EDHEC RISK AND ASSET
MANAGEMENT RESEARCH CENTRE
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Banking: Why Does Regulation
Alone Not Suffice?
Why Must Governments Intervene?
November 2008
Samuel Sender
Applied Research Manager at the EDHEC Risk and
Asset Management Research Centre
Abstract
The position this paper takes is that if all institutional investors are bound by regulations
that force them to sell risky assets during downturns, these assets will ultimately be absorbed
by unregulated long-term investors. Additional examination shows that, in the current
environment, sovereign wealth funds and governments are the possible buyers of these
assets. As public intervention entails moral hazard, it follows that for the stability of the
financial system throughout the business cycle regulations must be improved. Our proposal
is to include buffers—by which we mean an amount of regulatory capital that will vary over
the business cycle and could eventually disappear provided it is recovered over the medium
term—above minimum capital requirements in the prudential regulations.
2
The work presented herein is a detailed summary of academic research conducted by EDHEC. The opinions expressed are those of
the authors. EDHEC Business School declines all reponsibility for any errors or omissions.
About the Author
Samuel Sender has participated in EDHEC
Risk and Asset Management Research Centre
activities since 2006, first as a research
associate—at the same time he was a
consultant to financial institutions on ALM,
capital and solvency management, hedging
strategies, and the design of associated tools
and methods. He is now a full-time applied
research manager at the EDHEC Risk and
Asset Management Centre. He has a degree
in Statistics and Economics from ENSAE
(Ecole Nationale de la Statistique et de
l'Administration Economique) in Paris.
3
Table of Contents
Abstract…………………………………………………………………………………………………………………………… 2
Introduction … ………………………………………………………………………………………………………………… 5
I. Equilibrium prices with pro-cyclical regulations… …………………………………………………………… 7
II. Prudential regulations for banking are pro-cyclical… …………………………………………………… 13
III. Who then are the long-term, risk-averse investors?… ………………………………………………… 17
IV. Can regulations and practices be improved? … …………………………………………………………… 27
References… ………………………………………………………………………………………………………………… 30
4
Introduction
In the recent sub-prime crisis, support from
central banks as lenders of last resort (LOLR)
has been insufficient, and governments have
had to inject capital into bank balance
sheets and act as market-makers to stabilise
the market prices of bank assets.
Despite initial estimates of losses related to
sub-prime assets in the range of $100bn
and actual write-downs of nearly $400bn in
May 2008 (Onaran 2008), new bailout plans
discussed this summer exceed the trilliondollar threshold, with $700bn for the second
Paulson plan and more than $300bn in
Europe.
After thirty years of attempts to improve
prudential regulations, the financial sector
has yet to ensure stability throughout the
business cycle. In the current position paper,
we examine the role of regulation in this lack
of stability. In particular, we examine the
pro-cyclicality of regulations for financial
institutions in general, their consequences
on the trading prices of risky assets and
the impact on the solvency of the banking
system.
The objective of this paper is not to provide
a detailed review of the transmission
mechanisms of the current crisis, from early
pressures in the American credit market
to tentative intervention by central banks
and current discussions on the practical
implementation of plans for bailing out the
global banking industry. We focus instead
on the pro-cyclicality induced by regulation.
The pro-cyclicality of Basel I and II has been
discussed in previous papers (see VanHoose
2007 for a literature review), but rarely
in the context of the current crisis. Procyclicality is loosely defined as a feature that
amplifies the swings of the business cycle.
Here, we focus mainly on two types of procyclicality.
The first type has to do with the general
impact of risk-based regulations on the
market. We argue that, whereas risk-based
regulations are an efficient risk-management
guideline for a small investor who has no
significant impact on market prices, the
situation is different when this type of
regulation and implied investment pattern
are applied to an entire sector. It may then
amplify the magnitude of both booms and
busts.
The other type (sometimes labelled type II)
has to do with additional features such as
an increase in capital requirements during
downturns. It is usually for technical rather
than philosophical reasons that these
requirements are increased.
The rest of this paper is organised as
follows:
• In section I, we derive the selling pressure
induced by prudential regulations stylised as
Value-at-Risk constraints in a discrete-time
setting. Because the selling pressure from
the regulated investor pushes trading prices
down, regulatory-driven sales may increase
the odds of bankruptcy and of systemic risk
for financial institutions, a result inconsistent
with the goals of regulations.
• In section II, we provide a brief outline
of the prudential regulations for banking,
assessing some of its pro-cyclical features.
• In section III, we summarise the constraints
on other financial institutions that in theory
can manage for the long term and should
be able to act as market makers. Because
most of these institutions are bound by procyclical regulations, we argue that the entire
set of prudential regulations for financial
institutions makes the support of central
banks and governments necessary—after
all, central banks and governments are not
bound by Value-at-Risk (VaR) constraints.
5
Introduction
• In section IV, we briefly summarise a
readily available option that will reduce the
magnitude with which prudential regulation
amplifies swings in the business cycle. We
argue that the two levels of capital in
Solvency II, the new body of prudential
regulations for insurance, can be used to
mitigate the cyclical impact, as long as
the solvency capital requirement is taken
as a flexible target, not as a hard target;
furthermore, regulators must require that
this target capital be managed in a countercyclical manner.
6
I. Equilibrium prices with pro-cyclical regulations
Binsbergen and Brandt (2008) have shown
that preventive regulations stylised as
Value-at-Risk constraints greatly improve
the efficiency of investment strategies
used by naïve or myopic investors. Exante controls on risk-taking can thus be
understood as a risk-management tool for
the least sophisticated investors, but also as
a limitation to speculative leverage for all
investors, including the more sophisticated.
If monitored in continuous time, preventive
regulations would lead to results very similar
to those obtained with dynamic optimisation
and state-of-the-art ALM techniques.
However, does subjecting all the investors in
an industry to the same VaR-type prudential
constraints result in more systemic risk?
General equilibrium theories may help
provide an answer.
Modern prudential regulations usually rely
on a constraint in which the surplus (net
asset value or shareholder’s equity net of
own credit risk) should cover the VaR of risky
assets. Institutions will report their solvency
in a discrete time frame, quarterly or yearly,
and modify their balance sheet accordingly;
for instance, they will raise equity or sell
risky assets. In addition, the calculation of
the Value at Risk is generally prescribed, and
is state independent.
The main insight from general equilibrium
theories is that trading prices cannot be
considered exogenous to investors, so when a
large fraction of market participants follows
rule-based strategies, these strategies, here
regulatory-driven sales and purchases of
securities, are less efficient. Morris and Shin
(2003) introduce a two-period model in which
traders with short horizons and privately
known trading limits interact in a market for
a risky asset. Here, risk-averse, long-horizon
traders have a downward sloping residual
demand curve that matches that of shorthorizon traders. Their model uses game
theory to solve for equilibrium and find the
trigger point where liquidity black holes are
generated. Grossman (1988) underscores the
importance of the option market for the
feasibility of portfolio insurance strategies.
Grossman and Zhou (1996) extend this work
to a continuous time setting, showing also
that portfolio insurance increases price
volatility, and raises the Sharpe ratio in bad
states of the world.
The illustrations of price-setting mechanisms
in the current section draw on the works
mentioned in the paragraph above and show
how the regulatory-driven sale of securities
from regulated investors faces the demand
curve from long-term investors.
