Financial Regulation

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					  The Perimeter of Financial
Regulation before and after the
       Ouarda Merrouche
        Bern Spring 2013
  Rational for and Objectives of Financial Regulation

• Key challenge of regulation: better align
  private incentives with public interest
  – without taxing
  – Without subsidizing private risk taking

• The case for financial sector regulation built
  around four market failures
Rational for and Objectives of Financial
(1) Anticompetitive behaviour
(2) Market misconduct
(3) Information asymmetries
(4) Systemic instability

• (1) & (2): market regulation
• (3) & (4): prudential regulation including capital regulation (Basel
  I/II/III) and liquidity regulation (Basel III)

• Objective: make financial crises less frequent and less severe
• «Ensure that all financial activities that may pose systemic risks are
  appropriately overseen. (….) Entities engaged in financiak activities
  on a leveraged basis should be regulated regardless of rge legal
  status of the institution.» (IMF, 2010)
               Basel accords
Three such accords
At the heart of all the accords is the issue of
 regulating bank capital
Rational: capital is the difference between
 liabilities (deposits) and assets (loans). Hence
 important for a bank to maintain enough
 capital to ensure it can repay its liabilities
                     Basel I
 Capital provide a cushion against insolvency,
 losses, sudden deposit withdrwals etc…
Basel I
   Approved in 1988
   To determine capital adequacy use of capital ratio:
    (Tier1 capital+Tier 2/risk weighted assets at 8%)
   Tier1: lower priority of repayment (common
   Tier 2: subordinated debt
                    Basel I
 Riskier assets should be offset by higher
                        Basel I
     Bucket approach to risk-weighting arbitrary and overly
      broad: within each bucket there are assets with very
      different level of risk

     The effect of this shortcoming is that banks have
      incentive to engage in regulatory arbitrage : start up
      preferred to well-established company
Basel II
                   Basel II
Expands the number of risk buckets (under
 the standardized approach)
Risk-weighting based on the unique risk
 associated with each assets using credit
 ratings agencies
Plus whether the claim is on a sovereign or a
 private counterparty
                   Basel II
 Internal rating-based approach: banks use
 their own internal methodology to determine
 the risk level of their assets

Addressed mainly to (large) banks that can
 demonstrate their technical ability and receive
 approval from the regulator
                     Basel II
   Reliance on credit rating agencies: conflicts of
    interest, what about unrated borrowers (all
  Example: inaccurately high ratings given to
  securitized products
  Banks’ own (internal) models which are not
    transparent and create problems of consistency
    between banks
  Manipulation under the IRB approach
                   Basel III
Narrower definition of capital

Leverage ratio

Liquidity ratio
Basel III
Basel III
          Lessons from the crisis
Countries where the global financial crisis
 originated had

  weaker regulation and supervision (e.g. less
   stringent definition of capital)

  less scope for market incentives (e.g. more
   generous deposit insurance, lower quality of
   financial information publicly available)
Lessons from the crisis
             Failure of regulation
 Focus on individual risks to financial
 institutions NOT systemic risk arising from the
 existence of externalities
Regulatory silos along functional and national
      no oversight at the financial group level (bank +
       insurance part) and systemic level

       Transactions channels through less regulated entities
           Failure of regulation
   National silos: banks are global and cross-border
    regulatory cooperation not operating
   Regulatory perimeter: the failure of some nonbanks
    had systemic repercussions (hedge funds) + bank
    regulation did not cover risks from off-balance-sheet
 Information gaps
   Information on exposures and risks difficult to compile
     as financial groups have grown more complex and
     interconnected, with operations global and spanning
     many business lines
  ( e.g. issue with CDS market)
             Failure of regulation
 Ill-designed micro-prudential policies

 Implementation constraints and incentives of
 regulators and supervisors
      Supervisory resources increasingly stressed as financial
      sector increased in size and complexity
     Some regulators lacked independence
      Exercise of regulatory forbearance under political
    Proposals for better regulation
 World Bank
     Pricing government guarantees in the system ( for example
     deposit insurancem TBTF status) to align risk-taking
     incentives of financial firms
    Fixe regulatory capital as a function of systemic size
     (financial firms need to internalize the cost of the negative
     externalities they impose on others)
    Greater transparency of OTC derivative markets
    Imposition of liquidity requirements for financial firms (to
     prevent or reduce the risk of runs in wholesale markets)
    Simplicity of regulation: complexity reduces transparency
     and accountability and strains regulatory resources and
    Proposals for better regulation
    Instituting a macroprudential approach to supervision and
     assigning a clear mandate to a systemic stability regulator.
     Expanding the perimeter of financial sector surveillance to
     ensure that the systemic risks posed by unregulated or less
     regulated financial sector segments are addressed.
    Filling the information gaps, especially with regard to lightly
     regulated financial institutions and ‘off balance sheet’
     transactions, ensuring that both supervisors and investors
     are provided more disclosure and a higher level of
     granularity in information provided.
    Resolving the political and legal impediments to the effective
     regulation of cross-border institutions, develop special
     insolvency regimes to be used for large cross-border
     financial firms, and harmonize remedial action frameworks.
           Proposals for better regulation
Proposal by              Specific steps
Admati and Hellwig       Replace risk‐weighted capital ratios by
(2012), Hellwig          (significantly higher) leverage ratios,
(2010)                   combined with strong disclosures about
                         risk exposures.
Rajan (2010)             Scale back explicit deposit insurance from
Demirgüç‐Kunt            large banks as an additional
(2011)                   measure to claw back implicit guarantees
                         and remove the “too‐big‐to‐fail”
Barth, Caprio and        Rather than focusing on the regulations
Levine (2012a)           themselves, focuses on how to better
                         oversee the regulators. Establishment of a
                         “Sentinel” agency, watching over
                         the regulators on behalf of the taxpayers.
     Regulatory reforms since 2007
• World Bank’s Banking Regulation and
  Supervision survey: 85% of responses
  unchanged between 2007 and 2011
• Countries have stepped-up efforts in the
  following areas:
  – Macroprudential supervision
  – Resolution regimes
  – Consumer protection
  – Incentives for market discipline have not
    improved: deposit insurance coverage has
Regulatory reforms since 2007
Regulatory reforms since 2007
Regulatory reforms since 2007
Regulatory reforms since 2007
Regulatory reforms since 2007
Regulatory reforms since 2007
Interbank Market: The Libor Scandal

