Regulation since
the Crisis:
What has changed and is it
enough?
Howard Davies
Director, LSE
ICEF Seminar
HSE Cultural Centre
29 November 2010
Six Topics
A. Global Regulatory Architecture
B. European Regulatory Architecture
C. Basel 3
D. Derivatives
E. Bankers’ Pay
F. Governance
A. Global Regulatory
Architecture
The Pre-Crisis Architecture
Six Problems with the
System
1.
2.
3.
4.
5.
6.
Complexity
Built on the old three-sector model
Unrepresentative membership
US dominance
No single European voice
No authority or hierarchy
The Post-Crisis Architecture
B. European Regulatory
Architecture
EU: Pre-Crisis
FSC
Financial
Services
Committee
EFC
Economic
and Financial
Committee
CoRePer
Ambassadors (legislative)
Council
Working Groups
(legislative)
Government Level
(Finance Ministries +
Observers from
regulatory level)
Regulatory Level
(Competent
Authorities)
Council of Ministers
(ECOFIN)
ESC
European
Securities
Committee
CESR
Committee of
European
Securities
Supervisors
ARC
Accounting
Regulatory
Committee
EIOPC
European Insurance
and Occupational
Pensions Committee
CEIOPS
Committee of
European Insurance
and Occupational
Pension Supervisors
3L3 Committee
Central Bank Level
ECB
Outside Commission
Committee Framework
Banking
Supervision
Committee
of the ECB
European Parliament
European Commission
EBC
European
Banking
Committee
CEBS
Committee of
European
Banking
Supervisors
EFCC
European
Financial
Conglomerates
Committee
IWCFC
Interim Working
Committee on
Financial
Conglomerates
AURC
Audit
Regulatory
Committee
EGAOB
European Group
of Audit
Oversight
Bodies
EU: Post-Crisis
European Systemic Risk Board (ESRB)
(Chaired by President ECB)
Macroprudential
supervision
Members of
ECB/ESCB
General Council
+
Chairs of
EBA, EIA
& ESMA
Information on micro-prudential
developments
+
European
Commission
Early risk warning
European System of Financial Supervision (ESFS)
Micro-prudential
supervision
European
Banking
Authority
(EBA)
European
Insurance
Authority
(EIA)
European
Securities and
Markets
Authority
(ESMA)
National Banking
Supervisors
National Insurance
Supervisors
National Securities
Supervisors
Source: De Larosière Report, February 2009.
So now we have
- A more representative but (probably) less
effective overarching body with highly
diverse views
- The same complexity below
- A little more discipline in the system
through the FSB, but with no new powers
- A partial European reform
- Weakened US leadership, but no
replacement for it
C. Basel 3
A capital shortage:
The charge:
Banks were allowed to operate
with too little capital. Leverage
grew, and revenues were
inadequate to cover losses
when asset prices fell.
The response:
‘Basel 3’ will triple capital in
the trading book, outlaw ‘soft’
capital, increase capital
backing for securitizations and
strengthen balance sheets
generally. BUT will the reforms
damage the system and make
credit scarce and too costly?
Bank Balance Sheets expanded
Large-cap banks’ aggregate assets rose to 43x tangible book equity,
2000 – 2007
Source: Silverlake, Capital IQ.
UK banks leverage grew sharply from
2003 onwards
Major UK banks’ leverage ratio, %, 1998 - 2008
Note: Leverage ratio defined as total assets divided by total equity excluding minority interest. Excludes Nationwide due to lack of interim data.
Source: Bank of England, Financial Stability Report, Issue 24, 28 October 2008.
Investment Bank leverage grew
Leverage ratios, 2003 - 2007
35
30
25
20
15
10
2003
2004
2005
2006
2007
Off-balance sheet vehicles:
The Canary in the Coalmine
The charge:
Credit creation expanded off banks
balance sheets, as banks took advantage
of regulatory arbitrage opportunities to
skimp on capital. Regulatory capital rules
parted from the economic reality, as banks
had to support these vehicles when they
went under.
The response:
An economic approach, requiring onbalance sheet treatment of SPVs in future.
BUT will this prevent any revival of the
securitisation markets and thereby
constrain credit unduly?
The growth of securitised credit
Securitisation issuance trends in the UK, £ Billion, 2000 - 2007
Source: The Turner Review. A regulatory response to the global banking crisis. March 2009.
Procyclicality
The charge:
The capital rules tended to
accentuate the cycle, allowing banks to
hold less capital as asset prices rose, as
back-testing revealed low losses and
loss given default over previous years.