We do not take liquidity constraints into
account. The supply of securities from the
short-term investor stylises actual constraints
faced by regulated entities in general, as
follows:
• Assets are marked to market.
• Institutions face Value-at-Risk constraints.
• Value-at-Risk calculations are prescribed,
and fail to take into account the risk
premium on the worst-case scenario implied
by the regulatory requirements. Volatility
too tends to be prescribed for regulatory
calculations, and here is maintained fixed
for all investors.
• Regulated investors operate close to
target requirements (in practice, to ratings
requirements, slightly higher than prudential
requirements for large institutions). They
are described as saturating their prudential
constraints.
We note:
V as the value of the allocation to risky assets,
CI as the regulatory confidence interval, λ as
Ν-1(CI) or the confidence interval expressed
as a multiple of the standard deviation of the
normal law, σ as the standard deviation of
returns or market volatility, A as asset value,
and L as liability value.
7
I. Equilibrium prices with pro-cyclical regulations
The liability value is for regulatory purposes
a fixed liability. It is worth noting that for
banking corporations, where liabilities are
a mix of deposits and debt, the decreased
market value of the liabilities because of
own credit risk never results in an increase
in available regulatory capital.1 By contrast,
the asset values move in line with the price
of the risky security.
Regulatory constraints and
maximisation program for the
short-term investor
We note VaR(V) = N-1(CI).V.σ = λ.σ. V, and
the regulatory constraint is: λ.σ. V = S = A-L
We suppose that there is a single risky asset
and that the short-term investor saturates
the regulatory constraint at all times (zero
and 1), selling and buying the risky asset
to comply with regulatory requirements.
In what follows, s is the selling pressure or
supply of risky assets from regulated entities,
measured by number of securities (a positive
number is a sale of an asset).
V* stands for the equilibrium holding value
of securities. At time t=1, V*1 reads
V *1 =
S + V0 ⋅( p1 / p0 −1)
p / p −1
S1
= 0
= V0 ⋅(1 + 1 0 )
λ ⋅σ
λ ⋅σ
λ ⋅σ
and the selling pressure is:
s1 ⋅ p1 = −( V *1 − − V0 ⋅ p1 / p0 ) = V0 ⋅(1 − p1 / p0 ) ⋅(
or in units
s1 = −
1
−1)
λ ⋅σ
(1)
V0 p1 − p0
1
⋅(
) ⋅(
−1) , s ≤1
v1
p0
λ ⋅σ
s ≤1 because
minimising
regulatory
requirements, λ.σ.ω, leads to zero holdings
of risky securities (V1=0) and to s=1.
Example 1: an order of magnitude may be
found as follows: with λ.σ=36% representing
the VaR of risky investments, a firm with an
8
initial surplus of €36 will invest €100 in
the risky assets. A 10% fall in market prices
triggers a fall in the surplus of €10, and the
equilibrium risky holdings fall to €72, vs. a
market value at t=1 of €90. A sale of €18
is required.
However, as we will see below, because of the
impact of aggregate selling on market prices,
trading prices are not only lower, which
generates further sales to reach equilibrium.
Matching supply and demand for
securities–price equilibrium at
time 1
Our risky asset held at time 0 is traded at
two consecutive dates, t=1 and t=2. For
illustration purposes, we take the return
distribution assumption from Morris and
Shin (2003): “We do not need to impose
any assumptions on the distribution of υ.
The important feature for our exercise is
that, at date 1 (after the realization of υ),
the liquidation value [at time 2] of the asset
is normal with mean υ and variance σ2”,
irrespective of the trading price p1 at time
1.2
Arguably, the two important aspects of
the price-setting mechanisms are the riskaversion of the investor and the maximum
amount available to invest in the market at
time t=1.
• For the risk aversion, we follow Morris and
Shin’s (2003) representation of the longterm investors (designed as “risk-averse,
long horizon traders” in their work) stylised
as “a representative trader with constant
absolute risk aversion γ who posts limit buy
orders for the asset at date 1 that coincides
with his competitive demand curve. […]
From the linearity of demand with Gaussian
uncertainty and exponential utility, the
market-making sector’s limit orders define
1 - In Europe as well as in the US, in the event that a bank applies the fair value option to its liabilities, and discounts them with its own credit risk or spread in order to
reflect best its actual market value, prudential filters are applied so as to prevent rising own credit risk from resulting in additional available regulatory capital. In other words,
any (accounting) revaluation gains from decreased liability value is not taken into account for supervision and capital adequacy purposes.
2 - There is no interest rate in the system, or alternatively the interest rate is zero.
I. Equilibrium prices with pro-cyclical regulations
the linear residual demand curve:
d=
v1 − p1
γ
⋅σ 2
” (2)
- Much as in Grossman (1988), M is the buying
capacity, i.e., the euro value of the position
that the market makers can take in time 1:
d ⋅ p1 ≤ M
(3)
At t=1, a risk premium, positive or negative,
arises because of the selling pressure from the
regulated investor. A fall in the fundamental
price triggers a sale from the regulated
investor, because a diminished surplus involves
a reduced capacity to hold risky assets. The
long-term investor, in turn, requires a risk
premium, i.e., a trading price lower than
the fundamental price, according to (2) to
buy securities. Demand from the long-term
investor is linear in the “risk premium” v1-p1,
but limited in value by M.
For illustration purposes, we now compute
equilibrium values for the following
parameters:
V0=1, υ0=1
Regulatory confidence interval CI = 99.5%
λ = Ν(CI) = 2.57, σ = 14%, w0=1
Regulatory risk charge: λ∗σ = 36%
γ = 6, and M=∞
Figure 1: Supply and demand for securities as a function of expected return per share for various initial shocks
The demand from the long-term investor is linear in the expected € return per share (red curve). For the regulated investor there is an initial
sale of securities when the fundamental price falls, because of the regulatory constraint. There is no initial sale for v1=1 (thin blue line), and
initial sales of 60% of assets for v1=0.75 (thick dotted blue line). Further sales are generated when the market price falls further below the
fundamental price. Equilibrium is achieved when the blue and the red lines cross.
9
I. Equilibrium prices with pro-cyclical regulations
Figure 2: Selling pressure with and without price adjustment
Without price adjustment, the selling pressure is linear in the market price. With price adjustment, the selling pressure is exacerbated during
cyclical downturns as the solvency position of the regulated investor weakens. All risky assets are sold for v1=0.75.
Figure 3: Fundamental price and market price (adjusted for selling pressure)
Equilibrium between regulatory-driven supply of risky assets and demand for these assets is reached by market prices' falling below
fundamental prices. For the regulated buy-and-hold investor, a 0.64 trading price triggers bankruptcy. Bankruptcy occurs when fundamental
prices reach 0.75.
10
I. Equilibrium prices with pro-cyclical regulations
The selling pressure lowers the market
price: for the risk-averse investor to accept
additional market risk in his asset allocation,
a reward in the form of a discount must be
offered. Prudential regulations, based on
historical estimates of the Value at Risk, are
meant to prevent a fall in market prices with
a 99.5% confidence interval.
However, as the selling pressure induces lower
trading prices, the bank reporting assets
at trading value is pushed to bankruptcy
with a greater probability than implied
by the calibration of regulatory capital
requirements.
