Föhrenbergkreis Finanzwirtschaft

Unkonventionelle Lösungen für eine zukunftsfähige Gesellschaft

The current state and future challenges of financial regulation

Posted by hkarner - 27. November 2016

Thorsten Beck, Elena Carletti, Itay Goldstein

Professor of Banking and Finance, Cass Business School; Research Fellow, CEPR

Professor of Economics, European University Institute

Professor of Finance at the Wharton School, University of Pennsylvania

22 November 2016, voxeu

The recent financial crises have led to a wave of new financial regulation. Some of this regulation incorporates the lessons of the past few years. For example, we learned that focusing on the stability of individual financial institutions is not sufficient to understand the fragility of the overall financial system (Brunnermeier et al. 2009), and that monetary and prudential policy may not be completely separable (Allen et al. 2011). Also, financial intermediation has become more market-based, interconnected and global in the past decade. Some regulation arises from these underlying changes.

In a recent paper, we review the main innovations in financial regulation following the crises, and assess how well they address basic market failures (Beck et al. 2016). We also discuss future challenges in the continuously evolving financial regulation and make general recommendations for its design.

Below, we review capital requirements, liquidity requirements, bank resolution and cross-border regulatory cooperation, activity restrictions and regulatory perimeter, which are the main areas of new financial regulation. We also discuss future challenges and make recommendations.

Capital requirements

Capital helps alleviate the three basic sources of fragility in the banking system: coordination failure among depositors and creditors and possible panics leading to liquidity and ultimately solvency crises, moral hazard and the resulting incentives to take aggressive risks resulting in solvency problems, and interbank connections and contagion effects that can lead to widespread failures.  

The recent regulations (for example, Basel III and the subsequent CRD IV in Europe) have not only increased the quality and quantity of required capital, but also put a stronger focus on the macroprudential aspects of capital regulation. This includes higher capital requirements for systemically important banks, whose failure could have stronger negative repercussions for the rest of the system, and capital buffers that vary with the credit cycle.

This shift from micro- to macroprudential regulation responds to the ‘fallacy of composition’, that assumes we can make the system safe solely by making individual banks safe. We now understand that, in trying to make themselves safer, banks can behave in ways that collectively undermine the system. The new Basel accord, and the greater emphasis on bank capital both on the micro- and macro-level, is certainly a positive reform.

Liquidity regulation

Liquidity regulation is a new dimension to regulation that has been introduced following recent crises. Although there is practically no academic literature so far on the effects of liquidity regulation and its interrelation with capital regulation, it is plausible to argue that it will help mitigate the problem of fire sales, because banks will have more liquid assets in their portfolios. Therefore, they will be in a better position to withstand liquidity shocks without premature liquidation of long-term assets.

Liquidity requirements may also have some negative effects. Requiring banks to hold more liquid and short-term assets may reduce the long-term profitability of banks. This may induce bank managers to take more risk to compensate for lost profitability, and incentivise investors to respond more quickly, prompting fundamental-based bank runs. Finally, while capital requirements are mostly intended to preserve financial stability in the long run, they may also represent a form of loss absorption in the short run and thus interact with liquidity regulation in important ways.

Basel III and the corresponding CRD IV package in Europe introduces liquidity requirements in the form of a Liquidity Coverage Ratio and a Net Stable Funding Ratio. The former is a measure of an institution’s ability to withstand a severe liquidity freeze in the next 30 days, and the latter is a longer-term approach designed to reveal risks that arise from significant maturity mismatches between assets and liabilities. Unlike capital requirements, much less empirical research has assessed the effect of these new requirements (for one of few exceptions, see Bonner and Eijffinge, 2016).

Bank resolution and cross-border regulatory cooperation

The lack of effective bank resolution frameworks was one major impediment to intervention when financial institutions were in danger of failing during the recent financial crisis. This left most countries with the option to either bail out, or close and liquidate, banks through the corporate insolvency process. This problem was particularly acute for global banks that did not match the perimeter of national regulators. The result, in the words of Sir Mervyn King, the former governor of the Bank of England, was that “global banks are international in life but national in death”.

Post-crisis, many countries have therefore introduced or reformed their bank resolution frameworks. One important dimension has been the move from bail-out to bail-in. After the crisis, politicians pledged to ‘never’ force taxpayers to pay for bank losses again, and bail-in regimes have been introduced as an additional buffer to offset losses in worst-case scenarios. Total loss absorbing capacity (TLAC) for systemically important financial institutions and Minimum Requirement for Own Funds and Eligible Liabilities (MREL) for other banks in Europe are junior liabilities, to be bailed in before any government support can be provided.

The Eurozone has additionally introduced a banking union (though not a complete one) to break the adverse feedback loop between sovereigns and the financial system, and create more distance between banks and regulators, thus preventing forbearance.

Activity restrictions and regulatory perimeter

The recent crises have revived the debate on which activities are appropriate for a commercial bank that benefits from the financial safety net (and thus ultimately a public back-stop guarantee) and which are not (Boot and Ratnovski 2016). The crisis has also revealed gaps in the regulatory perimeter, as risk has been shifted from regulated banks to shadow banks, which are partly connected to regulated banks and partly stand-alone. Some of this risk-shifting has been the result of long-term changes in the intermediation process and landscape of financial systems, some of it has been the result of deliberate management decisions to maximise the use of existing capital to increase profitability.

