Building a More Resilient Financial System:Reforms in the Wake of the Global Crisis

Jonathan Fiechter İnci Ötker-Robe

Ceyla PazarbasiogluJay Surti

FPD Chief Economist Talk The World Bank

May 15, 2012

Outline

Brief backgroundPolicy response to fix the systemViews on the reform proposalsTaking stockLooking aheadConclusions

2

Global crisis exposed the existing cracks in the financial architecture

Pre-Crisis global financial system was characterized by:

Highly complex/interconnected financial systems in advanced countriesOverleveraged financial institutionsReliance on short-term wholesale funding Incentives that encouraged excessive risk takingPoor risk management practices

Inadequate regulation/supervision (individual/systemic level) Insufficiently wide regulatory perimeterPoor transparency/disclosure requirementsLack of effective resolution regimes & infrastructure to deal with failures

of complex, interconnected institutions

3

How to Fix the System Make failures (1) less likely & (2) less costly/messy

Reduce incentives that encourage excessive risk taking Tighten regulation (Basel 2.5, 3, SIFI framework) Better supervision Widen the regulatory/monitoring perimeter to cover shadow banks Address data/information gaps to facilitate market

discipline/supervision Establish effective resolution regimes (domestic and cross border) Infrastructure to deal w/ interconnected, complex, TBTF institutions Focus on systemic risk and macro-prudential policies

4

Impact of the reforms on the industry

Private sector ownership of the reforms key to successful implementation

Business models and practices need to be aligned with the new financial structure

But financial institutions will adjust business strategies in response to tighter prudential requirements

Analyze the impact of regulatory reforms for ~60 LCFIs

◦ Basel 3 capital rules (higher and better quality capital)◦ Liquidity requirements (NSFR—LT stable funding )

5

Capital requirements: Greater effect on investment & universal banks

6

Commercial Banks Universal Banks Investment Banks0

2

4

6

8

10

12

7.9%

8.8%

9.9%

7.1% 6.8% 7%

Core Tier 1 Ratio 2009

Basel III Core Ratio, 2012

2%2.9%

(1.9% RWA effect)

NSFR: Greater effect on investment and universal banks

‹15› 7

Basel 3 requirement: NSFR ≧ 100 %

Commercial Universal Investment 0

20

40

60

80

100

120

140

160

180

Ultimate impact will depend on how banks will adjust • Basel 3 rules likely to affect investment and universal banks more

• Also targeted by other measures (derivatives and securitization measures; SIFI measures, Volcker rule, other scope measures)

• But these banks have more flexible business models adjust strategies to mitigate the impact:

Some activities may shift to the unregulated shadow banking sector Some businesses may move to less tightly regulated locations/sectors

Policy challenge: ensure adj’s in business models don’t generate systemic risks through these shifts

Safeguards: - effective supervision - supervisory/regulatory coordination

- extended regulation to nonbanking sector - enhanced transparency/disclosure

8

Health of Financial Institutions Depends on Many Factors:

Financial Sector Performance

Economic & Market

Conditions

Internal Governance &

Risk Management

Market Confidence/

Discipline

SUPERVISION and

Regulation

9

Regulations Require Effective Supervision – But Supervision was Inconsistent (pre-crisis):

Was not proactive in dealing

with emerging

risks

Did not sufficiently question business activities

of regulated institutions

Did not keep up with the changing business

environment

Did not follow

through – lacked

skepticism

In some cases, supervision:

10

Main deficiencies reflected in FSAPs – areas of lowest compliance globallyBanking Supervision Insurance Supervision Securities Regulation

Consolidated Supervision Corporate Governance Operational Independence and Accountability

Country and Market Risk Supervisory Authority (Independence, Accountability, Resources, Powers, Protection)

Regulatory oversight of SROs

Risk Management Process Group-wide Supervision Supervisory Powers, Resources and Capacity

Operational Independence, Accountability and Resources

Risk-assessment and Management

Effective use of inspection, enforcement and compliance

11

“Good Supervision” is:

Intrusive

Adaptive

Credible –Follow-throughSkeptical and

Proactive

Comprehensive

12

Getting to “Good Supervision”

The will to act

The ability to act

High Quality Supervision

13

Will to Act

Clear MandateOperational

Independence

Accountability

14

Ability to Act

15

Adequate Resources

Strong Authority

Internal Organization

Forward-looking Strategy

Interagency Collaboration

The Perimeter of Supervision & Regulation

More intensive bank supervision and regulation will push some activities outside of banks

Leave risks in the system (ownership /funding links with banks)

Response: FSB/IMF/WB work on shadow banking risks

Greater transparency of off-balance sheet risk Limit bank concentration risk to nonbanks Prohibit nonbank deposit-taking activities If non-bank credit intermediation (e.g., finance company), solution less

clear Greater transparency/reporting – no downside Greater consumer/investor literacy

