Financial regulation: Not yet an efficient outcome

Angus Armstrong, Philip Davis

22 April 2016

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Editors’ note: This column summarises the views presented at the National Institute of Economic and Social Research (NIESR) conference on “Financial Regulation” held at the Bank of England, London, on 18 March 2016. The column includes several videos recorded at the event.

Since the Global Crisis, a number of regulatory policies have been discussed, proposed and sometimes implemented to address shortcomings in the regulatory framework. The question addressed at the NIESR conference (presentation slides for which are available here) is whether we have reached an efficient outcome. For most of the speakers, the answer was a resounding “no”.

The first session was a lively debate on capital adequacy, the core of prudential regulation. Anat Admati (Stanford) argued that following Basel III is a huge missed opportunity, as much higher capital ratios are required (Admati 2016). There is little evidence of improvement – the financial system today is even more dominated by large banks, leverage is still too high for safety, and a ‘ratchet effect’ from existing debt drives even greater leverage. Jean-Charles Rochet (Zurich) argued that the traditional Modigliani-Miller approach is the wrong starting point for understanding bank capital; there is a need to move away from a purely micro approach. Two lessons need to be learnt. First, banks create money and thus capital regulation has a macroeconomic impact on credit and growth. There is a ‘natural’ bank debt/equity ratio, but incentives are distorted by the fact that banks’ debt is subsidised (e.g. by the ‘safety net’). Second, aggregate bank equity matters for individual banks as well. Higher overall capital leads to more competition and lending, and hence lower returns on assets. Without an understanding of these monetary and general equilibrium effects, the long-term impact of prudential policy will not be properly understood.

Watch Anat Admati below

The second session looked at the degree to which regulation has grappled with the issue of ‘too big to fail’ (TBTF). Jim Barth (Auburn) suggested that TBTF has not been sufficiently challenged because the authorities in the US and elsewhere have chosen not to break up large banks, but instead require more capital (Barth and Wihlborg 2016). The only measure of leverage that investors rely on – the unadjusted equity/assets ratio – is too low under Basel III; the risk-adjusted measure is unreliable due to mis-measurement of risk. Bank business models need to be better understood by regulators as they contribute to complexity, which is a neglected aspect of TBTF as compared to size. Franklin Allen (Imperial College, London) maintained that TBTF really matters due to contagion risk. It is because of fear of the unknown scope for contagion that authorities do, and will continue to, save large banks. In the Eurozone, the scope for such contagion is enhanced by the large size of interbank claims, meaning that banks bear significant counterparty risk. Moreover, the main problem of regulation before the crisis was an excessive focus on individual banks and not enough on systemic risk. Economists do focus on systemic risks generated by panics, but are often less aware that asset price falls, weaknesses in the financial architecture, and FX mismatches can also be at the root.

Watch Jim Barth below

Watch Franklin Allen below

The third session assessed progress in macroprudential regulation. According to Dirk Schoenmaker (Rotterdam), some regulators still believe risk is exogenous, when it is endogenous behaviour generating procyclicality that is the main problem for financial stability (Schoenmaker and Wierts 2016). In that context, banks have an incentive to raise leverage in the boom as asset prices rise. We need to adopt a wider macroprudential approach than one solely focused on banks, with targets being set for total credit growth, house prices, and leverage for the whole financial system. Charles Goodhart (Emeritus, LSE) also advocated much higher capital adequacy, but highlighted key issues in the transition. Bank CEOs focus on the return on equity; hence, if asked to raise capital adequacy they tend not to issue shares which would dilute equity holders and benefit creditors, but rather they delever, cutting back on assets, especially cross border. The optimal response to minimise such deleveraging could be to ban dividends, buybacks, and bonuses until a higher capital level is attained, but political opposition to such policies would be intense. Furthermore, owing to political pressure, Goodhart doubted that macroprudential policy will operate as planned, unless central banks develop much more sophisticated analytical tools to justify policies of requiring higher capital adequacy in the boom and relaxing in the bust.

Watch Dirk Schoenmaker below

Watch Charles Goodhart below

The fourth session considered the issue of liquidity and its appropriate regulation. Market failures in bank and market liquidity, such as fire sales and rollover risk, were key to the crisis, said Gianni De Nicolo (IMF). Whereas the lender of last resort is essential to offset such risks, it needs to be better integrated with the tools of regulation to offset moral hazard (De Nicolo 2016). Capital regulation may be more effective than regulation of liquidity in this respect, and indeed liquidity regulations as currently being introduced may reduce efficiency, lending, and welfare. Jon Danielsson (LSE) highlighted that major crises are very infrequent, but the risk models used by banks are both too short term and unreliable, underestimating risk before the crisis and overestimating it afterwards. The use of the same models across banks, at the behest of the regulators, causes procyclicality and systemic risks. There is a need for heterogeneity in behaviour that might arise from new entrants and new forms of intermediation. In terms of liquidity, banks need incentives to self-protect rather than imposition of regulations.

Watch Gianni De Nicolo below

The final session reviewed cross-border coordination of regulation and resolution. Thorsten Beck (Cass) showed that traditional instruments such as consolidated supervision, memoranda of understanding, and supervisory colleges failed in 2008 (Beck 2016). They proved to be forms of ‘sunny day cooperation’, ill-suited to a crisis. But progress is being achieved with, for example, more supervisors in both home- and host-country roles, and coordination across heterogeneous country groups. Research was still needed into the feedback loop between supervisory architecture and bank behaviour, while more cooperation is needed in macroprudential policies and more generally in the European Union. Peter Brierley (Bank of England) spoke positively of progress in making banks “global in death as well as life”. Before the crisis, most countries didn’t have resolution regimes, leaving the options as insolvency or bailout, neither of which accounted for cross-border externalities from bank failure. Post-crisis, there are usable tools for resolution, including bail-in provisions featuring a debt-equity swap. Jurisdictions are seeking to align home and host incentives to cooperate when they resolve a cross-border bank. This is well understood by markets and bankers but less so by academic economists. The risks of non-cooperation and contagion are being addressed by policymakers.

Watch Thorsten Beck below

The conference closed with a general discussion led by Sir John Gieve, David Miles and Sir Paul Tucker.

Acknowledgements: The conference has received support from the Brevan Howard Centre for Financial Analysis at Imperial College London, the Centre for Macroeconomics, the Economic and Social Research Council, the Money, Macro and Finance Research Group, and the SWIFT Institute. The organisers were Angus Armstrong, E Philip Davis and Luca Pieri.

References

Admati, A. (2016), “The Missed Opportunity and Challenge of Capital Regulation”, National Institute Economic Review February 2016 235: R4-R14

Barth, J. R. and Wihlborg, C. (2016), “Too Big to Fail and Too Big to Save: Dilemmas for Banking Reform”, National Institute Economic Review February 2016 235: R27-R39

Beck, T. (2016), “Regulatory Cooperation on Cross-Border Banking – Progress and Challenges After the CrisisNational Institute Economic Review February 2016 235: R40-R49

De Nicolo, G. (2016), “Liquidity Regulation: Rationales, Benefits and CostsNational Institute Economic Review February 2016 235: R18-R26

Schoenmaker, D. and Wierts, P. (2016), “Macroprudential Supervision: From Theory to Policy”, National Institute Economic Review February 2016 235: R50-R62

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Topics:  Financial regulation and banking Global crisis

Tags:  NIESR, systemic risk, BASEL III, Too big to fail, capital adequacy, financial regulation

Director of Macroeconomic Research, National Institute for Economic and Social Research

Visiting Fellow, National Institute of Economic and Social Research; Professor of Banking and Finance, Brunel University

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