More generally, the fact that banks have been so heavily regulated has limited their ability to provide credit and liquidity, and led to the emergence of other institutions that had many similar features, but which are not regulated like banks. The common name for such institutions is ‘shadow banking’, although the precise definition is unclear (Claessens and Ratnovski, 2014).

Two reports set out proposals on activity restrictions in Europe. In the UK there is The Independent Commission on Banking: The Vickers Report (2013) and the Report of the European Commission’s High-level Expert Group on Bank Structural Reform (2012), known as the ‘Liikanen Report’. Both aimed to make banking groups safer and less connected to trading activities to reduce the burden on taxpayers. While the Vickers approach suggested ring-fencing essential banking activities that may need government support in the event of a crisis, the Liikanen approach suggested that activities that would be bailed-in in a crisis, but not receive government support, should be isolated in a separate subsidiary. Ring-fencing is being implemented in the UK, but to date no structural reforms have been formally introduced in Europe.

The challenges

While the regulatory reforms enacted so far are clearly addressing important problems, the crisis and post-crisis years have provided new challenges for constructing an appropriate regulatory architecture.

One of the key lessons from the last crisis has been that the regulation of the financial system should take an integrative approach, and consider the potential fragility of banks alongside shadow banks. This would prevent regulatory arbitrage and regulate the system with a holistic view. Take, for example, money-market mutual funds, which invest in bonds, treasuries, and other such assets and have a liability structure that is like that of banks. While regulation did not treat money-market funds like banks, and so they were free to do many of the things banks could not do, this has now changed (Rosengren 2014). This has shifted attention to fixed income mutual funds, which invest in corporate, government, and other types of bonds and have recently grown rapidly in the US. They provide much of the liquidity transformation that has been traditionally provided solely by banks (Goldstein et al. 2015). Again this is likely to be a response to the tightened regulation of banks. Going forward, regulators should think more about incorporating such entities into the regulatory framework.

Freixas et al. (2015) argue that financial innovation more generally is one of the key drivers of systemic risk. Financial innovation that allows for better risk management and sharing (such as by developing new securities or new types of financial intermediaries) may reduce idiosyncratic risk, that is the risk of individual financial institutions considered on a stand-alone basis. But at the same time it may increase systemic risk as larger parts of the financial system are exposed to the same systematic or aggregate risk, or it may increase the appetite and capacity of banks to take on risk. Wagner (2010) shows theoretically that, as banks become more similar due to diversification of risks, systemic risk increases.

In recent decades, there has been a clear trend towards more complex financial institutions, which is challenging for regulators. For example, many of the major banks have hundreds if not thousands of subsidiaries, making it very hard for supervisors to properly monitor them (Cetorelli and Goldberg 2014). Higher financial sector complexity calls for greater complexity of regulation, and also creates regulatory complexity due to the lengthening of the intermediation chain and closer international financial integration.

Looking forward

What have we learned since the onset of the Global Crisis about how to cope with these challenges? We drew four general conclusions.

  • As the financial system gets more and more complex and sophisticated, there is a tendency to make regulation also more complex too. This may backfire. First, increasing the complexity of the financial regulation may create stronger incentives for financial institutions to make themselves more complex (Haldane and Madouros 2012). Second, financial institutions and investors may see an opportunity to manipulate complex financial regulation rules (Mariathasan and Merrouche 2014 examine the case of risk weights). Hence we believe it is important to complement complex regulation with simple rules. For example, the return to a simple leverage ratio in the new Basel accord alongside risk-weighted capital requirements is a step in the right direction.
  • The systemic risks mean there is the need for a stronger focus on macroprudential policies to complement traditional microprudential policies. New policy measures, such as bank stress tests and capital requirements that depend on the aggregate state of the economy, are steps in the right direction. A lot of work is still needed to measure systemic risk and assess the effectiveness of macroprudential policy measures.
  • Recent crises show that it is critical to have frameworks in place to resolve financial intermediaries in a way that minimises disruption for the rest of the financial system and the real economy, while allocating losses according to creditor ranking. An incentive-compatible resolution framework has therefore not only important effects ex post (in the case of failure), but also important ex-ante incentive effects for risk-decision takers. A lot of attention and preparation is needed to prepare for the potential failure of big and complex institutions. Imposing living wills and requiring bail-in strategies would be important steps that will make institutions think more about the event of the failure and internalise the risks that they are imposing on the system. Resolution in the case of cross-border institutions remains a critical issue.
  • We need to have a dynamic and forward looking approach to regulation. In the past regulatory reform addressed the regulatory gaps exposed in the most recent crises at that point. As regulators tightened restrictions on institutions that had problems in the past, activity and risk-taking shifted to other institutions and markets. the next wave of crises happened in places outside the regulatory perimeter at the time, and tended to catch regulators unprepared. It is thus important to think about the entire system, and understand the next wave of innovations as they happen. Regulating one type of institution will lead to the emergence of others, and so we need to understand how to design forward-looking regulation. This would imply that the regulatory perimeter must be adjusted over time, and that the focus of prudential regulation (both micro- and macro-prudential) might also need to  adjust as new sources of systemic risks arise.


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