Is increasing employment a true political will?

maart 5, 2014 in Columns-Artikelen by onze redactie

There is no empirical evidence that over-regulation has any relation at all to financial stability or increase in employment. Last time we were over-regulated was in the 70-ties, when even the currency regime collapsed (Bretton Woods). What we know however is that when free markets are severely restricted through intrusive rules and regulation we’ll sooner or later will experience the build up of financial unbalances that finally burst. The bursting of the American and European real estate bubbles in 2007-08 is the most recent example. The real estate bubbles were caused by a political will to grow the middle class (US) and to create employment (Europe). This political will was keenly supported by the Basel Accord.

Over-regulation also leads to an increase in what we call “shadow banking”. That happened in the 70-ties and is happening now as well. What is the reason that shadow banking grows? It’s simple, the real economy (corporations) requires to borrow money, efficiently manage and allocate its cash, send payments, and hedge financial risks etc. This is something the new regulation is intentionally restricting the real economy to do. There are ample evidence that the new regulation has e.g. hugely restricted access to working capital from the banking sector to the SME. This is an intended consequence from the new regulation. Banks have instead been forced to fill their balance sheets with government debt, which is still regarded as basically risk free. With over 100% government debt/GDP ratio, this can indeed be questioned.

We must take a bigger view on the situation. It’s not about compliance, it’s about building the rule set for a well functioning economy. The new set of regulation we’re now implementing does the contrary.

The SME sector (companies with up to 250 employees) employ 92% of all private employees in the EU according to the ECB. We also know that it’s the young companies that grow employment, not the old and mature. Therefore we need a regulatory framework that supports entrepreneurship and global trade. The current regulation penalizes it. This is the problem. Now the EU has also imposed regulation of small venture funds that will restrict even further the access of risk capital. In the mean time more and more EU countries sell citizenships to attract rich immigrants in a desperate move to compensate. Our favourite central bank – the Bank of England – has introduced the “funding for lending scheme” and supports supply chain platforms for the same reason.

It’s very unfortunate that the regulation focuses on pushing risk out of the banks to the real economy and disintermediating the banks from the SME. This mistake has now been done and the costs will be visible in the economy for many, many years. Enforcing even more regulation that stubbornly claims that Greece et al government bonds are risk free whilst the private sector is a toxic risk, isn’t a good thing. If you want empirical evidence of the economic effects of over-regulation – we propose you study the economic developments of France for the past decades.

With EMIR, the intrusive regulation has stepped directly into the hearts of the corporate sector. Previous regulation has been affecting the corporations indirectly via the banks. There is no doubt that the corporate sector has reacted very negative on the level of intrusiveness and irrelevance brought by EMIR. There is therefore a risk that the corporate sector will adjust its strategic decisions based on the expectations of how future regulation and bureaucracy will affect them. We also doubt EMIR will provide a shield from future crises.

Compliance might be a pleasant way to make a living for some, but not for the masses.

Kind regards,

Magnus Lind

About the author: Magnus Lind

Magnus Lind chairs and is the founder of Treasury Peer™. He has a background as an international business executive in Europe, SE Asia and North America. Magnus has gained exposure to international and multicultural management from having customers and suppliers in more than 30 countries. He has started companies in 7 countries and acted as CEO, board director, investor and entrepreneur for 20 years through the NFS Group, a financial technology consultant divested in 2012. Magnus started in 2008.  Find out more and – click here – to see his website.

Let’s Overhaul The Financial System

juli 10, 2013 in Columns-Artikelen by onze redactie

Work with me on this. It’s a bit theoretical, but the purpose is to stimulate ideas for reforming the financial system. Much of the new regulation since 2008 is really just “more of the same” – more rules, more regulation, and more capital, which really amounts to a band aid patch job on the financial system. There are very complex problems and we need simple, “out of the box” solutions.

