogy, pointing to animals such as elephant seals and peacocks, which pursue advantages to the cost of other members of their species, and ultimately to themselves as their former sources of advantage become sources of vulnerability.
European Commission Conference “Towards better regulation of the shadow banking system”
He emphasised that shadow banking is “not the same as the non-bank financial sector.”
He concluded by saying that the policy framework would need to be adaptive, and that “it would be foolhardy to imagine that we can frame policies today that will stand the test of time” with an evolving, innovating financial system.
The “underlying problem” of failures in “behaviour, attitude, and in some cases, competence” remains unsolved by new financial regulations.
“Insufficient progress” has been made towards effective corporate governance of firms.
He highlighted the FSA’s regime for vetting potential senior appointees, noting that “too frequently” applicants for such roles had not done sufficient due diligence on the firm or role for which they were applying, and further suggesting that some still view senior positions as entitlements “regardless of their skills and experience.”
Markets’ “remorseless focus” on upcoming earnings announcements was exacerbating short-termism and excessive risk taking.
“A successful regulatory regime will not be sufficient to ensure good outcomes” without changes to culture, which should be rooted in “strong ethical frameworks”.
A relationship of “constructive tension” should prevail between regulators and the regulated, joined by a “common purpose”, in which individuals do not work solely for personal gain.
Discussion of a regime for bailing-in creditors of distressed banks, the construction of which raises a whole host of seemingly intractable policy problems.
The note covers its rationale, and a range of principles which a bail-in regime would need to have regard to.
Difficult issues include the level at which a bail-in process is triggered, the range of instruments which would be subject to bail-in, the impact of bail-in on the creditor hierarchy, cross holdings of bail-in-able debt, and bail-in for cross-border banks.
Says it may be necessary to “carve out” some types of senior unsecured debt, such as inter-bank deposits, which “may be of systemic or strategic importance”.
Recognises that bail-in will not of itself solve the problem of ‘too big to fail’ banks, and that official liquidity assistance and even government financing may be needed during debt restructurings to prevent outflows of capital. Perhaps the most difficult of issues is bail-in for a cross-border bank.
Expressed support for the Securities and Exchange Commission
(SEC) to adopt further reforms to money market funds (MMFs).
Said there was a “compelling” case for reform because
despite the introduction in 2010 by the SEC of an increased liquidity buffer to
be maintained by MMFs, the “combination of fixed net asset value, the lack of
loss absorption capacity, and the demonstrated propensity for institutional
investors to run together” made it clear the risks of a run on MMFs could not
be discounted, such that additional measures expected to be shortly introduced
by the SEC (including requiring MMFs to maintain capital buffers) is needed to
mitigate any possible systemic risk posed by this section of the shadow banking
system.
Using a “macro-historical framework, we can see Japanese deflation, European debt, and even the Arab Spring as phases of systemic changes within complex structures that are interacting with one another in a new, multipolar global system. We are witnessing simultaneous global convergence and local divergence.”
“The INET conference in Berlin showed the need for a new [consensus of free-market reforms] – a consensus that supports sacrifice in the interest of unity. Europe could use it.”
Warns that the recommendations of the Bank of England’s Financial Policy Committee, which include sectoral capital requirements – where banks would have to post more money against companies in specific risky sectors – and possibly a time varying liquidity tool, “could easily materially impact access to credit and its pricing.” (see p6)
FSB: reports to G20 on progress of financial regulatory reforms
Letter by Mark Carney (FSB Chair) to the G20, sent ahead of their meeting, reporting on the progress being made in the following priority reform areas: (i) building resilient financial institutions; (ii) ending “too big to fail”; (iii) strengthening the oversight and regulation of shadow banking activities; (iv) completing OTC derivatives and other reforms to create core continuous markets; and (v) implementing agreed G20 reforms in a timely and consistent manner.
Report on progress in extending the framework for Global Systemically Important Financial Institutions (G-SIFIs) to domestic systemically important banks.
Report on progress in strengthening the oversight and regulation of the shadow banking system.
The Board announced the formation of the Model Validation Council, which will provide the Federal Reserve with independent advice on its assessment of the models used in bank stress tests, and will hold a two-day symposium in September to discuss best practices in stress testing.
Highlights a number of areas where challenges remain for statisticians trying to create systems to enable monitoring of risks in the financial system
However, he noted that data challenges “would be far more modest”, and the need for supervisors to collect information would be reduced, if the level, quality, and consistency of public disclosure “were more satisfactory.”
“On the one hand, we all need to be attentive to the effects that easy monetary policy globally can have on risk-taking behaviour. On the other hand, financial regulators cannot afford to focus exclusively on the health of individual banks and dealers as though they were isolated atoms ... The FPC is about filling the space between monetary policy and microregulation.”
Recent stress tests showed that US banks are much more robust and resilient than they were a few years ago. But US money market funds have significant European holdings, so “if the crisis were to broaden further and intensify, it would put pressure on the capital and liquidity buffers of US banks and other financial institutions.”
ECB Spring Bulletin 2012: including (on p2) Bubbles, banks and financial stability by Kalin Nikolov
Economic and financial cycles are not harmonised across EU countries, and the structure of the financial system varies from country to country.
The issue is controversial, with some member states pushing for ‘maximum harmonisation’, whereby capital requirements would pose both minimum and maximum capital levels.
Existing proposals allow for some flexibility, but these comprise mainly micro-prudential tools aimed at individual institutions, rather than macroprudential tools aimed at systemic risk.
The ECB recommends that the scope for national discretion should be expanded to allow member states to impose stricter requirements for capital and limits on large exposures, as well as liquidity and leverage ratios, when these latter elements are introduced.
The ECB suggests that the European Systemic Risk Board (ESRB) could play a coordinating role in order to ensure consistency across the EU, with the ESRB and the European Banking Authority (EBA) publishing a list of measures more stringent than those in the regulation.
