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.
Examines “whether banks in Asian jurisdictions have in fact been provisioning in a fashion that reduces financial system procyclicality.”
“The analysis of Asia’s post-financial crisis experience should be of interest to the many national and international authorities that are now considering measures to promote more forward-looking provisioning practices, so that banks enter periods of worsening credit quality with higher levels of reserves, providing a buffer to reduce the downward pressure on earnings and capital that would otherwise occur.”
Main findings:
Japanese banks show procyclical provisioning;
Countercyclical loan loss provisioning by banks dominates throughout emerging Asia, and most strikingly so in India;
The degree to which policy initiatives were responsible for this, as opposed to simply more prescient behaviour on the part of banks, remains a subject for future investigation.
Collection of papers relating to a 2011 workshop look at issues of cross-border flows and some of the difficulties encountered in trying to develop towards the ideal of a “globally consolidated balance sheet”.
The discussion paper for the workshop argues that an inability to “see” such a balance sheet at the level of institutions or even nations, means that systemic risks cannot be monitored, and that a globally consolidated approach to measuring the ‘where’, ‘who’ and ‘how’ of financial exposures is needed.
The Irving Fisher Committee on Central Bank Statistics (IFC) has said it will produce a further discussion paper to follow up this work.
Chapter 3 probes the implications of recent reforms in the financial system for market perception of safe assets.
Notes the likely trend for a rise in the demand for safe assets at a time when there is likely to be a restricted supply. Useful boxes contain an analysis of the effect of Basel III and the changes to the OTC derivative market on the demand for safe assets.
(Chapter 4 investigates the growing public and private costs of increased longevity risk from aging populations.)
Reflects on the causes and consequences of the financial crisis, the authorities’ response and the changing structure of financial regulation in the UK (BoE news release summary here).
Contributions from Jaime Caruana (p2) and Paul Tucker (p8), as well as discussion of the evolution of the business models of financial institutions (p2-6) and of risk weighting of sovereign debt (p13).
Capital regulation – as well as a firm-based approach to capital regulation we need the creation of a more systemic, or macroprudential, component of capital regulation.
Basel is assessing the consistency of risk-weighting practices by banks.
Liquidity standards:
Liquidity Coverage Ratio (LCR), is designed to ensure a firm’s ability to withstand short-term liquidity shocks through adequate holdings of highly liquid assets.
Net Stable Funding Ratio (NSFR), is intended to avoid significant maturity mismatches over longer-term horizons.
SIFI failure resolution:
The coexistence of internationally active firms with nationally based insolvency regimes means that there could be important cross-border legal complications when a home jurisdiction places into receivership a firm with significant assets, subsidiaries, and contractual arrangements in other countries.
A comprehensive, treaty-like instrument for a global bank resolution regime is an unrealistic prospect for the foreseeable future.
Regulatory reform should reinvigorate the principle that risks and returns have to be closely aligned:
Market participants must be held responsible for their actions, the possibility of losses or even default is a constitutive element of any functioning market, and the financial markets are no exception.
The financial system plays an indispensable role in fostering innovation and growth. This role has never been static: it is evolving constantly. And throughout history, this process has been accompanied by exaggerations.
The continuing, never-ending challenge of financial market regulation is to limit the latter without stifling the undeniably beneficial forces at work in the financial system – we have to tame market forces and self-interest, but should not exorcise them.
Congressman Barney Frank, one of the architects of the Dodd-Frank Act, has urged regulators to simplify the rule and release a new version by 3 September.
Frank’s proposal is for regulators to issue guidance on the time period between 21 July and 3 Sept, and then subject a simplified version to a two year review period, throughout which regulators would be able to learn from experience.
BCBS is set to allow all bank deposits at central banks with a maturity period of under 30 days to be classified as short-term liquid assets, eligible for inclusion in the new liquidity coverage ratio (LCR) buffer.