The response:
Macro-prudential requirements –
which will allow regulators to tighten
capital in anticipation of price bubbles
bursting – ‘leaning into the wind’. Stresstesting. BUT how do we know when
there is a bubble? Why not use interest
rates ?
a. Tier 1 Capital
a1. BASEL II:
- Tier 1 Capital Ratio = 4%
- Core Tier 1 Capital Ratio = 2%
- The difference between the total capital requirement of 8%
and the Tier 1 requirement can be met with Tier 2 capital
a2. BASEL III:
- Tier 1 Capital Ratio = 6%
- Core Tier 1 Capital Ratio (Common Equity after deductions)
= 4.5%
- Core Tier 1 Capital Ratio (Common Equity after deductions)
before 2013 = 2%, 1st January 2013 = 3.5%, 2014 = 4%,
2015 = 4.5%
- The difference between the total requirement of 8% and the
Tier 1 requirement can be met with Tier 2 capital
b. Capital Conservation
Buffer
b1. BASEL II:
- No Capital Conservation Buffer
b2. BASEL III:
- Banks required to hold a Capital Conservation Buffer of
2.5% to withstand future stress bringing the total common
equity requirements to 7%
- Capital Conservation Buffer will be met with common equity
- Capital Conservation Buffer before 2016 = 0%, 1st January
2016 = 0.625%, 2017 = 1.25%, 2018 = 1.875%, 2019 =
2.5%
- The purpose is to ensure that banks maintain a buffer of
capital to absorb losses during periods of stress. When
regulatory capital ratios approach the minimum
requirement, constraints imposed on earnings distributions
c. Countercyclical Capital
Buffer
c1. BASEL II:
- No Countercyclical Capital Buffer
c2. BASEL III:
- A Countercyclical Buffer within a range of 0% – 2.5% of
common equity or other fully loss absorbing capital will be
implemented according to national circumstances
- Banks with a Capital Ratio lower than 2.5% will face
restrictions on payouts of dividends, share buybacks and
bonuses
- Phased in from January 2016 to January 2019
- Countercyclical Capital Buffer before 2016 = 0%, 1st
January 2016 = 0.625%, 2017 = 1.25%, 2018 = 1.875%,
2019 = 2.5%
d. Capital for Systematically
Important Banks only
d1. BASEL II:
- No explicit Capital for Systemically Important Banks
d2. BASEL III:
- Systemically Important Banks should have loss
absorbing capacity beyond the standards. Work
continues in the Financial Stability Board and the Basel
Committee
- The Committee and the FSB are developing an
integrated approach to systemically important financial
institutions which could include combinations of capital
surcharges, contingent capital and bail-in debt
D. Derivatives
“There is growing recognition that the dispersion of credit
risk by banks to a broader and more diverse group of
investors, rather than warehousing such risk on their
balance sheets, has helped make the banking and overall
financial system more resilient.
The improved resilience may be seen in fewer bank
failures and more consistent credit provision. Consequently
the commercial banks may be less vulnerable today to
credit or economic shocks.”
IMF Global Financial Stability Report
April 2006
Derivatives: The Problem
1. The capital value of global derivatives peaked at
$760 trillion in June 2008 (equals last 20 years
of global GDP!).
2. Derivatives, supposedly designed to spread and
diversify risk, created new risks and caused
financial instability.
3. The complexity of products was impossible for
regulators, customers and even originators to
understand.
4. Opacity created additional risks: when the crisis
hit, no one knew who held the losses.
Derivative volumes quadrupled in five
years
OTC derivative volume by product type, volume ($ Trillion),
Jun 2003 – Jun 2008
Source: The Turner Review. A regulatory response to the global banking crisis. March 2009.
Derivatives: Solutions
1. More capital in the trading book against
derivative exposures (see Basel 3).
2. Central Counterparty (CCP). New margin
requirements, standardised contracts.
3. (US) Dodd-Frank requires banks to move
(some) derivatives out of banks.
E. Bankers’ Pay
Bankers’ Pay: Problems
1. Moral hazard: If the bank is profitable, the
managers earn huge amounts, if it fails, the
taxpayers pay: Heads they win, tails we lose.
2. Pay incentives drive risk-taking behaviour which
can reward individuals in the short-term, but
cause the bank losses in the long term.
3. Bankers are simply paid too much.
Bankers’ Pay: Solutions
Different regimes have been introduced by country:
-
-
EU: 60% of bonuses deferred for 3 – 5 years.
Retention period for share-based incentives.
Upfront cash capped at 20%.
UK: Additional proposals for disclosure of high
earners’ pay. Bonus tax.
US: No detailed rules. 75% in shares for senior
executives.
Why are bankers paid so much?
-
Lack of competition?
Winner takes all?
Insider dealing?
Opacity?
F. Governance
Financial Institutions Management
and Governance: Problems
1. Bank boards did not understand the risks they
were taking on.
2. Bank directors were often too old and too
ignorant.
3. Risk management was undervalued.
Financial Institutions Management
and Governance: Solutions
1. (UK) Bank directors interviewed by the FSA and
assessed for competence.
2. (UK and US) Board-level risk committees now
established.
3. Chief Risk Officers report to CEOs.
4. Regulators attention focussed on risk
management.
Is it enough?
The ‘plumbing’ of the financial system and its
regulation has been overhauled, but problems
remain:




Highly complex regulatory structure with no
central authority.
Many conflicts of interest.
Regulators still struggle to catch up with
markets.
Global imbalances, which were at the heart of
the crisis, persist.
Regulation since
the Crisis:
What has changed and is it
enough?
Howard Davies
Director, LSE
ICEF Seminar
HSE Cultural Centre
29 November 2010