RD News 3Feb12

• BIS: Jaime Caruana Financial stability and risk disclosure
• To be effective in promoting market discipline, disclosure must be complemented by strong incentives for counterparties to engage in monitoring.
• The public sector's role in promoting transparency arises from a number of market failures, including the externalities to be gained from common standards, the "free rider" problems that may lead to too little investment in producing and gathering financial information, and the tendency of markets to overreact to bad news when the information environment is clouded.
• Accounting standards need to converge, standards for the discussion and analysis that accompany financial statements need to be established, and external auditors need to insist on higher-quality risk disclosures.

• BIS: Jaime Caruana The need for effective international collaboration in times of financial stress
• Consistency of regulation, in particular on risk-weighted assets – need to keep the playing field level.
• The Basel Framework lets banks use their own internal data and models as inputs for the calculation of capital requirements, so that some variation in risk-weighted assets is inevitable.
• Minimum capital requirements must accurately reflect the risk that banks actually face. Regulators are therefore doing studies based on benchmark or hypothetical portfolios.
• Treatment of sovereign exposures - sovereigns with strong fundamentals need to earn back their risk-free status by credible and tangible fiscal consolidation.
• Where this is not the case, sovereign risk should be appropriately reflected in the calculation of risk-weighted assets.
• Liquidity – we must ensure that banks have a stable funding structure and maintain the minimum required stock of high-quality liquid assets in normal times - assets that can be drawn down to meet new liquidity needs in times of stress.
• We will provide guidance on the circumstances that would justify a bank's temporary breach of the liquidity requirement, and to ensure that markets do not unduly stigmatise a bank for using the liquidity buffer appropriately.

• Andreas Dombret (Deutsche Bundesbank) Global financial market regulation - need for a coordinated implementation and a global level playing field
• Policy development is currently progressing on how to extend the framework from global SIFIs to non-bank and domestic SIFIs.
• Basel III allows some discretion in national implementation: For example, the transition period permits jurisdictions to determine how quickly they adopt the new rules – which will depend on both the state of the national financial system and the macrofinancial environment.
• Moreover, as Basel III is an international minimum standard, jurisdictions might adopt tougher rules than the internationally agreed versions. Considering the significant differences in the size of banking sectors relative to domestic economies and the implied potential consequences in case of bank failures, I believe this to be a sensible approach, although it will raise level playing field issues.

• Andreas Dombret (Deutsche Bundesbank) Systemic risk analysis and crisis prevention
• Reducing complexity - complexity leads to non-linear dynamics in the system which are very difficult to handle both for the risk management of financial institutions and for supervisors.
• There are a lot of regulatory target variables which involve the use of complex risk-adjusting methods. For example, the core capital ratio is the ratio of core capital to risk-weighted assets. But the models used for adjusting the risk did not perform perfectly and underestimated the true risks stemming from CDOs.
• Communicating risk analysis - important to find the balance between making realistic assumptions about scenarios and avoiding devastating self-fulfilling prophecies of the markets.

• Duvvuri Subbarao (Gov, Reserve Bank of India): Price stability, financial stability and sovereign debt sustainability policy challenges from the New Trilemma    
• Under the old trilemma – the impossible trinity – countries had to sacrifice one of the three objectives – fixed exchange rate, independent monetary policy and free capital flows.
• Under the new trilemma – the holy trinity – no country can afford to sacrifice any of the objectives as the feedback loops can quickly shift the economy from an equilibrium to a disequilibrium.
• The issue really is of managing the inter se prioritization among the objectives and of determining the role of the central bank in this management.

• Stefan Ingves (Ch BCBS): SIFIs: is there a need for a specific regulation on systematically important financial institutions?
• An unqualified yes. Basel III framework is based on the "negative externalities" that these firms create and which current regulatory policies do not fully address.
• The impact caused by the failure of large, complex, interconnected, global financial institutions can send shocks through the financial system which, in turn, can harm the real economy.
• The moral hazard arising from public sector interventions and implicit government guarantees can also have longer term adverse consequences. These include inappropriate risk-taking, reduced market discipline, competitive distortions, and increased probability of distress in the future.
• G-SIB surcharge - the costs of requiring additional loss absorbency for G-SIBs are outweighed by the associated benefits of reducing the probability of a systemic financial crisis.
• Swiss too-big-to-fail package:
• A capital buffer of 8.5% of risk-weighted assets. This is in addition to the Basel III minimum requirement of 10.5%.
• Of this 8.5%, at least 5.5% must be in the form of common equity while up to 3% may be held in the form of convertible capital (CoCos). The CoCos would convert when a bank's common equity falls below 7%.
• The two big Swiss banks, Credit Swiss and UBS will have to hold a total of 10% common equity tier 1 capital. This exceeds both Basel III and the internationally agreed capital surcharge for G-SIBs.
• UK: Ch ICB Sir John Vickers recommended:
• that systemically important retail banks defined as retail banks with RWA exceeding 3% of GDP should have primary loss-absorbing capacity of at least 17-20% of RWA.
• At least 10% must be covered by equity capital while the remaining 7-10% may consist of long-term unsecured debt that regulators could require to bear losses in resolution. These are the so called bail-in bonds.
• The proposed changes related to loss absorbency are intended to be fully completed by the beginning of 2019.

• BoE: Paul Tucker ‘Investing in Change’
• A market economy cannot succeed without a financial system that efficiently allocates capital to investment and development projects, and helps households ride the peaks and troughs in their lifetime income.
• Because of myopia about risk, herding, asymmetric information and incentive issues, the state cannot leave finance entirely to its own devices.
• The greatest failure of all was the absence of a regime for the orderly resolution of distressed financial firms, without taxpayer solvency support.
• We are building macroprudential frameworks under which capital requirements can be adjusted temporarily – or ‘counter-cyclically’ – as and when risks are unusually high, and reduce them back to more ‘normal’ levels as extraordinary incipient threats recede.
• Pursuing reform now is not just a matter of responding to public concern, important though this is. Credible reform is also crucial to restoring confidence in the financial system and thus to delivering a vibrant, effective system.
• This is necessary for durable economic recovery, and for sustainable economic growth over the longer term.

• BoE: ‘Does macropru leak?
• The regulation of bank capital to improve the resilience of the financial system and, related to this aim, as a means of smoothing the credit cycle are central elements of forthcoming macroprudential regimes internationally.
• For such regulation to be effective in controlling the aggregate supply of credit:
• changes in capital requirements need to affect loan supply by regulated banks
• substitute sources of credit should not fully offset changes in credit supply by affected banks.
• International ‘leakage' was material although only partial: it offset - by about one third - the initial impulse from the regulatory change.
• These results suggest that, on balance, changes in capital requirements can have a substantial impact on aggregate credit supply by UK-resident banks.

• IMF: How Risky Are Banks’ Risk Weighted Assets? Evidence from the Financial Crisis   
• Banks with lower RWA performed better during the US and European crises.
• This relationship is weaker in Europe where banks can use Basel II internal risk models.
• For large banks, investors paid less attention to RWA and rewarded instead lower wholesale funding and better asset quality.
• RWA do not, in general, predict market measures of risk although there is evidence of a positive relationship before the US crisis which becomes negative afterwards.