16

Enhanced transparency/disclosure complements…

Adequate data/information key to reducing info asymmetries

Increased transparency and disclosure essential to

◦Enhance supervisors’ ability to capture risks on time◦ Increase market ability to assess risks/impose market discipline

Aimed both at banks and shadow banks to limit regulatory arbitrage

Progress made on addressing data gaps—BIS/FSB/IMF initiatives (info on G-SIFI exposures, structure, interconnectedness etc)

But slow progress (subset of the data available by end 2014 )

17

Effective resolution regimesRecovery and Resolution Plans (living wills)

Special national schemes for orderly and timely resolution of financial institutions

Financial sector contribution (FSC) to cover costs

Arrangements for bailing-in creditors

Cross-border resolution and burden sharing

Resolving TITF institutions—requires tough decisions

18

IMF Proposal for Resolution of Cross Border Financial Institutions

Permit cooperatio

n where possible Adherence to core standards

with non-discriminatory treatment of domestic and

foreign creditors

Agreement on procedures for rapid and predictable

resolution

Framework for burden

sharing and

allocation of

responsibilities

Coordination

19

What are CoCos for (tool for prevention & resolution)?

Higher capital buffers to recapitalize a bank under difficult market conditions

Private sector involvement /more burden sharing between creditors and equity holders

Reduce debt level in times of stress / prevent fire-sale of assets

Prudent risk management and monitoring

20

Contingent Capital is only one intervention tool

Senior Secured / Covered Bonds / OthersLoss sharing by all creditors Resolution

Bail-In of Senior Unsecured Regulatory discretion to impose

conversion/losses on all creditors

Gone Concern “Bail-in Capital”:Regulatory discretion to convert to equity or

write-off at point of non-viability

Regulatory Intervention

New Style Hybrid Tier 1Non-step cancellable coupons, with principal write-down or equity conversion

Contingent Capital(Post Conversion )

Core EquityCommon Shares and Retained Earnings

Capital Conservation

measures

ManagementActions

Future Earnings

Loss

es

Profi

t

0

Probability of occurrence

Going Concern

Gone Concern

Liquidation

Status Intervention mechanismType of capital / debt affected

21

Useful addition to the toolkit …Provide extra loss-absorbing capital at cheaper cost

than equity

May help SIFIs meet the capital surcharge

Facilitate automatic burden sharing with private investors

May help prevent a bank failure or reduce the severity of failure

22

…but carries risks…

May complicate and obscure capital structures

Negative signaling effects of conversion

Speculative investors may trigger a conversion; cause a “death spiral” in stock prices

Domino effect on equity prices triggering one conversion after another

Significant risk transfer to institutional investors and political economy considerations

23

…that should be safeguarded against

Supervisors need to be vigilant in monitoring◦the design and issuance of contingent capital instruments◦the implied transfer of risks within the financial system◦potential build-up of systemic risks, including liquidity risks.

Circuit breakers to avoid potential “death spirals”

Instrument standardization to maintain capital transparency

24

Bottom lineCoCos may work in support of the regulatory agenda

to meet supplementary capital requirements (Pillar 2, SIFI surcharge)

provided suitable measures are taken to assure convertibility when needed and guard against risk

but some incentives may be necessary to garner investor interest

25

How about living wills (Recovery Resolution Plans)?

Blueprints (contingency plans) jointly developed by firms/regulators

Guide smooth orderly resolution of a failed bank to stem contagion to the broader financial system

Valuable contribution to effective resolution frameworks

Global SIFIs required to prepare RRPs to improve “resolvability” (drafts by June 2012; finalized by end-2012), to:

show how they would recover under stress & unwind if they fail

provide information on firm’s structure, commitments, exposures, A&L

expected to facilitate recovery, supervision and resolution efforts

encourage/force firms to simply their structure to facilitate R&R

26

Implementation has been very slow, however…

Very limited progress in preparing living wills by 29 G-SIFIs (recent Ernst & Young survey)

Only 1/19 institutions completed a draft RRP

European and Japanese banks particularly lagged behind US/UK

Resolution part of RRPs: least progress made (1/3rd not started)

Cross-border differences among regulators biggest hurdle

Further highlights the need to establish effective cross-border regimes for cooperation, information-sharing, decision-making

27

Lack of progress for effective resolution regimes at the core of Too-Important-To-Fail (TITF) Problem

Share in the global financial system doubled during the crisis … likely to

have grown further

0

5

10

15

20

25

30

35

402000

2009

TITF problem SIFIs Difficult to manage, supervise, resolve

High capacity to disrupt the entire system / economy:

