International Insights: Re-regulating out of crisis

It only takes one flawed link

There must be ‘global ownership’ of regulatory reforms if we’re to avoid another financial crisis, bank chief Lord DAVIES warns this year’s conference of European researchers at Bangor.

We’re not out of danger yet. In the wake of September’s Basel III Accord on bank capital adequacy, and July’s Wall Street Reform Act in the US, it’s clear that still more needs to be done to prevent another global financial crisis.

That was the sober conclusion of this year’s conference of the European Association of Banking and Finance researchers, hosted by Bangor University’s Business School in Wales.

The so-called ‘Wolpertinger’ Conference, heard former Trade Minister Lord Davies, warn about the danger of ‘fragmentation’ in global banking discussions and with any regulations that follow. There had to be global ownership of the necessary policy responses, he said.

Lord Davies, former Government Minister and Chairman of Standard Chartered Bank, and currently Chairman of Bangor University’s Council, emphasised the need to ensure that the new, fast emerging banking nations – China, India and Brazil in particular – are part of the global discussions on banking supervision.

And, in discussing ‘Re-regulating out of the crisis’, the Conference identified other concerns that included the nature of ‘safe’ competition in modern banking, the importance of not impeding economic recovery by amplifying economic cycles via supervisory rules in key areas like loan loss provisioning and capital adequacy, and recurring anxieties about governance and bonuses.

In the ‘chain of regulation’, the Conference concluded, ‘it only takes one flawed link for the chain to be ineffective’. Complex and apparently high precision rules had to be tempered by common sense, flexibility and adaptability.

‘In this fast-changing environment where the costs of getting it wrong are so high, it is better to be approximately right than precisely wrong.’

WALL STREET REFORMS
‘Impressive – but not credible’
At the recent conference, Professor JOHN THORNTON of Bangor University and formerly the International Monetary Fund, discussed theWall Street Reform and Consumer Protection Act. As the first major post-crisis re-regulation to limit the scope of future crises, he said, securing Congressional approval was certainly impressive, given the fierce political and financial opposition.

But the Act fails to address the core problem of dealing with too-big-to-fail institutions. The legislation envisages regulators imposing a charge on all financial institutions (both troubled and untroubled) at the time of a crisis to pay the costs of the crisis.

At times of crises, though, institutions are short of capital and liquidity. And, if the crisis is severe, many may be close to collapse. A ‘tax’ at such a time would only worsen the crisis; in reality, it’s not credible that regulators would seek to impose it, or that financial institutions would be able to pay it.

A much better option would have been to levy an institution-specific, up-front tax on financial institutions to reflect the extent to which their debts carried a real or implied government guarantee and the institution’s contribution to a potential systemic crisis.

This would push financial firms to become smaller, reduce their risk-taking activities and leverage, and provide up-front revenue to compensate solvent institutions that suffer in a crisis.

The Act’s failure is especially important as the consolidation associated with the 2007 crisis has worsened systemic risk by creating more institutions large enough to threaten the overall system.

There are other shortcomings:
• Form v. function: regulating firms by form (bank) rather than function (banking) means regulators will struggle to keep pace; institutions will have an incentive to change their form at times of crisis to take advantage of the most generous state-backed safety nets, happened in 2007.
• Shadow banks: implicit government guarantees for large parts of the shadowbanking sector remain. The Act doesn’t address the bankrupt mortgage guarantee institutions, Freddie Mac and Fannie Mae.
• Market runs: there’s no provision for the orderly resolution of runs in systemically important markets such as the repo and money market funds, which were at the centre of the 2007 crisis.

By not dealing effectively with the too-big-to-fail issue, the Act doesn’t address the propensity for individual institutions to put the financial system at risk and to get taxpayer bailouts.

BASEL IIIACCORD
‘Is the phasing too slow?’
Bangor University’s Professor TED GARDENER led discussion on the Basel III Accord (whose details were announced on September 12, the last day of the Conference).