1. GSEs

Though you would think that Dodd-Frank changed everything, it didn’t address the Government Sponsored Enterprises (GSEs), like Fannie Mae and Freddie Mac. The GSEs have long enjoyed quasi-government status, allowing stockholders to enjoy the benefits of monopoly power, yet be bailed out when they fail. Remember, Fannie Mae and Freddie Mac collapsed just weeks before Lehman in September 2008, so there’s a lingering issue about what to do with them. Currently, there’s a bill floating around Congress to combine them and partially privatize them. It’s a good step forward, but not a full solution. Here’s my solution:

The new GSE (formerly Fannie Mae, Freddie Mac, Ginnie Mae, FHLB, SIPIC, and the FDIC combined) will remain government owned, but cannot leverage itself beyond its deposit base. That is, it can only make as many mortgage loans as its deposit base can support. Where will deposits for the GSE come from? The Post Office.

Post office branches would collect and maintain savings and checking accounts, giving them a new business line. The Post Office will lose all government subsidiaries, relying instead on collecting deposits to plug revenue holes, and most importantly, it will become the only place for government insured deposits.

This will limit GSE competition with the private sector and it means the new GSE cannot become over-leveraged and cannot again collapse like in September 2008.

2. Banks

Now the question is how to solve the “too big to fail,” “too big to prosecute,” and therefore “too big to succeed” issue for the banks. In reality, today’s banking system was created 100 years ago with the establishment of the Federal Reserve in 1913 and reformed twice in 1933 and 1934. The entire banking system and regulation is outdated and based on an old banking model. It needs a complete reform, so here’s a start:

  • U.S. banks would be free to collect deposits from the public, but with the complete understanding that the deposits are no longer government guaranteed. You go to the Post Office for that
  • Banks, broker-dealers, Futures Commission Merchants (FCMs) can buy insurance from the GSE if they want, but it will come at a price and with increased regulation.
  • Financial institutions without a government guarantee or support will enjoy far lighter regulation.
  • All transactions booked on an exchange or CCP receive much lower regulatory capital charges.
  • Banks which operate within multiple financial arenas, like banking, investment banking, asset management, insurance, futures, will be required to hold more capital. The more interconnected they are in the financial system, the more there needs to be a larger capital cushion. But just because an institution is large, doesn’t mean it needs to be regulated out of profitability.

3. Shadow Banking

The idea of eliminating “overnight” Repo funding gets discussed often. Theoretically, it would make a financial institution more stable, so yes, the idea is good in theory. However, picture a traditional bank 100 years ago and suggest they stop taking deposits that can be withdrawn at anytime – the equivalent of “overnight” funding. It’s the same principle today for overnight Repo funding because bank deposits are effectively the same thing. Back a hundred years ago, if a bank asked depositors for a one month notice period before withdrawing their cash, the bank wouldn’t attract any deposits and would be out of business.

Today, banks provide funding for broker-dealers, FCMs, ABCP conduits, mortgage lenders, and hedge funds during stable economic times, but often pull that funding during any sign of trouble. Just witness how MF Global collapsed after their clearing banks and CCPs pried additional margin from them.

In 1913, the solution for supporting the banking system during a financial crisis was the Federal Reserve system. It functions as a back-up funding facility to provide liquidity to the banking system during bank runs (see my history of CCPs). The Fed was made for the banking industry of the early 20th century, but not for the Shadow Banking industry that developed in the past 40 years. The Federal Reserve system worked great for years, but now there’s a large and significant fundamental problem in our financial system:  there’s no back-up funding for Shadow Banking. So here’s what’s needed:

  • All regulated financial institutions should have access to Fed liquidity, including: money market funds, banks, broker-dealers, FCMs, and even hedge funds.
  • The Fed can haircut the funding based on the type of institution and it’s capital. A small hedge fund might have access to Fed funding with a 5% haircut on U.S. Treasurys and a double A-rated global bank might only have to pay a 0.25% haircut.
  • The allowable collateral for Fed funding should be greatly expanded and the haircuts adjusted accordingly.

