BUILDING THE NEW REGULATORY FRAMEWORK: CHALLENGES AHEAD

Xavier Freixas UPF, Barcelona GSE and CEPR

Based on “Systemic Risk, Crises and Macroprudential Regulation” with Luc Laeven and

José Luis Peydró

Banking externalities: • Banks bankruptcy costs

– Cost to small uninformed depositors – Cost of severing relationship banking – Contagion and systemic risk

• Fire sale and liquidity crises • Herding • Cost of fiscal resources • Credit crunch • Sovereign crises (Deadly embrace) • Zombie lending

• Financial Market imperfections and the misallocation of resources – credit cycles – credit rationing – excessive risk taking

Basic principle

• An externality should be dealt with at the point where it originates, thus limiting the impact on other markets and institutions.

Cost-benefit of bank regulation

• Multiplicity of instruments imply that the cost-benefit is to be determined for every combination of instruments.

• The per dollar marginal net benefit should be equal accross different instruments.

Basel III Micropru Achievements

• Correcting risk-weight errors (Internal models, Accepting models without considering systemic risk…)

• Accounting harmonization • Risk provisioning (Expected loss) • Restructuring and resolution • Macroprudential

– Procyclical provisions – New institutions

The Net Benefit of Liquidity Regulation

• The role of banks in maturity transformation • Credit supply reduction? (No, Banerjee y Moi,

2014) • Market segmentation between HQLA and non-

HQLA • Causes fire sale prices when one asset stops

being HQLA • Increases Repo funding and decreases unsecured

interbank lending (peer monitoring)

6

Concerns on microprudential elements

• Internal models ((Mariathasan and Merrouche 2012, Haldane, 2013)

• Accounting rules • Regulatory ratios: numerator or denominator? • What about market discipline? (Laeven and

Huizinga, 2011, Parwada, Ruenzi and Sahga, 2013)

Consumer protection

• Search goods, experience goods vs. Credence goods depending on consumer’s financial literacy.

• Examples: real estate financed in foreign currency.

• Link to systemic risk: Hungary for foreign currency, Spain for banks’ preferred shares.

Link macro/monetary policy and credit risk justifies a macroprudential policy • Savings glut • Impact of low interest rates on banks’ risk taking

(Borio and Zhu, 2008, Adrian and Shin, 2011, Bordo et al., 2011, Paligrova and Santos, 2011, Dell’ Ariccia et al., 2013. Ioannidou et al.,2013, Jimenez et al. 2012, 2014)

• Impact of excessive credit growth on systemic risk (Maddaloni and Peydró, 2011, Dell’Ariccia et al., 2012, Jorda et al., 2013)

• Impact of excessive leverage (Reinhart and Rogoff, 2008, Schularick and Taylor, 2012, Gourinchas and Obstfeld, 2012)

• Impact of excessive asset growth prices (Reinhart and Rogoff, 2008)

The complexity of the macroprudential task

• Weighting financial stability vs. economic growth • Measuring systemic risk

– Time dimension – Cross-sectional dimension – A dichotomy of models

• Choosing the right instrument – Aggregate countercyclical buffer – Targeted: LTV, DTI – Effectiveness and lags

• Measuring the impact of the instrument

Creating the right institutions (FPC, ESRB, FSOC)

• Information from the Central Bank • Independence in risk prevention, cooperation

in crisis management! • Accountability

– Transparency? – Only type 1 errors (miss the buildup of a crisis) are

visible • Limit political pressures and forbearance • Limited communication policy

The contercyclical credit buffer

12

• Credit to GDP (Repullo and Saurina, 2012) • Two different views : cycles vs. crises.

Overarching concern: the international dimension

• Underresearched topic • Bubbles may be financed by other countries

savings. Restrictions on domestic banks will not apply to foreign ones.

• Liquidity movements from subsidiaries to parent companies (Peek Rosengren 1997, Cetorelli and Goldberg 2012)

• Regulatory «race to the bottom » (Dell’Aricchia and Marquez 2006, Houston, Lin, and Ma, 2012)

The Architecture Of Regulatory Responsibilities: The Coupling of Micro

and Macroprudential

• CGFS 2012: top-down and bottom-up. • Systemic risk estimates should be an input for

internal models. • Microprudential regulation is an input for

macroprudential risk: example, LTV or DTI vs. countercyclical buffers in bubbles prevention.

Ex ante prevention vs. Mopping up ex post

• As there is a cost in ex ante prevention, a balance should be found between ex ante prevention and crisis management costs. The marginal dollar should produce the same net return.

• Define strong restructuring and resolution mechanisms (bail-ins, cocos, loss absorbing debt capacity) so as to reach the efficiency frontier.

• Olivier Jeanne and Anton Korinek : ex-post policy are better targeted but distort incentives and create moral hazard . Ex-ante measures are blunter since they depend on crisis expectations.

On Bail-outs

• Bail-ins, Cocos and restructuring will make a lower cost of bail-outs

• Bail-outs may limit the cost to the deposit insurance company. Still: – The legal design should make bail-ins and Cocos

renegotiation proof (legal certainty) even if the bank does not go bankrupt.

– The incentives impact on uninsured deposits and junior debt should be negligible.

Banks corporate governance Price manipulation: FX, libor Consumer abuse: misselling of pension funds or of

Bankia’s stocks Disclosure: Lehman Repo 105 Empirical evidence:

– Laeven and Levine (2009) and Ellul and Yerramilli (2013) show that the presence of institutional investors increases the risk of the bank.

– Fahlenbrach and Stulz (2010) CEO’s objective aligned to shareholders ones implies more risk taking.

Incompetence (risk supervision failure) or shareholder value maximization?

17

Remuneration policy

• Say on pay, caps on bonuses,… may not really change managers’ incentives to take risk.

• Fines and insurance fees paid by the bank • Woody Allen: « I think crime pays » • UK Parliament commission on Banking

Standards proposed criminal sanctions.

18

Improving banks’ corporate governance

Acknowledge that banks are different – Opacity – Deposit insurance (lack of market discipline) – Collateralization of assets – Leverage – Access to instruments to change the risk profile

Importance of expertise, independence and engagement

Maximize value of the bank rather than shareholders’ value. Structure compensations accordingly (Bolton, Mehra and Shapiro).

19

Capture theory

• Political economy/lobbies • Assessing the costs and benefits of regulation:

Regulatory cycles. Excessive regulation today will lead to inefficiently low levels of regulation tomorrow.

• Regulatory cycles reacting to political immediacy

• Macroprudential decisions are political • Checks and balances (Norway)

Should macro Prudential policy rules based or discretionary?

• The political economy framework implies rules based are desirable

• Accountability depends upon a well-defined task and simple, verifiable, rules

• Discretion needed: • New financial innovation • changes in the macro financial framework

– Future sources of imbalances – Methodologies not fully developed

21