Previously it had been expected that only 50% of these deposits could be used to meet banks' liquidity requirements.
The FSB will facilitate the formation of a joint private sector task force to develop principles for improved disclosures based on current market conditions and risks, including ways to enhance the comparability of disclosures. The task force will be encouraged to have dialogue with standard-setting bodies.
The FSB will also ask the task force to identify leading practice risk disclosures presented in annual reports for end-year 2011.
Possible shadow banking entities and activities on which the Commission is currently focussing its analysis:
Special purpose entities which perform liquidity and/or maturity transformation; for example, securitization vehicles such as ABCP conduits, Special Investment Vehicles (SIV) and other Special Purpose Vehicles (SPV)
Money Market Funds (MMFs) and other types of investment funds or products with deposit-like characteristics, which make them vulnerable to massive redemptions ("runs")
Investment funds, including Exchange Traded Funds (ETFs), that provide credit or are leveraged
Finance companies and securities entities providing credit or credit guarantees, or performing liquidity and/or maturity transformation without being regulated like a bank.
FSB rough estimate of the size of the global shadow banking system € 46trillion in 2010, having grown from € 21 trillion in 2002. This represents 25-30% of the total financial system and half the size of bank assets.
In the US, this proportion is even more significant, with an estimated figure of between 35% and 40%.
The loosening in monetary policy undertaken in recent years encourages people to spend more and save less, and slows the reallocation of capital and labour to more productive uses.
“Loose monetary policy can in part be thought of as a form of forbearance: putting off difficult changes and adjustments to a later day”. Monetary policy must trade off short-term support against stifling long-term change.
U.S. financial institutions have very limited direct net credit exposures to the most vulnerable euro-area countries, and U.S. ssss
Although U.S. banks have limited exposure to peripheral European countries, their exposures to European banks and to the larger, “core” countries of Europe are more material. Moreover, European holdings represented 35% of the assets of prime U.S. money market funds in February, and these funds remain structurally vulnerable despite some constructive steps, such as improved liquidity requirements, taken since the recent financial crisis.
Commenting on the announcement, Sir Mervyn King said, “I am sad that Hector Sants has decided to stand down. I am very grateful to him for staying on for longer than he had planned."
The Bank will work closely with HM Treasury in searching for the first Chief Executive of the Prudential Regulation Authority (PRA) who will also be the Deputy Governor with responsibility for Prudential Regulation. That appointment will be made by the Chancellor. The person appointed will take up the position when the PRA comes into existence in 2013.
It is the complexity of an interconnected financial system, and not the absolute size of the ‘shadow banking’ system, which are relevant for financial stability.
Three big risks from shadow banking:
the procyclicality which results from secured finance and mark-to-market accounting;
non-transparent maturity transformation in long, complex chains;
the relationship between funding and market liquidity.
Recommends a “bias to prudence”, and a “bias against complex interconnectivity”.
Encourages further work to be done to improve the role of external audits in providing information to regulators and supervisors.
Includes work which will improve the information produced by external audits, as well as work to improve audit regulation to improve the quality of audits.
Emphasises the importance of audits, and notes its view that greater international consistency in external audit practices will be beneficial for audit quality.
IOSCO have launched a consultation on 15 high level principles for the regulation of exchange traded funds (ETFs), falling into three categories: classification and disclosure; marketing and sales; and structuring of ETFs.
ETFs have been highlighted by regulators as a potential source of systemic risk for the financial system, due to rapid growth in the size of the market, and the increasing complexity of some products which fall under the name of ETFs.
IOSCO are inviting comment on whether the principles will address financial stability concerns, and whether further work is required on ETFs and broader subjects relevant to their regulation. The principles outline actions that regulators should both “encourage” and “consider imposing”, ranging from disclosure requirements on the workings of particular ETFs, to compliance functions and potential sources of systemic risk. The deadline for consultation is 27 June 2012.