4. Repo/Funding Market Reorganization

There’s a growing problem in the Repo/funding markets because they’re fragmented – there are multiple CCPs (FICC and LCH.Clearnet), multiple tri-party clearers, clearing banks, and still many trades done direct. The solution is to move funding onto an exchange. Imagine a central execution and clearing exchange where cash providers and collateral providers meet? Say a hedge fund needs financing for investment grade corporate bonds, they could access that funding through the exchange. The cash provider (money market fund) is on the other side of the transaction, but the exchange stands in the middle.

Exchange traded funding is two steps beyond current central clearing counterparties. Not only is funding centrally cleared, but it’s also centrally executed and all market participants have access.

The Repo/funding trades, futures contracts, stocks, and bonds could also be cross-marginable. Think of it like “portfolio margining” for bank funding. By adding funding into a central exchange, not only would it create a more efficient market, but also be another financial instrument to offset risk, not to mention the benefits of having an exchange counterparty for regulatory capital charges. Being short a 2 year note in the Repo market can partially offset any number of long futures contracts.

Of course, for collateral to trade on an exchange, pricing must be more standardized, so there needs to be a global securities pricing system . . .

5.  Global Mark-To-Market Pricing

These days, liquid and exchange traded financial instruments are easy to price. The pricing problem arises with lower grade paper or securities with complicated structures – like CDOs. If all CCPs, clearing banks, and exchanges could accept a wide variety of collateral for Repo/funding purposes and for margin pledging, there must be a standardized pricing service. In addition, consider the benefits to regulators from a continuous global pricing system. Here’s how it’s done:

  • Securities pricing becomes a rolling cycle – meaning there’s no end-of-day. With all the advancements in computerization and trade processing systems, there’s no need for the day to end. Once a time zone, like Asian the markets, close they continue to submit prices into the global pricing system.
  • Regulators, exchanges, CCPs and clearing banks collect margin and run reports continually during the global cycle. For example, if markets move in Asia early in their business day, U.S. banks would be required to deliver margin within a specified time period, perhaps within 2 hours.
  • Underwriters would be required to price all securities they underwrite and submit the prices to the global pricing network throughout the day. For securities not on the global pricing system, there would be increased regulatory capital charges and much larger haircuts for pledging them as margin.
  • Securities in the global pricing system then could be completely fungible as margin held at exchanges and CCPs. Both the collateral and haircuts could be standardized, something like 0.25% for AAA-rated sovereigns and 2% for investment grade equities. This would also eliminate much of the anticipated problems being created by regulatory demand for higher grade collateral.

I hope you find these ideas interesting and I welcome your comments.

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

Repo Reform And Shadow-Banking

juni 7, 2013 in Columns-Artikelen by onze redactie

There’s a lot talk from Fed governors, including the Fed Chairman Ben Bernanke, about the reforming the Repo market. One critique is that Repo funding is generally unstable, that is, cash Repo investors quickly flee a teetering bank leaving it insolvent. Then once a bank collapses, the assets are inherently illiquid and the Repo cash investors have a liquidation risk in a “fire-sale.” Strangely, by substituting the word “deposits” for “Repo” and “loans” for “assets,” we’d be talking about the traditional banking system 100 years ago. Since the explosion of securitization and the development of the Repo market in the 1980s, there have been two parallel banking systems:  The traditional banking system with existing stability mechanisms that developed over the years, and the Shadow Banking system which is still in the process of developing.

Traditional Banking System

The traditional banking system, in a general sense, is the business of a Savings And Loan (S&L) – they take deposits and make loans. As the saying goes, it used to be a “3-6-3″ business: borrow money at 3.00%, make loans at 6.00% and be on the golf course at 3:00 pm. Not that there’s anything wrong with that kind of business, but there’s a fundamental a problem with it – the loans are long-term and the deposits are short-term, which meant that a bank can easily become insolvent if depositors suddenly withdrew their funds.