◦ Large size◦ Interconnectedness & complexity◦ Limited substitutability

Too Important To Fail

Bailing out generates moral hazard

influence over regulatory process competitive funding advantage

28

TITF funding/competitive advantage (US SIFIs)

29

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010-Q1

2010-Q2

2010-Q3

2010-Q4

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

(Difference in Cost of Non-deposit Liabilities between insured US banks with assets over $100 bn compared to those with assets

$10-100 bn)

80 bp

14 bp

57 bp

Greater challenge for countries with large financial systems

30

Systemically important bank assets multiples of home GDP (%)

(In percent)

Framework to Reduce SIFI Moral Hazard

Market-based approachReducing probability/consequences of “systemicness”

More stringent capital and liquidity

requirements

Consistent with SIFI’s contribution to

systemic risk

Intensive and proactive

supervision

Consistent with complexity and riskiness of the

institutions

Enhanced transparency and

disclosure

Facilitate risk pricingCapture emerging risks in the system

Effective resolution regimes

(national/globally)

Recovery and resolution plans

(Living wills)

Creditors share losses

(CoCos, Bail-in)

31

Internalizing systemic risks

However, long before TITF is put to rest…

Methodology to identify SIFIs and scope of application (for D-SIFIs)

Level/composition/coverage of the capital surcharge (for D-SIFIs)

Translating SIFI supervision recommendations to national practices

Enhancing disclosure and closing data gaps

Understanding/monitoring/regulating the shadow banking system

Obstacles to national and cross-border resolution frameworks

Compensation policies to limit incentive for excessive risk taking

32

What should be done in the interim?Growing pressure at the national level to take

immediate action to limit the risk posed by SIFIs

Reaching a consensus internationally more difficult

Credible and visible actions are needed in the interim:

Require SIFIs to hold significantly more loss-absorbing capital

Subject them to enhanced and intensive supervision

Globally coordinate these actions to maintain a level playing field

Provide a reasonable transition period33

More direct approaches to address the TITF problem?

34

Preventing institutions from becoming systemic

Limits on size

Absolute size (assets, liabilities)

Relative size(GDP or system

aggregates)

Limits on scope

Narrow bankingVolcker rule

Swap push out

Limits on structure

Organizing groups as a set of separate,

self-sufficient subsidiaries

Caps on future growthDeleveraging

Breaking up banks34

Why re-scope business models?Banking leveraged intermediation managed by agents with

profit-sharing & limited liability Assumption of risk excessive from capital suppliers’ perspective

Incentive problem significantly magnified in case of SIFIs Presumption of diversification size and complexity at low capital costSIFIs are TITF presumption of wide (implicit) public backstopComplexity prevents use of appropriate resolution options in a crisis

Ways forward?

Goal ensure continuity of retail business + protect retail depositsApproach reduce leverage, risky investments, complexitySide-benefits credibly reduce perimeter of public guarantees

increase incentives for market discipline35

Narrower banks

36

General idea Reversion of deposit funded banks to payments function outfits Lending restricted to mortgages, retail cards, etc. Securitization, trading, risky investments shipped out to stand-alone

finance companies Only narrow banks receive public backstop / deposit insurance

Concrete policy proposals Volcker Rule of the U.S. Dodd-Frank Act U.K. Retail Ring-fence

What do the proposals entail?

37

Volcker rule U.K. retail ringfence Prohibited businesses Proprietary trading

Investments in hedge funds, private equity funds

All IB business All non-EEA business

Application of prohibition to group structure

To all levels, including: parent bank all affiliates holding company

Only applies to retail business that must: be subsidiarized be subject to solo

capital/liquidity standards Geographic reach Applies to:

U.S. banks globally Foreign banks’ U.S.

businesses/transactions

Applies to: U.K. banks globally Foreign banks’ U.K. retail

businesses Impact severity More on IBs More on IBs

Will re-scoping do the job? Proposals are, in principle, structured carefully to address key

objectives

However, implementation is made challenging because Complex business models Desirable / risky transactions sharing same markets and counterparties Incentives to push risky activity into shadow banks

Prohibiting trading via structural constraints—is it overkill?

Could Basel’s trading book fundamental review already do the job?

Success will depend on a number of complementary measures

38

“Subsidiarization” as a way to reduce financial stability concerns

Distressed affiliates can leave home/host authorities with heavy financial obligation burden sharing issues

“To minimize financial stability risks from distressed foreign banks” affiliates must be:

◦under the regulatory oversight of local supervisors and◦Hold self sufficient levels of capital and liquidity

Easier to ensure under a system of host-supervised subsidiaries

‹5›

39

Structuring banks as subsidiaries vs. branches ?