Our stylised prudential regulation was
designed to prevent asset values from falling
below liability value at a 99.5% confidence
interval over one year, thus leading to a
probability of bankruptcy of 0.5%. However,
the market feedback from selling risky assets
involves a fall in prices that may trigger
bankruptcy. In our illustration, a 25% initial
fall in asset prices (to 0.75) triggers an
additional fall in transaction price (to 0.65).
The resulting probability of bankruptcy is
3.7% instead of the target 0.5%—more than
seven times higher than planned.
This feature helps illustrate that VaR-type
prudential regulations in the context of
market-value accounting are pro-cyclical. Not
only is their ability to prevent systemic risk
overstated; in fact, they may even contribute
to it. It is worth noting that:
• Illustrations also show that the regulated
entity that saturates its risk constraint will
use capital during booms to buy risky assets
above their fundamental price. Irrational
valuations during booms are thus a possible
outcome of pro-cyclical regulations (and
short-sighted investors).
• During downturns, an alternative to selling
risky assets is to raise fresh capital. When
losses are covered by new equity, shedding
risky holdings is no longer necessary, insofar
as the combined losses of all regulated entities
are covered by fresh injections. Though the
channels for buying risky assets and injecting
fresh equity are different (there may be more
statistics on capital injections than on final
counterparties for banking assets), the results
are strictly equivalent for our purposes: in
the presence of systematic shocks, the actual
probability of bankruptcy of regulated shortterm investors (banking corporations here) is
much higher than planned, and the system is
far less stable than the designers of prudential
regulations intended.
• Interestingly, when as here distress arises
because pressure on trading prices lead to
technical bankruptcy for institutions, liquidity
injections from central banks may provide
short-term relief, preventing discontinuity
in the payment system, but they do not help
prevent insolvency.
• The fire sale of assets and the fall of market
prices below fundamental prices, as described
in the current model, are not at odds with the
recent recognition by the US Securities and
Exchange Commission (2008) that the trading
value of assets may not be a clear indication
of their fundamental value:
The concept of a fair value measurement
assumes an orderly transaction between market
participants. An orderly transaction is one that
involves market participants that are willing
to transact and allows for adequate exposure
to the market. Distressed or forced liquidation
sales are not orderly transactions, and thus the
fact that a transaction is distressed or forced
should be considered when weighing the
available evidence.
The IASB (2008) has aligned European and US
practices.
• Contagion from one source of risk to the
full balance sheet occurs as the full balance
sheet needs to be adjusted to comply with
prudential requirements, whatever the origin
of the shock.
• Finally, systemic risk depends on the risk
aversion of long-term investors, or on that
of those who have the resources to buy risky
11
I. Equilibrium prices with pro-cyclical regulations
assets during market downturns. The greater
their risk aversion, the higher systemic risk.
As far as market-making investors are
concerned, the resources available to buy risky
assets are another essential factor. A limited
buying capacity from the long-term investor
leads to a very catastrophic outcome.
term investor for a combined value of 0.35
of initial value is feasible (but undesirable) at
any time. This risk of undesirable outcomes
underlines the fact that VaR-type regulations
are infeasible without first considering—as we
do in section III of the current study—whether
some long-term investors are available to
provide sufficient funds to clear the market
during downturns.
After all, as soon as the long-term investor
is not able to absorb supply because of its
limited capacity, the regulated investor must
sell all its risky assets for a total price of
M/V0=35% of its value at t=0. This solution
is clearly sub-optimal because with an asset
price of 0.35, the regulated entity in example
1 sees its surplus (or “equity”) fall from €35
at t=0 to minus €30 at t=1. Deficit (or
“negative equity”) means no other institution
will take over the bankrupt company without
government subsidies.
In addition, the sale of all assets to the long-
Figure 4: Fundamental price and market price, with limited buying capacity
M=0.35: the total value of the position that can be taken in t=1, including leverage, is equal to 35% of the initial value of risky assets held
by regulated investors. No more than €0.35 worth of assets can be bought, out of an initial balance sheet value of the regulated investor
of €1. When regulated entities need to sell close to €0.35 worth of risky assets, prices fall steeply so the total book value of risky assets is
€0.35 and all assets held by regulated entities must be sold. In the current illustration, a 20% fall in fundamental value leads to a 65% fall
in trading prices.
12
II. Prudential regulations for banking are pro-cyclical
In recent downturns, banks were reporting
under either the older Basel I rules for bank
capital or the new Basel II accord, depending
mainly on their geography. Banks in the US
reported under Basel I because of delays in
implementing the new set of rules, whereas
many banks in Europe reported under Basel II.
Under both Basel I and II, capital requirements
come to 8% of risk-weighted assets; the
latter are calculated as a function of the asset
class. A more detailed description is provided
below, as for the main banking business lines
we assess the pro-cyclicality features of the
Basel accord.
We consider three types of exposure. The
first is the trading book, subject to capital
requirements for market risk. We split capital
requirements for credit risk into two subcomponents that do not precisely match
the Basel II categories. The first is that in
which market references are available (loans
to rated companies or credit risk through
securitised markets); the second is the retail
book, the standardised lending business of
banks.
1. Market risk: bank “trading
books”
Bank trading books include all activities
linked to derivatives, structured products, and
trading accounts. They exclude long-term
market risk (e.g., strategic equity holdings),
hedge funds, private equity, and real estate.
Most credit risk was initially thought to be
excluded, but the increasing use of credit
derivatives and their classification for
accounting purposes as held for trading
has meant that an ever-greater share of
credit risk is dealt with in the trading book,
as described in Prato (2006). Accordingly,
analysis of the pro-cyclicality induced by
regulation of bank trading books is taking
on greater and greater importance.
The trading books of investment banks
represent a greater proportion of their
business than do those of retail banks
(universal banks are in-between). The weight
of the trading book has risen for a variety of
reasons, from accounting (“held for trading”
or “fair value through profit and loss”),
product design (with the offering of hedge
funds), regulatory arbitrage (the regulatory
assumption of a ten-day holding period
leads to lower capital requirements for an
exposure in the trading book than for an
exposure in the banking book; the latter is
regulated under the assumption of a oneyear holding period).
Most banks have adopted an internal model
for their trading books. Capital requirements
are calculated according to a historical Value
at Risk of the daily P&L of the trading book.
For this study, the relevant features are that
the capital is linked to the average over
sixty days of the ten-day “buy-and-hold”
estimate of Value at Risk , i.e., of the Value
at Risk with the assumptions that positions
will be liquidated after a ten-day holding
period.3 Basel I and Basel II have somewhat
similar rules in this respect; in particular, the
calculations for market risk required by the
SEC fit this general description.
j −1
capital = max(( 3 + backtesting_multiplier ) * ( ∑ VaR j ),VaR j )
j − 60
The backtesting multiplier is linked to the
number of the last 250 working days the
daily negative P&L is below estimated VaR.
The 99% daily VaR is assumed to be breached
in 1% of the last 250 days, or 2.5 days. When
the estimated VaR is breached more than
three times, penalties are incurred.
There is no public regulatory information
on VaR backtesting multipliers, but these
multipliers have increased materially since
3 - VaR is generally calculated as the daily VaR, then multiplied by the square root of ten to account for the holding period. Additionally, technical implementation and calibration
may resort to extreme value theory and hypothetical historical VaR estimated on the basis of current rather than historical holdings.