Shadow-Banking System

In short, the term “Shadow Banking” refers to non-banks which perform banking functions.  It’s a relatively new term attributed to Paul McCulley who first used it at the Jackson Hole, Wyoming economic conference in 2007 to describe “the whole alphabet soup of leveraged up non-bank investment conduits, vehicles and structures.” Instead of making loans, a Shadow Bank purchases long-term assets in the form of securitized loans: mortgage-backed and asset-backed securities.  The “deposits” for a Shadow Bank come from Repo financing, so it’s the Repo market that provides all the short-term funding.  In essence, the business of a Shadow Bank is the same as a traditional bank, except the Shadow Banking industry has securitized financial instruments.  What’s more, where traditional savings and loan assets are estimated to be $14 trillion, Shadow Banking assets are estimated at $20 trillion. The Shadow Banking industry has overtaken the banking industry!

Instability In The Banking System

Since the beginning of banking, banks have been faced with that common problem:  assets are long-term while deposits are short-term. During normal times, the business model works well, there is historically a good spread between long-term and short-term interest rates. Years ago, major problems arose when there was trouble at a bank – depositors lined up outside the doors to withdraw their funds, because at the time, when a bank went bust a depositor would lose everything. During a crisis, the public would take their deposits out of many banks, not knowing which ones were necessarily in trouble, and that made the entire banking system inherently unstable. Luckily, solutions developed over the years.

The first step was the establishment of the Central Clearing Counterparty (CCP), which was not Fixed Income Clearing Corp (FICC) or LCH.Clearnet. The first bank clearinghouse was organized in 1853 to clear checks and become the era’s “bank examiners,” but most importantly, the clearinghouse served as a mutual support mechanism for its members in times of crisis or bank panic, which were numerous in the 19th century.

In 1913, Congress established the Federal Reserve System which provided back-up funding facilities for traditional banks and took over the CCP function from the clearinghouses. Ironically, the back-up funding facilities the Fed created was the Repo market, by allowing banks to temporarily finance Banker’s Acceptances with the Fed in 1919. The traditional banking system was then further stabilized with the Banking Act of 1933 which created FDIC insurance for depositors and allowed the FDIC to unwind failed banks. With the Federal Reserve, FDIC insurance and a mechanism to unwind failed banks, all the pieces were in place for a stable banking system for the next 70 years.

Evolution of The Shadow Banking System

With the creation of money market funds and securitization in the 1970s, then the development of the Repo market in the 1980s, Shadow Banking grew in parallel with traditional banking. It should be no surprise that Shadow Banks would have the same historical problems as a traditional bank – in a crisis, the deposits (Repo funding), can be pulled and banks become insolvent.

So far, support for the Shadow Banking industry has developed along the same lines as that for traditional banks. The first CCP for the Repo market, Government Securities Clearing Corp (which later became FICC), was created in the late 1980s and initially only compared trades – making sure the Street booked their trades correctly. In the mid-1990s, trade netting emerged and GSCC became the counterparty in between banks. At the time, the Fed was providing some liquidity in the Repo market for Primary Dealers, but support was minimal until after the Banking Crisis in 2008.

Current State of Shadow Banking

The Fed is now worried that the over-reliance of short-term funding in the Repo market is inherently unstable, which was the original issue in the traditional banking system. The development of the Shadow Banking system is now, historically, somewhere between the establishment of CCPs and the establishment of the Fed and FDIC for the traditional banking system.

So that’s where we are now. Much of the insolvency and liquidity problems for traditional banks were initially solved through CCPs, then through the creation of the Fed, then with FDIC insurance and liquidation. The Shadow Banking system is still developing and the traditional banking system can be a model. If this really is the path of the evolution, then the next step for Shadow Banking is a form of FDIC insurance and/or a mechanism to wind-down a failed institution. That’s exactly what the Fed is talking about now, since the Fed is pushing the Repo market to develop a liquidation facility which is to be maintained by the industry.

For all the talk about the need for a liquidation facility, still no one is sure what it should look like. Should there be a Repo Deposit Insurance Corporation (RDIC) and buy up failed Shadow Banks? I doubt it. Can you imagine Fed officials explaining that the Wall Street Repo market would be back-stopped by the government and ultimately taxpayers? Could the Repo liquidation facility be an extension of FICC and LCH.Clearnet, the CCPs? Maybe. But one thing has been made clear, if the market doesn’t come up with a solution, the Fed will mandate it through regulation.