Pros and Cons…Subsidiary structure can:

• Shield an affiliate from losses in other parts of the group (reduced interconnectedness)

• Easier to spin off /restructure businesses and affiliates individually

• Facilitates living wills by simplifying structure of a group

• But: imposing self-sufficiency regardless of business models:

• Limits advantages of a given structure to a particular business model

• Undermines ability to manage risks given the intra-group constraints

• Leaves affiliates alone under stress, if local markets are shallow

40

Bottom line

1) One size does not fit all - neither branch nor subsidiary structure is obviously preferable

2) Organizational structures themselves cannot reduce the probability of cross-border bank failures

3) Imposing certain structures can be costly/inefficient for certain banks

4) 1st BEST: a combination of policies and practices that involves:

Harmonized resolution regimes and coordinated supervision Adequate buffers and risk management capacity

Home/Host can be more indifferent between different legal structures Banks can choose a structure that fits best their business focus

‹3›

41

Where are we today in the reform efforts?Considerable progress has been made in correcting the

weaknesses that led to the crisis, especially in

◦ banking regulation ◦ framework for effective supervision◦ frameworks to identify and deal with SIFIs◦ infrastructure to deal with OTC derivative markets

But important challenges remain with respect to

◦ resolving the TITF problem◦ agreement on resolution regimes—esp. for cross border banks ◦ implementation of new Basel standards◦ implementation of agreed frameworks: SIFI policies, supervision, …◦ understanding and overseeing shadow banking system

42

Looking Ahead

Rapid progress remains crucial to complete the unfinished agenda

Regulatory uncertainty weighs on the financial system and economy not conducive to lending

Potentially large shocks may still be upcoming (euro area tensions)

Financial system is not sufficiently resilient with pockets of weaknesses in advanced countries

New regulatory framework not yet complete to protect the system from future crisis

EMDEs need a benchmark to limit a build up of financial imbalances

There is less policy and political room to maneuver across the board

43

Key conclusions?

Current reforms are moving in the right direction—towards building a more resilient financial system to support sustainable growth

Progress has been made in some areas

Some novel ideas put forward (living wills, CoCos, bail-ins..)

But implementation lagged in many areas and

Disagreements over some others

Policy/regulatory coordinationCross border resolution frameworksInformation gapsAdequate cushions sized up to risksRealigning incentives

Key challenges and Key ingredients to stability

44

Thank You…

45

Extra Slides

47

Enhancing Resilience: Individual institutions

•More and better quality bank capital (greater loss absorption)

•Better risk recognition for market/counterparty risk

•Capital conservation buffer

•Non-risk based leverage ratio

•More bank liquidity and stable funding

Prudential regulation (probability of failure)

•More intensive supervision

•Proactive and adaptive to changing conditions

•Capacity and willingness to act

•Mandate, resources, independence, accountability

Better supervision(probability of failure)

•Special resolution regimes for orderly wind down, at national and global levels

•Recovery and resolution plans (living wills)

•Arrangements for burden sharing by creditors (CoCos/Bail-in)

Effective resolution(cost of failure)

47

48

Enhancing Resilience: System as a Whole

•Systemic capital and liquidity surcharges

•Systemic levies (for banks and non-banks)

•More intensive supervision of SIFIs in line with systemicness

Regulation/ supervision(probability of failure)

•Effective national resolution schemes for SIFIs

•Cross-border resolution-burden-sharing regimes for global SIFIs

•Living wills (resolution plans to wind-down SIFIs if they fail)

•Bail-in’able debt at a point of nonviability

•Structural measures (subsidiarization/size-scope limits)

Resolvability(cost of failure)

•OTC derivatives clearance through central counterparties (CCPs) to limit contagion

•Repo markets (collateral, margining practices)

•Credit rating agencies (greater oversight, less mechanistic use of ratings)

Market infrastructure(impact of failure)

Countercyclicality(impact on economy)

• Countercyclical capital charges• Forward looking loan-loss provisioning• Fair-value accounting• Macro-prudential policies against cycles and systemic risk

48

Basel III: More and Better Quality Capital

49

0

2

4

6

8

10

12

Tier 2

Other Tier 1

Common Equity

Higher Quality of Capital

Higher Level of Capital

4.5%

7%4%2%

2%

Implementation over a gradual phase-in period till 2019 to allow smooth adj.

Basel III: Liquidity Rules: Higher liquidity & Stable Funding

High quality liquid assets to meet short-term stresses

Enough liquidity to last 30 days without new borrowing

Liquidity coverage ratio

(LCR)Reducing maturity mismatches

More long-term funding; less reliance on volatile and ST wholesale funding sources

Net stable funding ratio

(NSFR)

50

Implementation considerably phased out to allow smooth adjustment and calibration (2015 for LCR ; 2018 for NSFR)