13
II. Prudential regulations for banking are pro-cyclical
early 2007, as a result of exceptions. Campbell
(2008) writes that
Credit Suisse reported 11 exceptions at the
99% confidence level in the third quarter,
Lehman Brothers three at 95%, Goldman
Sachs five at 95%, Morgan Stanley six at 95%,
Bear Stearns 10 at 99%, and UBS 16 at 99%”.
As there are 62.5 trading days, approximately
three exceptions are expected at the 95%
confidence interval and less than one at the
99% confidence interval.
Though internal models in general make
it possible to reduce capital requirements
for bank trading books, they induce procyclicality both because of the use of VaRtype constraints and because of punitive
revision of VaR estimates: after all, market
deviations of several confidence intervals,
with an ex-ante probability of occurring
of less than one in one thousand are often
reported during crises.
The trading book has one of the most procyclical regulations:
• VaR requirements in the context of fair
value measurement are pro-cyclical, as
illustrated in section I.
• Market volatility generally rises during
downturns, which results in increased VaR
estimates.
• The rise in capital requirements is
magnified by the (punitive) backtesting
multiplier.
• Additional technical factors may come
into play; for instance, the very heavy
selling pressure resulting from all the procyclical factors mentioned above will make
it all the more difficult to find demand for
these risky assets, so the ten-day holding
period assumed in the calculation of capital
requirements may in turn prove wrong, and
losses higher than forecast.
It goes without saying that the systematic
repricing of risk in the trading book may
lead to very high selling pressure and
14
require trading prices to fall significantly
below fundamental prices.
2. Credit risk, corporate exposure,
and securitisation
Credit risk is the risk of loss as a result of a
counterparty’s inability to repay its debts. A
great difference between Basel I and Basel II
is that Basel II requires using external credit
ratings when they are available, even in the
standard approach.
As we will see, a consequence is that when
credit risk is accumulated via securities
(lending through securities markets, whether
investment in securitisation exposures or
in listed interbank or corporate bonds/
instruments), as well as lending to rated
corporations, the business cycle impacts
capital requirements.
As is well known, the use of external
ratings involves downgrades during market
downturns and higher capital charges when
the situation worsens, one of the sources of
pro-cyclicality.
Noticed less often is that valuation is in
most cases consistent with IFRS, with lower
credit quality for the borrower triggering
impairment of the asset. Reported asset
values are therefore close to market value
during downturns, so when external ratings
are used the regulatory constraint is similar
to the stylised model (assets at market value,
VaR constraint) described in the first section
of this document. More precisely, market
value adjustments for corporate exposures
are as follows:
• Investments on securities markets will
generally be classified available for sale.
Lower market value triggers recognition of
loss and diminished capital.
• Loans to rated corporations are accounted
for at book value under IFRS just as in local
GAAP. For these loans, the general Basel
II. Prudential regulations for banking are pro-cyclical
requirement for impairment is defined as:
- Repayment of debt is more than ninety
days past due (a more accurate definition
of default or delinquency than that of
IFRS).
- There are significant reasons to believe
that the obligor is unlikely to repay its
obligation (a notion similar to that of
significant probability of not recovering
principal or coupons under IFRS).
Market signals (such as a steep fall in the
market value of the obligor’s securities
or a major downgrade) may thus trigger
impairment.
This reliance on IFRS statements is
important, since available capital is
usually based on accounting amounts
(shareholder’s equity, tier I, total capital).
How changes in values are passed through
to equity or P&L under IFRS may be judged
arbitrary. However, they have an impact
on the bank’s solvency. So do changes in
accounting rules.
3. Credit risk, retail exposure
Retail exposure is the result of the bank’s
standardised lending business. In Basel
I, products in retail books were assigned
constant weights. In Basel II, banks may
choose the standard approach, equivalent
to that of Basel I but with more granularity
in the product definition. Banks have
incentives to adopt the internal ratings
based (IRB) approach, in which they can
use statistical models calibrated on their
own books for the rating process and the
calculation of capital requirements.
Arguably, retail is the least pro-cyclical
line of business in banking. After all,
loans are mainly valued at amortised cost
(book value) in the bank’s account, and
impairment is most often linked to the
difficulty of a single borrower, less often to
external market signals, as is the case for
other business lines (see above).
The same reasoning applies to capital
requirements. Technically, they are
computed on a conservative estimate of
the probability of default through the
business cycle (the “through the cycle”, or
TTC approach). In theory, then, the end of
a boom has far less of an effect on capital
requirements than it does on other business
lines.
Unlike capital requirements, credit approval
systems usually rely on point in time (PIT)
measures of the short-term probability
of delinquency, as these measures better
reflect recent information on the borrower
and lead to better assessments of individual
applications.
Retail credit risk is not totally immune to
the business cycle though. A significant
downturn can involve a downwards
revision to the average creditworthiness of
clients. After all, an average delinquency
rate as observed with a six-month to oneyear delay will imply a downgrade of the
portfolio and higher capital requirements.
From a technical standpoint, other factors
may play a role.
• For instance, the goodness of fit of
rating models usually falls during severe
downturns, so potential unexpected losses
rise. The intuition behind this technicality
is that a model with perfect foresight
makes it possible to predict expected
losses and leaves no room for unexpected
losses. However, as goodness of fit falls,
the possibility for mistaken forecasts and
greater-than-expected losses rises. So do
capital requirements.
• Loss given default may also suffer when,
for instance, house prices fall, or when the
entity that guarantees the value of the
collateral is downgraded.
15
II. Prudential regulations for banking are pro-cyclical
Liquidity under Basel II
Although regulation is the driving force behind much of risk management (but no excuse
for inadequate practices), the Basel accord makes no quantitative requirements for
liquidity risk and management. This lack of regulatory requirement, together with the
actual presence of the LOLR as an unconditional provider of liquidity, probably explains
the large need for liquidity, as in Smith (2008): “Indeed, in the wake of the Northern Rock
debacle the Governor of the Bank of England cited that in the 1950s banks held as much
as 30% of assets in liquid assets, today that figure is closer to 1%”.
The fact that banks had off-balance sheet exposures with liquidity commitments (for
instance, concerning some asset-backed instruments in the very heart of the crisis)
certainly helped worsen banks’ liquidity imbalances.
We may note that Basel II requires liquidity risk management as part of its pillar II, and
the Basel Committee revised its “Principles for Sound Liquidity Risk Management and
Supervision” in June 2008, so as to reflect the lessons from the financial market turmoil.
Supervisors will probably ensure that more liquid assets are held in the future at banks,
thereby strengthening the foundations of the banking system.
In conclusion, we argue that the business
lines (and products) most exposed to
external ratings and market references are
the most pro-cyclical lines. Additionally,
as briefly mentioned, the reliance on IFRS
may involve negative impact. Beyond
technicalities, when trading prices fall
significantly below fundamental prices
because of global regulatory-driven selling
pressure, banking corporations may be
pushed into bankruptcy.
Retail banks—unlike investment banks—are
somewhat sheltered from the effects of the
business cycle and the systematic repricing
of risk.4 Major stand-alone investment
banks have either gone bankrupt (Lehman)
or merged with or transformed into
commercial banks (Bear Stearns, Goldman
Sachs and Morgan Stanley). In addition,
the greater pro-cyclicality of the trading
book may account in part for the recent
proposal by the SEC (2008) and the IASB
(2008) to allow some instruments to be
re-classified from the trading book to the
16
banking book—this reclassification would
allow them to avoid bearing the full brunt
of marked-to-market accounting.
