Transcript Netherlands-United States Roundtable on Financial Services

A New Regulatory
Environment: What can we
Expect?
Arnoud W.A. Boot
University of Amsterdam and CEPR
FSA on Shadow Banking
April 28, 2011
My remarks
• Understanding the 2007-09 crisis and
beyond
• Regulation/supervision
–What is wrong?
–Dodd-Frank, EU, UK Independent
Committee, Basel… What needs to be
done?
• Do we understand the economics of
banking?
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Arnoud W.A. Boot April 28, 2011
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The crisis: Economic setting
• How do you regulate an increasingly dynamic
financial services industry?
– Proliferation of financial markets with institutions
and markets being increasingly intertwined
– Rapid innovation in financial instruments,
distribution channels and institutions
– Blurring distinction between banks and other
financial institutions
Mushrooming of the financial sector…
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Arnoud W.A. Boot April 28, 2011
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Financial crisis...
Much can go wrong in the financial sector
• Modern banking suffers from extreme
interconnectedness...
• Existing regulation/supervision lacked macroprudential focus
• In euphoric times risk is underpriced and always
too much capital...
• When times are good no support for tough
regulator….
• Where money is being earned rests control
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Arnoud W.A. Boot April 28, 2011
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Information technology key
What did information technology really do to the
financial sector?
… Extreme tradability… and ‘changeability’…
Risks via
• Herding behavior
• Power structure within financial institutions..
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Arnoud W.A. Boot April 28, 2011
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How to look at financial innovations?
• Extensive literature shows value of innovations
– Spanning
– Other direct benefits for real activities (e.g.
commercial letter of credit)
• Yet this literature may say little about more
recent financial innovations
– (Often?) creating opaqueness
– Aimed at regulatory arbitrage only?
 Opened up bank balance sheet: marketability and
changeability key
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Arnoud W.A. Boot April 28, 2011
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Crisis? You can sleep soundly again...
Amerikaanse Dodd-Frank Financial Reform Act:
“[This Act] ends the possibility that taxpayers
will be asked to write a check to bail out
financial firms that threaten the economy,
consumers, investors and businesses…”
… really????
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Arnoud W.A. Boot April 28, 2011
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Length of the bill not an issue...
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New regulation?
• Scope of regulation and supervision needs to be
contained? How to limit systemic reach?
– Cross-sector footprint
– Cross-border issues
– Most importantly (?) “seamless” integration of
financial markets and institutions
• Marketability has its limits….
• Complexity…
Issue: all this obscures object of supervision
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Arnoud W.A. Boot April 28, 2011
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Greenspan…
Can we accept Allen Greenspan’s statement that
the financial system is like Adam Smith’s
invisible hand
…. some type of complex eco-system that is
beyond anyone’s control or imagination, and
is “unredeemably opaque” (Financial Times,
March 31, 2011)
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Arnoud W.A. Boot April 28, 2011
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Fundamental reform
• Will international coordination go far enough?
– Role IMF, FSF/FSB and BIS (Basel)
– EU-wide regulators, ESAs, ESRB, role ECB
– Burden sharing
• More capital…
• Market discipline?
Need more than that?
• Structure of the banking sector
– Limits on use of deposits? OTC? Etc.
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Arnoud W.A. Boot April 28, 2011
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Market discipline?
• Sensible complementary ‘tool’. Idea behind third pillar
Basel II
• Complicated effect in crisis times: everyone may “head
simultaneously for the exit”
• Paradox in normal times… momentum in financial
market may lead to opportunistic behavior of banks, yet
same momentum driven markets would simultaneously
have to impose discipline?