Securities Markets: The Flash Crash

Payment systems: example of the Suffolck
 system (Calomiris and Kahn, 1996)
              The Libor Scandal
— bbalibor is the most widely used "benchmark" or
reference rate for short term interest rates. It is
calculated by Thomson Reuters and released to the
market shortly after 11.00am London time each
— Contributor panel banks (selected on the basis of
scale of activity) are asked the following queston:
"At what rate could you borrow funds, were you to
do so by asking for and then accepting inter-bank
offers in a reasonable market size just prior to 11
            The Libor Scandal
— Based on the answers from each participating
bank Thomson Reuters calculates the average rate
using the following method: submissions are ranked
in descending order and then the highest and
lowest 25% of submissions are excluded. This is
repeated for every currency and maturity,
producing 150 rates every business day.
— A bank cannot see other contributor rates during
the submission window – this is only possible after
final publication of the BBA LIBOR data.
              The Libor Scandal
— The Libor scandal involves several banks, notably
Barclays, that have admitted to have announced
lower quotes at the height of the crisis to hide
funding problems. Other banks currently being
investigated include: Deutsche Bank, Citigroup,
Royal Bank of Scotland, UBS, Lloyds Banking Group,
Citigroup and JPMorgan Chase
— no issue with the functioning of the interbank
             The Libor Scandal
Evidence of Manipulation
 banks reporting costs significantly lower than
  the rates justified by bank-specific cost trend
  movements in the CDS market (Snider and
  Youle (2010)).
Gyntelberg and Wooldridge (2008): LIBOR did
  diverge from other key reference rates to “an
  unusual extent” during the crisis period, but
  other explanation than manipulation (loss of
             The Libor Scandal
— To address the problem Mervyn King and
other regulators propose to have a rate based
on actual transactions rather than what the
banks say they pay.
— Issue: the thinness of certain market
segments, in particular at longer maturities.
             The Libor Scandal
Weathley proposal (10 points plan)

New regulatory oversight. Credible
 independent supervision, oversight and
 enforcement, both civil and criminal.
Hand the rate-setting process to an
 independent administrator (BBA failure
Transparency: Surveillance and scrutiny of
 submissions, publication of a statistical digest
 of rate submissions
             The Libor Scandal
Submitting banks to make explicit and clear
 use of transaction data to corroborate their
The BBA should publish individual Libor
 submissions after 3 months to reduce the
 potential for submitters to attempt
 manipulation, and to reduce any potential
 interpretation of submissions as a signal of
                  The Libor Scandal
Extent of usage

 bbalibor is the primary benchmark for short term interest
  rates globally.
 Increasing range of retail products such as mortgages and
  college loans. It is used as the basis for settlement of
  interest rate contracts on many of the world's major
  futures and options exchanges
 Considered key barometer to measure strain in money
  markets and as a gauge of market expectation for future
  central bank interest rates.
 bbalibor figures are issued daily on more than 300,000
  screens around the world. It serves as a reference for
  financial products amounting to 350 000 billion USD
             The Libor Scandal
Economic risks

— Key business risks in banking markets.
Securities markets affected indirectly.

— Costs from substantive potential legal and
litigation issues.
              The Flash Crash
On 6 May 2010, prices of futures and equities
dropped sharply between 14:42 and 14:46
before recovering around 14:50
                The Flash Crash
• According to the SEC, this large drop has been
  caused by a massive sell pressure with few
• Around 14:32, an execution algorithm started to
  sell e-Mini contracts on a large scale. Those sales
  were quickly absorbed by funda-mental buyers
  and HFT players. However, the algorithm
  continued to sell the contracts while HFT players,
  who have bought the first batch, started also to
  sell those instruments in order to maintain a close
  to zero inventory position, resulting in increasing
  sell pressure which lead to a drop in prices as few
  buyers were left.
               The Flash Crash
Policy proposals in the US
Imposition of circuit breakers (security-specific
trading halts triggered by sharp price moves) on
1000 equities and review of existing systems
Rational for such response:
(1) the crash was concentrated at few stocks; over
98% of all shares traded at prices within 10% of
their pre-crash levels; (2) none of the market-wide
circuit breakers implemented in response to the
crash of October 1987 was triggered.
             Payment Systems
 Success stories of self-regulation
 Set their own rules, entry conditions,
 procedure in case of outage, exposure limits,
 default arrangements, contingency
(Limited and recent) oversight by the central
Stability demonstrated during the crisis

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