We have seen that from both a conceptual
and a technical standpoint, Basel II implies
some pro-cyclicality,5 And following the
rationale developed in the first sub-section,
these features have adverse consequences
on cyclical (systematic) fluctuations.
The reasoning that long-term investors
the supply of securities from regulated
institutions is valid to the extent that these
short-term investors can be identified. We
will now further examine the constraints
faced by potential investors.
4 - Even without solvency problems, however, retail banks will cut credit lines during downturns because of the cyclicality of credit approval models relative to credit models
used for the calculation of capital requirements.
5 - As illustrated, another concern for the regulator is that the credit approval policy tends to be widely restricted by the cyclically diminished quality of credit applications, but
that is beyond the scope of our study.
III. Who then are the long-term, risk-averse investors?
Institutions with VaR constraints will sell
assets in a systematic manner when asset
prices fall. The model in section I captures
the systematic component of the selling
pressure. In this model, market prices
depend on longer-term investors without
a prescriptive VaR constraint but with a
risk aversion to supply liquidity to match
the selling pressure from the short-term
investors. Market makers demand a discount
(a market price below the fundamental price,
i.e., a high yield or a positive risk-premium)
to buy shares from cyclical investors such as
banks.
In practice, as underlined in section I, it is
essential that total funds available from
market makers (long-term and unregulated
investors) be sufficient to absorb–at a
discount coherent with their degree of risk
aversion–the supply of risky assets from
regulated investors. Limited buying capacity
leads to further catastrophic falls in prices.
Banking regulators must attempt to identify
these long-term investors and assess whether
they have the capacity to buy up bank
assets or provide needed capital infusions.
The community of regulators must ensure
that the mix of regulations for institutional
investors always allows the provision of
funds to the industry under threat.
In the current section, we analyse the
regulatory constraints of institutional
investors, and, when data is available, their
behaviour in the recent crisis. The following
patterns are expected:
• Short-term investors—typically acting with
a VaR constraint—have a convex allocation
strategy. As illustrated in section I, they sell
risky assets when prices fall, so their holdings
of risky assets fall faster than their market
value.
• Long-term investors with a constant
opportunity set keep their asset allocation
unchanged, holding the same share of risky
assets in their portfolios.
• Market makers, long-term investors,
increase their allocation to risky assets
to absorb the supply of these assets from
regulated short-term investors. They do so
by requesting a specific discount on their
investments.
Figure 5: Assets of various sectors.
Pension funds, mutual funds and insurance companies have the largest balance sheets of all institutional investors—here, large investors
excluding governments and banks. Sovereign wealth funds, though growing quickly, are still relatively small.
Source: Cited in ISFL Maslakovic (2008), various IMF publications - Global Financial Stability Report, Sovereign Wealth Fund Institute
Last update August 2008. Cited in SWF Institute (2008).
17
III. Who then are the long-term, risk-averse investors?
1. Asset managers behave as
short-term investors.
Long-only funds
In general, asset management firms are
perceived as largely free of regulatory
constraints. In some countries, such as
France, where private pensions are relatively
undeveloped, asset managers control a
significant amount of private investments.
Sophisticated UCITS6 funds are required to
manage with a VaR approach. The Committee
of European Securities Regulators (CESR
2005) proposes that “For this purpose,
Member States should consider, as a possible
reference the following parameters: a 99%
confidence interval, a holding period of
one month and ‘recent’ volatilities, i.e. no
more than one year from the calculation
date without prejudice to further testing
by the competent authorities”. That results
in a VaR-type pro-cyclical regulation, with
possible additional type II technical effects,
such as a rise in “recent volatilities” during
downturns.
For non-sophisticated UCITS funds, though
regulation of asset managers usually
involves restrictions (limited possibility for
leverage and/or use of derivatives unless
in specific funds), there are no Value-atRisk constraints embedded in regulation. In
general, the investment mandate includes
most possible restrictions, so in theory there
is room for counter-cyclical behaviour in the
asset management industry.
Here, two types of funds must be
distinguished:
• Funds benchmarked to a single assetclass, for instance, European equity funds,
typically involve a tracking error and limit
the possibility for investment outside the
chosen benchmark. Overall, fund mandates
and manager expertise involve valued added
essentially in the stock selection process,
rather than through changing exposure to
risk throughout the business cycle.
• Balanced funds, which have more flexibility
than other benchmarked funds because part
of their mandate involves rebalancing the
weight of the main asset classes. Rebalancing
between asset classes may arise when there
is no benchmark but rather an absolute
return target, or when there is a benchmark
that involves an average exposure to various
asset classes, but when the expertise and
value added require rebalancing.
For both types of funds, structured credit
exposure, however, is usually off-mandate
for many asset managers, so any exposure to
these securities will generate tracking error
relative to their benchmark and appear as
voluntary risk-taking, regardless of the total
amount of risk in the portfolios.
Arguably, the short-term horizon for
performance measurement contributes to this
rising risk aversion of asset managers during
downturns. After all, even if asset managers
need not pay for any lack of performance,
the client can always redeem, switching his
investments from an equity fund to a money
market when his risk aversion rises or when
the manager is underperforming.
This measure of risk relative to standard
benchmarks adds to the general practical
observation that end-customers show
rising risk aversion during downturns,
and implicitly encourages asset managers
to become “prudent”, in other words, to
“underweight”—meaning selling risky assets.
The current downturn is no exception, as most
managers report that they are remaining
cautious, as reported in Porier (2008).
Balanced fund managers have decreased
their relative exposure to risky assets, as
shown by the ECB’s Euro area investment
fund statistics.
18
6 - UCITS (undertakings for collective investments in transferable securities) is a European union directive for collective investment schemes.
III. Who then are the long-term, risk-averse investors?
This reasoning applies in particular to
balanced funds, which, as data from the
European Central Bank illustrate, show a
rising risk aversion during downturns.
Figure 6: European balanced funds, allocation to cash.
Increased allocation to cash during downturns, just as in 1998 and 2002, reflects the higher risk aversion of fund managers.
Figure 7: European balanced funds, allocation to equities and to other investment funds.
During the 2000 boom, balanced fund managers significantly increased their allocation to equities and other investment funds, and
reduced this weight dramatically afterwards. Since 2007, the diminished exposure has been less visible. Note that the overall higher share
invested in other investment funds (not visible in the current graph) makes shifts in asset allocation less visible from these statistics.
19
III. Who then are the long-term, risk-averse investors?
Hedge funds
Hedge funds, opportunistic investors, could
be the natural candidates to serve as market
makers, willing to accept any kind of security
provided the discount is steep enough. In
reality, however, the capacity of hedge funds
to behave as long-term investors depends
partly on the stability of their liabilities.
Just as for asset management in general,
most hedge funds are subject to the risk of
investors’ retrieving their savings in the short
term, a risk that limits their ability to act as
long-term investors.
To the extent that hedge funds rely on
leverage for investing, a contraction in
bank balance sheets leads naturally to a
contraction in lending to hedge funds, by
means of a contraction in liquidity and a
higher cost of credit, in such a way that hedge
funds cannot act globally as counterparties
to banks. As banks take credit risk by lending
to hedge funds, hedge funds could be
considered off-balance sheet exposures of
a sort, and are immediately affected by the
cyclical downturns that affect the banking
sector.