He rehearsed the banking sector responses to last December’s consultative documents leading to the Basel III package of measures to strengthen banking resilience, and establish an international framework for liquidity risk measurement, standards and monitoring.

A major concern, he said, had been that excessively stringent supervisory regulations could choke off a still-shaky economic recovery. Many worried specifically about the proposed leverage ratio, the redefinition of capital with its strong emphasis on core Tier 1 capital, and the new liquidity requirements.

Some felt the proposed leverage ratio was contrary to Basel’s risk-based principles. The French Banking Federation was particularly concerned that the proposed redefinition of capital would produce a major capital shortfall in eurozone banks.

The July proposals, fully endorsed in the September Accord, addressed many of these concerns. The package of reforms will increase the minimum common equity requirement from 2%to 4.5%. In addition, banks will be required to hold a capital conservation buffer of 2.5%‘to withstand future periods of stress bringing the total common equity requirements to 7%’.

British banks already exceed this 7% threshold, but some banks in Continental Europe may find themselves at a competitive disadvantage with these new rules.

There’s some criticism of the slow phasing in of the new rules, with the final deadline now set at 2019. Nevertheless, the timing of the new rules will help countries like Germany which were not so badly affected by the crisis.

Some argue that the regulators ‘caved in’ to bank lobbying. However, as an August Financial Times survey confirmed, a major concern of the Basel regulators had been to help stimulate economic recovery.

SPAIN’S CYCLICAL LABORATORY
‘Useful – but not enough’
The University of Granada’s Professor SANTIAGO CARBO-VALVERDE discussed the importance of counter-cyclical capital adequacy and loan loss provisioning rules at the conference.

Many studies have focused on factors that amplify or smooth economic cycles. The banking sector’s main interest has been on so-called forward-looking (dynamic or statistical) provisioning. To date, Europe’s only practical experience with counter-cyclical loan loss provision has been Spain’s ‘laboratory’.

In the late 1990s, loan loss provisions were strongly pro-cyclical (and thereby they helped to amplify economic cycles) in many countries, including Spain, because they were largely linked to the volume of contemporaneous problem assets. These static provisions were only applied to a loan when borrowers failed to repay or their situation deteriorated significantly.

In July 2000, the Bank of Spain’s new solvency provision – the so-called statistical or dynamic provision – came into effect. Its main idea is to capture expected losses, together with the other loan loss provisions of the Spanish system. From the moment a loan is granted, and before any impairment on this specific loan appears, a positive default probability (no matter how low) follows a statistical distribution with an expected loss outcome.

The expected loss is known in a statistical sense but not yet identified in a specific loan operation or borrower. With this system, provisions run parallel to revenues and are therefore distributed through the cycle allowing for a better mapping between income and costs in the profit and loss account.

In good years, the net ‘specific’ provisions are very low (or even negative, if there are substantial recoveries), so the ‘new’ provision accumulates.

In bad years, the ‘specific’ provisions increase sharply, eventually exceeding the gross burden of the statistical provision. The net result is that provisions are distributed over the cycle, providing a better recognition of expected losses and not excessively amplifying economic downturns.

Ten years after Spain implemented dynamic provisioning, the evidence suggests it is a useful tool and a step in the right direction. But it was not sufficient – credit losses have gone beyond these provisions in many troubled institutions. And excessively risky lending behaviour has not been prevented.

A Wolpertinger?
For almost 30 years, theWolpertinger Club of researchers in the European Association of Banking and Finance has been meeting annually for a two-day conference to discuss contemporary policy issues in banking. Launched in Bavaria, it adopted as its symbol theWolpertinger, a legendary animal said to inhabit Germany’s alpine forests – a rabbit with wings, antlers, tails and fangs.

One of the main ‘founding fathers’ of the Wolpertinger Club was Professor Jack Revell , Fellow of Fitzwilliam College at Cambridge University, who also became Head of the Department of Economics (the forerunner of the Business School) at Bangor University. Jack Revell was famous for emphasising the importance of institutions and their practical workings in studying banking and financial systems.

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