Markets work better than anything else at delivering opportunity and prosperity.
An efficient and resilient financial system is an essential enabler to growth and inclusion.
Markets only work well within sound policy frameworks. All markets – and financial markets in particular – need clear rules, diligent oversight, and consistent enforcement of the rules. Systemic crises are not the inescapable product of capitalism, and inequality is not the necessary by-product of growth.
BoE: Speech by Andrew Haldane drawn from a paper written jointly with two Bank colleagues, Robleh Ali and Paul Nahai-Williamson: Towards a common financial language
The recent financial crisis exposed failures in the information systems of many firms, with few having the means to aggregate quickly information on exposures and risks.
There are no technological barriers to a transformation in finance similar to that of product supply chains and the World Wide Web, where the adoption of a common language has delivered huge improvements in system resilience and productivity. Four potential benefits:
improvements in risk management in firms;
improvements in risk management across firms;
mapping the financial network could be comprehensively improved, both in terms of granularity but also timeliness;
help lower barriers to market entry in banking and “…might even begin to erode the too-big-to-fail problem through market forces”.
The Federal Reserve has announced summary results of the latest round of bank stress tests (the Comprehensive Capital Analysis and Review 2012).
The tests show that the majority of the largest US banks would continue to meet supervisory expectations for capital adequacy despite large projected losses in an extremely adverse hypothetical economic scenario.
This time around banks are not expected to be required to raise capital.
According to the Fed banks that participated in both 2011 and 2012 stress testing have increased their capital to $759 billion in the fourth quarter of 2011 from $420 billion in the first quarter of 2009.
the new arrangements for macroprudential policy in the Financial Policy Committee (FPC) are “truly ground-breaking”, but the effective implementation of macroprudential frameworks “offers plenty of challenges”
the pursuit of financial stability “does not mean eliminating all risk”
the FPC will hold its fourth meeting on Friday 16 March, where macroprudential tools will be discussed, following a period of consultation
ICFR - Financial Times Research Prize (The contest asked: “What does good regulation look like?”)
Results of the analysis provides support for the regulatory reform embodied in the most recent revision of the Basel prudential framework for banks. In particular, they suggest that higher capital requirements can be beneficial to equity investors by restraining bank leverage, and provide an additional rationale for the introduction of countercyclical capital buffers.
Over a quarter of the 192 rules have no cost-benefit analysis at all.
Over a third have entirely non-quantitative cost-benefit analysis.
The majority of the 50 rules that do contain quantitative analysis limit it to administrative and similar costs, but ignore the Rule’s expected broader economic impact.
The socioeconomic composition of executive boards impacts banks’ risk taking, with more risk taking at banks managed by younger executives and banks with a higher proportion of female board members, and less risk taking at banks with a higher proportion of executives with PhDs.
The first of these is statistically significant and with an economically large effect; the second is found to have an economically marginal effect; while the third is statistically significant but with a small effect.
The study was conducted using data from all German banks between 1994 and 2010.
Increasing capital buffers may contribute to maintaining a bank’s solvency over the medium term, but increasing banks’ capital burden in a stressful time might create an adverse feedback loop of intensified capital constraints, weak bank lending and economic slowdown, thus accelerating the bank deleveraging that could lead to a devastating credit crunch.
Regulatory changes often have unintended and sometimes considerable cross-border impacts in the increasingly integrated world of finance, as evidenced by the leveraging rule and other regulatory changes of 2004 on European financial institutions, and now possibly by the Volcker Rule on non-U.S. financial institutions.
There are significant links between banks’ asset quality, credit and macroeconomic aggregates.
Lower economic growth, an exchange rate depreciation, weaker terms of trade and a fall in debt-creating capital inflows reduce credit growth while loan quality deteriorates.
This analysis was used in th Global Financial Stability Report (Sept11) to help evaluate the sensitivity of banks’ capital adequacy ratios to macroeconomic and funding cost shocks.