The view that hedge funds are affected by
bank problems is consistent with the IMF’s
(2008) just-released financial stability
report:
A similar deleveraging process is underway
for […] hedge funds, where the ability to use
margin financing and private repurchase
(repo) markets to take leveraged positions
has been severely curtailed; “finally, the credit
market crisis has resulted in tighter financing
conditions specifically for fixed-incomeoriented hedge funds, reducing their ability
to lever returns.
This deleveraging has been measured by the
IMF (2008).
20
Figure 8: Leverage and cash balances of global hedge funds. (in
percent)
The figure shows that leverage of global hedge funds diminished
from more than 60% in 2007 to less than 40% in mid-2008. This
is one of the indications of risk taking, and points towards a more
than 30% reduction in risk taking in hedge funds.
Source: IMF (2008), Morgan Stanley Prime Brokerage.
Note: Leverage defined as assets divided by equity capital cash
balances as a percent of total assets.
Asset sales from the deleveraging process
are exacerbated by the diminishing capital
base when investors withdraw their funds,
as happened in particular in September, as
reported in Robinson (2008):
Investors pulled at least $43bn from US
hedge funds in September amid market
turmoil, according to data from TrimTabs
Investment Research. […] TrimTabs said its
estimate of September withdrawals were
based on preliminary data and that the final
tally would probably be higher because funds
with heavy redemptions tended to report data
later. JPMorgan has estimated that hedge
fund outflows could total up to $150bn over
the coming year, leading to asset sales worth
about $400bn.
2. Recently, insurance companies
have also behaved as short-term
investors
Insurance companies have a significantly
longer horizon than banking institutions.
Though waves of surrenders are possible,
similar in spirit to banking runs, insurers
benefit from a number of safeguards.
III. Who then are the long-term, risk-averse investors?
• Liquid assets. Banking assets tend to
be illiquid (with a large share of loans),
whereas banking liabilities are very liquid
(a large share of deposits and short-term
refinancing bonds). On the other hand, most
insurance assets are liquid, traded assets,
whereas liabilities are more “illiquid”, as
there are some limitations to redemption.
For instance, there may be contractual
restrictions to the full liability redemption,
either at the contract level (for a single
investor) or at the book level (for a given
category of contracts). In other cases, weeks
may be needed to obtain the full repayment
of amounts due.
• Higher contractual and effective duration
of liabilities. Banking deposits have no
contractual maturity. Insurance liabilities
often do. Moreover, policyholders of the
insurance savings industry (life insurance)
generally benefit from tax incentives that
are lost when policies are surrendered,
and non-life insurance (motor third-party
liability, fire) is often mandatory. In some
cases, insurance allows reduced death taxes.
For these reasons, participation in insurance
is dictated by non-financial conditions,
which in turn means that the probability
of massive surrenders is much lower—and
the impact much less significant—than the
probability of bank runs. Surrenders will
take place during downturns and shorten
the duration of the liability, but not to the
extent of what may happen in the banking
industry.
Overall, the longer horizon should make
it possible for the insurance industry to
provide liquidity and demand for banking
assets during market downturns.
In practice, this tends not to be the case,
as Solvency II is based on a Value-atRisk concept. Though this new set of
prudential regulations is not yet in place—
it will be in force in 2011—regulators are
using intermediate regulations, as well as
quantitative impact surveys, to monitor the
shift towards this new regulatory standard.
Rating agencies, themselves gradually
converging towards the prudential riskbased approach of Solvency II for the ratings
they award, are also exerting pressure that is
accelerating the convergence of the largest
companies towards this norm.
We have not found aggregate data regarding
changes in asset allocation. However, the
largest insurance companies have reported
falling exposure—most often active—to
equity.
• Axa (2008) has reported having hedged
most of its equity exposure in local withprofit books as well as at the holding level.
The 2008 Half Year Earnings Presentation
shows that €26bn notional exposure out of
a total €28bn exposure has been covered
with “swaps, puts and calls”, so a 20% fall
in equity markets would impact total P&L
by €0.3bn.
• Aviva (2008a, 2008b) has reported derisking, i.e., selling equity holdings in 2007,
and an increase in downwards protection in
2008.
• Allianz (2008) has reported that equity
gearing, defined as net equity exposure
attributable to shareholders, divided by net
asset value excluding goodwill, has been
significantly reduced, from 260 in 2002
to 140 in 2003 (in the previous market
downturn), and to 62 in 2007.
• CNP (2008) has slightly diminished its
equity exposure by selling some dedicated
investment funds, and additionally bough
derivatives in Q2 2008 to protect a nominal
of €800m of equity exposure.
• ING (2008) has reported having reduced
its equity exposure in the Dutch insurance
segment, and market risk overall.
• Aegon (2008) reported reducing equity
exposure prior to the crisis, and has
continued to do so. Direct equity exposure
is limited to 0.2% of total investments, and
3% of the general account portfolio.
21
III. Who then are the long-term, risk-averse investors?
• For Dutch insurance companies as a whole,
DNB’s latest statistical bulletin (2008) shows
that there was continuing selling pressure
throughout 2007; this pressure eased only in
the first quarter of this year.
Overall, it can be argued that though
insurance companies are not yet regulated
by Solvency II the largest companies
have already adopted risk-management
systems that are compliant with risk-based
supervision, in effect monitoring the oneyear VaR and reducing equity exposure
during downturns.
As a consequence, pension funds would be
the natural price-maker and liquidity provider
for banking institutions in our model.
The historical behaviour of pension funds
could be likened to a fixed-mix asset
allocation resulting from their label of longterm investors (with a constant opportunity
set and constant relative risk aversion).
Figure 9: Historical asset allocation in the UK.
With this information, insurers would best
be labelled relatively short-term investors.
3. Pension funds, the traditional
long-term investor, have a mix
of short-term and long-term
characteristics.
In theory, pension funds have no short-term
constraints. In the landscape for savings
providers, pension funds stand out for their
role as going concerns. In most countries,
after all, it is the responsibility of the employer
to make good on pension commitments in
the event of pension fund shortfalls. Pension
funds, then, are managed as going concerns
because of the long-term relationships
between employees and their employers and
because of the mandatory participation of
employees in their occupational pension
plans. In other words, they are not subject to
runs or to surrenders, unlike the banking and
insurance industries.
In principle, defined-benefit pension
funds enjoy relative autonomy. Moreover,
most also benefit from flexibility in
funding requirements, with allowances for
underfunding for a “limited period of time”
in all European regulations subject to the
European “IORP” pension directive.7
22
Source: the Pension Policy Institute. From 1987 to 1997, the share
of equity holdings in UK pension funds was constant, even slightly
rising during the 1993 recession. This illustrates the traditional
“equity cult” as well as the very light prudential constraints in that
period. Since 1997, we can observe a continuous decline in equity
holdings in the UK, arguably as a result of tighter accounting and
prudential standards.