 Market discipline effective for idiosyncratic differences
between institutions, less for financial market driven
strategies
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Arnoud W.A. Boot April 28, 2011
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Cost of capital fallacy
We do not need to like M&M, nor believe M&M
has relevance to banking, but to deny that
“the cost of capital is affected by the risk that the
capital is exposed to” is disturbing
Implications:
- Fixed cost of capital does not make sense
- Maximizing ROE fundamental violation of
corporate finance theory
…. No free lunches, yes self-fulfilling prophecy…
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Complexity
• Simplifying structure of financial institutions
of paramount importance for alignment
market forces and prudential concerns
• But existing complexity itself makes it also
difficult to act on structural measures.
• No readily available prescriptions on how to
simplify
– Difficult to grasp interlinkages and intralinkages
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Arnoud W.A. Boot April 28, 2011
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Dealing with complexity
i. Complex institutions difficult to manage and
supervise (problem of opaqueness);
ii. A complex financial institution has many,
difficult to discern linkages with the financial
system at large; TBTF, too-interconnected-to-fail
concerns;
iii. As a consequence systemic concerns might
become more prominent;
iv. Complexity puts supervisors in a dependent
position, e.g. how to intervene (timely)?
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Dealing with complexity – 2
• Living will idea aimed at mitigating this
– Only effective if dealt with ex ante
• How to disentangle businesses?
– Separate legal structures, no recourse?
• Would it work, and does market accept it?
• UK Banking Committee?
– Breaking-up banks? (Volcker Rule and beyond…)
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You ain’t seen nothing yet….
‘Anyone who deals in the financial markets knows that
anticipating trends is difficult at best. But he or she also
realizes that not to try is tantamount to accepting the
most unlikely scenario of all: no change’
(Sandford, 1994)
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Appendix:
Structure EU banking sector
supervision
Elaborate EU coordination being implemented….
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History of EU banking regulation
• System of home-country control –2nd Banking
Directive 1988
• Lamfallusy framework
• Larossiere report
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European Systemic Risk Board (ESRB)
Macroprudential
supervision
Steering Committee (12 persons)
- 7 ESCB members
- 3 chairs of ESAs
- Member of the European Commission
- EFC President
General Board (at least 62 persons)
Micro-prudential information
Report to
ECOFIN
Early risk
warning and
recommendations to
governments
Early risk warning and
recommendations to supervisors
European System of Financial Supervisors
(ESFS)
Steering Committee:
Microprudential
supervision
Chairsof 3 ESAs
European Banking
Autority (EBA)
European Insurance and
Occupational Pensions
Autority (EIOPA)
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Arnoud W.A. Boot April 28, 2011
European
Securities Markets
Authority (ESMA)
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Macro-prudential policy
“Macroprudential policy focuses on the interactions between
financial institutions, markets, infrastructure and the wider
economy. It complements the microprudential focus on the
risk position of individual institutions, which largely takes
the rest of the financial system and the economy as
given.”
“[Systemic risk is defined by the IMF, FSB and BIS for the G20]
as a risk of disruption to financial services that is caused by
an impairment of all or parts of the financial system and has
the potential to have serious negative consequences for the
real economy”
[Committee on the Global Financial System, emphasis added]
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Characteristics of systemic risk to
address
•
•
•
•
•
•
•
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Excess credit growth to private sector
Widespread maturity mismatches
More opaque chains of intermediation
Cross-exposures and contagion
Massive undervaluation of risk
Procyclicity
Bubbles
Market freezes/ fire sales
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Implications for Basel II
Note: Basel II was just being implemented, thus
not the direct cause of current problems …But…
• Induces herding behavior via use of models
• VAR not just ignores tail risks but ignores
systemic issues
• Induces low capitalization in general and
particularly in good times… procyclicality…
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BIS III … (Basel III)
What does it seek to do??
• Level of capital
• Quality of capital
• Leverage ratio and timely intervention
• Liquidity
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Other issues..
• Contingent capital??
–What does it seek to address?
• More capital for systemically relevant
institutions?
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Economics of banking
• Government involvement lasting...
• Regulation has a cost too..
– Regulatory arbitrage
– Level playing field
• What is optimal for banks?
–ERM perspective, risk appetite
 Implications for business model
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