RD News 1Dec11

• BoE: Financial Stability Report Dec 11
• Given the current exceptionally threatening environment, if earnings are insufficient to build capital levels further, banks should limit distributions and give serious consideration to raising external capital in the coming months.
• Banks should improve the resilience of their balance sheets without exacerbating market fragility or reducing lending to the real economy.
• FSA should encourage banks to disclose their leverage ratios, as defined in the Basel III agreement, as part of their regular reporting not later than the beginning of 2013.

• ECB: Jürgen Stark: Globalisation and monetary policy – from virtue to vice?
• Monetary policy in the run up to the crisis was too complacent about macroeconomic stability. It lacked sufficient medium-term orientation and under-appreciated the role of monetary and credit dynamics in monetary frameworks.
• It was poor at identifying financial imbalances and globally interconnected risks.
• Need to reaffirm the centrality of price stability for monetary policy. It is the single best contribution that monetary authorities can make to overall economic welfare.
• But globalisation implies a greater emphasis on medium-term orientation of monetary policies designed to maintain price stability.

• Ravi Menon (MD, Monetary Authority of Singapore): Asia – no room for complacency
• Eurozone problems will reduce trade financing, project financing, asset leasing, SME lending, and syndicated lending to Asia.
• Asian banks will step up and fill some of these gaps, but it is unlikely that there would be full substitution. The resultant tightness in credit could lead to a slowdown in economic activity. 
• According to the IMF, if growth in the EU declines by 3.5% points below the baseline for two years, growth in Asia will decline 1.5–4.0% points below the baseline.
• On the plus side Asian banks are well-capitalised. The 25 largest comfortably meet Basel III Tier 1 capital adequacy ratios.
• Asia will remain the fastest growing region in the world. But most of Asia is still relatively poor in per capita terms, its financial markets are still under-developed, and it lacks truly global businesses.
• International Journal of Central Banking Dec11 Issue
• Capital Regulation and Tail Risk
• Under tail risk scenarios banks do not internalize losses independently of the level of initial capital, the buffer and incentive effects of capital also diminish. Higher capital may become a less effective way of controlling bank risk.
• Higher capital may have an unintended effect of enabling banks to take more tail risk without the fear of breaching the minimal capital ratio.
• Left tails limit the effectiveness of capital as the absorbing buffer and restrict ‘skin in the game’ because a part of the losses is never borne by shareholders. Hence, under tail risk, excess risk-shifting incentives of bank shareholders may exist almost independently of the level of initial or required capital.
• If highly capitalized banks internalized all losses, they would only take risks if that was socially optimal. But with tail risk banks never internalize all losses, and may take excess risk.
• A bank may choose to hold higher capital in order to create a cushion over the minimal capital requirement so as to be able to take tail risk without the fear of a corrective action.
• This suggests that as well as minimum capital ratios we need a bound from above to curb excessive tail risk taking.
• The Capital Conundrum
• In historical terms the Basel III leverage ratio of 3% is ‘quite timid.’
• Equity-to-asset ratios should be raised substantially above currently proposed levels.
• Contingent convertible capital (CoCo) instruments may address some of the problems of bank capitalisation.
• A substantial CoCo requirement protects society from loss as effectively as an equivalent amount of additional equity capital, but CoCos enable a bank to recapitalize automatically if it falls short of the equity capital requirement.
• A Pigovian Approach to Liquidity Regulation
• Paper discusses liquidity regulation when short-term funding enables credit growth but generates negative systemic risk externalities.
• Focuses on the relative merit of price versus quantity rules, showing how they target different incentives for risk creation.
• When banks differ in credit opportunities, a Pigovian tax on short-term funding is efficient in containing risk and preserving credit quality.
• Liquidity buffers are either fully ineffective or similar to a Pigovian tax with deadweight costs.
• When banks differ instead mostly in gambling incentives, excess credit and liquidity risk are best controlled with net funding ratios.
• In general, an optimal policy should involve both types of tools.

• NY Fed: Monetary Policy Implementation: Common Goals but Different Practices
• Fed, ECB, BoE, SNB – first three target overnight rate, while SNB targets a range for the three-month Libor for the Swiss franc.
• The choice between a short-term and longer-term rate presents trade-offs: the former is easier to target, but the latter is more relevant to economic activity, since it more directly influences firms’ investment decisions and households’ real estate decisions.
• During periods of financial stress, the use of the three-month rate permits a central bank to stabilize the long-term rate while letting shorter rates fluctuate to absorb changes in risk or liquidity premia.
• The four central banks have adopted different combinations of three instruments to manage their expanded balance sheets: the payment of interest on excess reserves at the policy rate, the issuance of central bank bills and the use of reverse repurchase agreements. Too early to tell what the outcome will be.