This fixed-mix asset allocation is consistent
with the theoretical results for long-term
investors without short-term constraints, as
in Martellini (2006) and Life and Pensions
(2006).8
Overall, in Europe, the trend has been towards
tighter regulation and risk-based supervision,
as will be further detailed in a study to be
released in the coming months. In the UK, for
instance, reporting standards (FRS17) require
a full and immediate recognition of profit and
losses from the pension funds in the P&L of
the sponsor—a great incentive to avoid risktaking in pension funds altogether. Besides,
the new UK prudential regulations, schemespecific funding requirements (SSF), though
still flexible by European standards, have
7 - Switzerland is not part of the European Union and not bound by this directive; however, its regulation also embeds some flexibility.
8 - However, introducing explicit liability constraints, as in Amenc et al. (2006) involves decreased risk-taking when the surplus falls. For a nominal liability, below a certain level
of funding, pension funds will sell risky assets to protect their surplus, as opposed to buying risky assets for rebalancing.
III. Who then are the long-term, risk-averse investors?
tightened. This helps explain why, overall, UK
pension funds have been cutting their equity
exposure in favour of more diversified and
less risky assets.
As a consequence, there is a tendency to
reduce equity holdings for both structural
(tighter constraints) and cyclical (risk-based
rules) reasons. The structural trends towards
lower asset allocation to risky assets are
illustrated in figure 9 above.
Figures 10 and 11: Stock market returns and Dutch pension funds’ equity investments.
Source: Bikker et al. (2007). Dutch pension funds partly rebalance their equity portfolios according to market movements. Their purchase of
equities during market downturns does not fully offset the price effect, so their overall allocation to equities is reduced.
23
III. Who then are the long-term, risk-averse investors?
Interestingly, this trend can be observed in
Switzerland too, where, according to the
2008 Mercer survey, the Dutch pattern of a
rising share of equities in 2007 and a falling
share in 2008 is repeated.
In the Netherlands, from early 2007 to 2008
Q1, pension funds increased their investment
in equities by 2% of their total assets,
as illustrated in DNB’s statistical bulletin
(2008).
Figure 12 and 13: Asset allocation trends in continental Europe and the UK.
Source: Mercers’ 2008 asset allocation survey. The figure illustrates the decline in equity holdings in most European countries. For the three
major countries:
– the UK exhibits a structural decline in equity holdings
– Switzerland and the Netherlands partly rebalance their portfolios during market downturns
24
Overall, pension funds have a greater shortterm bias than was probably the case earlier.
But it is likely that they still help stabilise the
system through automatic rebalancing, as
lower asset prices translate into automatic
purchases.
In short, pension funds have been unable to
fulfil their potential as agents of stability.
Arguably, however, total asset purchases
during the recent downturn have been low.
Sovereign wealth funds have acted as
providers of capital to a series of banks,
4. Sovereign wealth funds, though
of limited size, behave as longterm, market-making investors
III. Who then are the long-term, risk-averse investors?
Source: Sovereign Wealth Fund Institute, Official Press Releases
and have perhaps helped smooth some of
the current downturn and countered some
of the effects of the contraction of capital
rations at banking institutions. Funds such
as the Abu Dhabi Investment Authority
(ADIA), which invests “solely on its economic
objectives of delivering sustained long-term
financial returns”, have brought liquidity and
funds to the markets.
Below is a table of the infusions from
sovereign wealth funds to the banking
industry in the last year.
The total direct support for the banking
industry amounted to nearly $45bn from
March 2007 to April 2008, according to the
SWF Institute.
Sovereign wealth funds are among the very
few investors that have actually met our
definition of the long-term, price-maker
investor: they have increased their direct
holdings of bank capital, often by making
specific investments (such as convertible
capital) that involve negotiation of the terms
of exchange, a discount relative to market
prices or a preferred status in the payment
of dividends or debt, similar to the pricesetting mechanism stylised in section I.
Limited support … for size reasons
The assets of sovereign wealth funds (SWFs)
are comparable to the market capitalisation
of banks in developed countries: total
assets under management at SWFs were
$3.1 trillion at the end of 2007, according
to Santiso (2008), whereas the Datastream
index for banks of developed countries
showed a market capitalisation of $4.8
trillion on the same date, but $3.6 trillion at
the time of writing (October 1). These assets,
however, are but approximately 5% of total
banksassets (see figure 5).
Overall, support from SWFs has been
limited. Had pension funds and providers
of retirement savings been able to behave
as SWFs did, the capital infusions would
have been much larger. Indeed, the OECD
funded pensions market, including both
occupational
(workplace-related)
and
personal arrangements, was approximately
$24.6 trillion at the end of 2006.9
One may naturally wonder if pension funds,
nearly ten times as big as SWFs and with
similarly long horizons, could have profited
from market opportunities in countercyclical times—and provided support to the
markets—to the tune of as much as $300bn.
25
9 - OECD data, including assets held outside of pension funds, such as insurance companies in individual savings schemes of the third pillar.
III. Who then are the long-term, risk-averse investors?
We have seen that insurance companies,
as regulated investors, have tended to add
to the selling pressure felt by banks; hedge
funds have also deleveraged, and long only
asset managers have not acted in a countercyclical manner. Only some pension funds have
bought limited amounts of equities in order
to partly rebalance their asset allocation, but
regulations make the outcome for the third
quarter quite uncertain. Overall, SWFs can
be identified as the main long-term investor.
However, with assets under management of
approximately 5% of those of banks, it may
be that market-makers (long-term and nonregulated investors together) have a limited
capacity, which means they may be able to
absorb assets from banking corporations
only at crash prices.
Are governments left with the role of
long-term investing?
Where demand for risky assets and solvency
capital is unable to match supply, despite
plunges in asset prices, one may wonder
who is left to play the role of the long-term,
market-making investor.
Though they are not bound by VaR
constraints and thus have the ability to act
as the market maker when no other investors
can play this role, governments are not the
natural buyers of assets sold by regulated
entities.
First, governments design and enforce
prudential regulations so that the financial
sector will be immune to systemic risk, and
so that any bankrupt financial institutions
will have sufficient assets for another
institution to take it over–without further
public support.
In addition, government intervention often
involves delays. After all, spending is usually
controlled by elected representatives, and
is subject to additional rules. In Europe, the
Maastricht criteria require that the structural
26
deficit be less than 3%. Overall, proposing
and approving supplementary government
spending is burdensome.
These delays are a further source of
inefficiency. After all, late intervention
means that governments will intervene only
once markets have reached critically low
levels; large capital infusions will thus be
necessary to support bank solvency.
However, when governments realise that
institutional investors have a limited capacity
to act as long-term investors and that the
banking industry is on the brink of insolvency,
central banks (as liquidity providers) and
governments (as price-makers) must step in.
As illustrated in section I, the role they must
take involves:
• acting as a price-maker, buying depreciated,
toxic assets, or simply committing to buying
assets at a minimum price, thereby restoring
the smooth functioning of the financial
markets and alleviating the solvency
constraint of banking institutions.
• providing direct solvency capital to
institutions that have been trapped in (near)
insolvency.
Because smooth markets mean a buyer
is available to avoid price and liquidity
disruptions, we would like to see prudential
regulations be modified so as to allow the
financial system to work smoothly on its
own, without having to make systematic
appeals to the LOLR and to governments.
We argue that prudential regulations with
more of a long-term focus could help longterm investors enter the market during
downturns.
IV. Can regulations and practices be improved?
In the previous sections, we have argued
mainly that prudential regulations for
banking as well as for other financial
institutions are pro-cyclical and tend to
reinforce the impact of the economic
cycle on the balance sheet of financial
institutions. In addition, long-term investors
have a limited buying capacity, with
regulatory constraints on pension funds
and the still limited size of SWFs. When the
supply of risky assets from banks (and other
short-term investors) exceeds the limited
buying capacity of long-term investors, the
outcome can be disastrous. In the current
environment, regulation unaccompanied
by billions of dollars of government money
may simply lead to crashes in trading prices
and great systemic risk.
In addition, liquidity support by central
banks and public intervention have
drawbacks, including the oft-mentioned
moral hazard (see Garcia 2000 and the
political debate surrounding the Paulson
plan).10
Because responsibility for systematic risk
does not lie with bankers alone, but also
with regulators, prudential regulations
must be improved. Borio (2003) argued that
regulations should use a macroprudential
approach, under which cooperating central
banks and supervisors would attempt to
assess the business cycle, then tighten
capital requirements during booms and
loosen them during downturns.
This approach has not been put into practice,
probably because it is somewhat idealistic.
As Bernanke (2002) explained when he was
a governor at the Federal Reserve, asset
bubbles are much more easily depicted expost than when they happen: “Identifying a
bubble in progress is intrinsically difficult.
Though the price of (say) a share of stock
is readily observable, the corresponding
fundamentals—such as the dividends that
investors expect to receive and the risk
premium that they require to hold the
stock—are generally not observable, even
after the fact”. In addition, central bank
oversight of asset prices is still seen as
an experimental concept, and Bernanke
illustrates this view with the tightening
that took place in 1928 and the resulting
negative effects on the stock market: “The
correct interpretation of the 1920s, then, is
not the popular one—that the stock market
got overvalued, crashed, and caused a Great
Depression. The true story is that monetary
policy tried overzealously to stop the rise in
stock prices”.
From a technical standpoint, the macroprudential approach suggested by Borio (2003)
is not readily available, as he puts it himself: “If this diagnosis is shared, then there
is still plenty of work ahead. The agenda
is a full one, both for researchers and policymakers”. In particular, regulators would
need to define precisely how their capital
requirements will evolve with the business
cycle, an analysis that first would need to
be conducted in a detailed manner.
Fortunately, there are solutions to reduce
the cyclicality of the requirements and to
encourage less pro-cyclical behaviour in
the banking industry. These solutions, we
argue, are entirely feasible with available
concepts.
An obvious choice would be to create
principles to be respected by institutions,
and to delegate most of the measurement
and implementation of these principles to
the institutions themselves.
We recommend that these principles involve
two levels of capital for bank management
and supervision: first, a strict minimum
requirement that, when not met, would
trigger bankruptcy and second, no less
important, a soft target that could make
10 - See Obama (2008): “There can be no blank check.... We cannot abet and reward the unconscionable practices that triggered this crisis....Taxpayers should be protected....[It
should] help homeowners stay in their homes”.
27
IV. Can regulations and practices be improved?
it possible to counter the worst effects of
downturns in the business cycle.
ratios during cycle highs and lower ones
during downturns.
Solvency II has two levels of capital
requirement. In this new body of regulation,
the minimum capital requirement (MCR) is
calibrated as a 90% one-year VaR, whereas
the solvency capital requirement (SCR) is
calibrated as the 99.5% VaR.
The typical set-up could formulate the
following idea: a company starts business
at equilibrium. This company would initially
hold the target capital as available capital.
However, available capital will move with
the business cycle: if stock returns are
poor, available capital will fall slightly
below target capital but the supervisor
would consider this shortfall normal:
the company would not be asked to take
corrective action, as the improvement in
the business cycle is expected to improve
solvency from a quantitative standpoint.
On the other hand, where more significant
losses or degradation are observed, the
company is supposed to take action,
for instance, to modify its risk profile to
restore its solvency strength.
However, it is important that the SCR be
a soft target. In other words, the solvency
position must be allowed to decrease
through the business cycle (as well as
possibly for idiosyncratic losses).
Furthermore, the principle for risk
management explained here may be written
into law: financial institutions would then
be required to manage according to the
principle that they have higher solvency
The Dutch prudential regulation for pension funds: FTK (Financieel Toetsingskader)
The closest application today of the use of flexible buffers in a prudential framework
is the Dutch prudential regulation for pension funds, the FTK, as it has embedded some
flexibility in the definition of the target funding ratio.
The FTK embeds two levels of capital requirement that must be tested every year:
• A minimum funding ratio of 105%. The Dutch National Bank (DNB) must be informed
immediately of any shortfall and a subsequent strategy must be developed within three
months to bring the funding ratio back above 105% within three years. The strategy
usually involves higher contributions.
• A solvency test calibrated over a one-year risk horizon. The assets must be high enough
(105%) to cover the liabilities over a one-year horizon with a probability set at 97.5%.
The average required regulatory funding ratio is around 130%. When the buffer is too
low (coverage ratio of less than around 130% under the simplified method, a correct
approximation for a standard pension fund under the two other methods), pension funds
should present a recovery plan to the supervisor aiming for recovery in at most fifteen
years. Interestingly, expected future returns on the investment strategy may participate
in restoring the target funding ratio.
The allowance for future investment returns to help achieve the target funding ratio
over the fifteen-year horizon is aligned with the view that pension funds are long-term
investors and can maintain their investment strategy during cyclical downturns, provided
that lower current prices involve higher long-term returns. That Dutch pension funds need
not necessarily adjust their asset allocation after the recent deterioration in markets has
been emphasised in DNB’s October 2008 “Letter to pensionfund directors”.
28
IV. Can regulations and practices be improved?
In short, we propose that regulators
require the counter-cyclical use of buffers at financial institutions, but leave the
implementation and to some extent the
calibration of these buffers to risk management and regulatory compliance in financial
institutions. Unlike more general macroprudential considerations, our proposal
is easy to implement because it does not
require the regulator to perform a precise analysis of how precisely the capital
position should evolve throughout the
business cycle. It simply requires a strict
minimum (possibly close to zero) capital
requirement, as well an estimated average
buffer (possibly close to average mid-cycle
capital ratios of financial institutions).
business is as usual, and low when a crisis
occurs. Naturally, a low buffer—available
capital close to the regulatory minimum—
requires the institution to have a recovery
plan that allows it to restore its buffer over
the medium term.
How buffers need to be embedded in
regulations can be summarised and
illustrated as follows:
• Suppose that target capital requirements
are calibrated so that institutions can
withstand a shock equivalent to a 0.5%
probability, i.e., a 2.5 standard deviation.
In the context of a normal downturn (a
magnitude of, say, one standard deviation),
financial institutions should not be obliged
to raise capital, cut lending or sell risky
assets in large amounts. After all, capital
had been set aside to withstand such a
downturn, so raising new capital should
not be considered necessary.
• A buffer has a function: absorbing
losses. Buffers that are hard targets or
strict capital requirements lose their lossabsorption capacity and become useless
when it comes to pro-cyclicality. For this
reason, prudential regulations must impose
the use of truly loss-absorbing buffers,
i.e., regulators must oblige institutions
to develop internal policies to hold
some buffers above the strict regulatory
minimum, to a level aligned with their
own assessment of the degree of stress
they are facing: high during periods of
above-average profitability, medium when
29
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31
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