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

Comments On “The Fed Squeezes the Shadow-Banking System”

mei 24, 2013 in Columns-Artikelen by onze redactie

Andy Kessler wrote an interested article in the Wall Street Journal today, “The Fed Squeezes the Shadow Banking System,” which, of all things, discussed the Repo market. Click here to read the article.

I have some comments on the article which should be interesting:

  • In traditional economics text books, we learned there was a money multiplier when banks took in deposits and made loans – those funds filtered back into the economy a number of times over.  In a traditional banking system economy, it was the bank loans which caused the velocity of money to increase.  These days, the velocity of money is more a function of the Repo market, which finances the shadow-banking system. This is interesting and I’d like to see if there is a formal economic study on it.
  • Question:  What’s the opposite of Quantitative Easing (QE)? Answer:  The Fed (or government) selling debt into the markets and taking in cash.  Well, isn’t that exactly what the Treasury does on a weekly basis? So if you believe QE is money creation, shouldn’t you believe that net new Treasury issuance is money destruction? The Fed, through it’s QE programs, injects $85 billion into the economy each month. In theory, they’re “creating” $85 billion in new money. However, since QE2 began three years ago, the market has had to absorb a net $2 trillion in new U.S. Treasury issuance.  So hasn’t the Treasury been “destroying” money faster than the Fed created it? The QE programs, combined with net new Treasury issuance, have really just slowed down the distortions in the economy which would have been created by so much Treasury issuance.
  • Right now the ultra low, near 0% overnight general collateral rates cannot be blamed on QE.  At least not yet.  The overnight funding market just passed the April seasonal collateral shortage period, so that may be contributing to near 0% rates.  However, the Treasury’s net new issuance of $84 billion Treasurys on May 31 and June 3 will determine whether there’s a continuing collateral shortage or not.  The 0% GC Repo rates will have to extend into mid-June before I believe the QE programs are moving GC rates down instead of overhang from the seasonal collateral shortage.

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

Shadow banking – the ECB perspective

mei 1, 2012 in Cash Management, Publicaties, Treasury Algemeen by onze redactie

Shadow banking – the ECB perspective

Paul Tucker: Shadow banking – thoughts for a possible policy agenda

mei 1, 2012 in Cash Management, Publicaties, Treasury Algemeen by onze redactie

Paul Tucker- Shadow banking – thoughts for a possible policy agenda

Basel III: Stronger Banks and a More Resilient Financial System

juni 15, 2011 in Columns-Artikelen by George Lekatis

It is has now been three and a half years since the global financial crisis began. The banking sector and financial system have now been stabilised. But this required unprecedented public sector interventions. Despite the severity of the crisis, we are already seeing signs that its lessons are beginning to fade.

At the same time, there are still significant risks on the horizons, while key reforms still need to be carried through if we are to achieve a truly stable banking and financial system. I would like to begin this morning by recalling the damaging effects of the crisis and why the Basel III reforms are central to promoting financial stability. I will then briefly outline the key reforms that comprise Basel III. Finally, I will focus on what still needs to be done to ensure longer-term stability.

In particular, I will discuss the need for global and consistent implementation of the Basel III reform package and the ongoing work to address the risks of systemic banking institutions.

II. Motivation for Basel III reforms

A. Damaging effects of banking crises

There is a wide body of evidence that the most severe economic crises are associated with banking sector distress. While there is variation in findings across studies, the Basel Committee’s long-term economic impact study found that the central estimate in the economics literature is that banking crises result in losses in economic output equal to about 60% of pre-crisis GDP. Why are banking crises so damaging? Banks are highly leveraged institutions and are at the centre of the credit intermediation process. In addition, credit and maturity transformation functions are vulnerable to liquidity runs and loss of confidence.

A destabilised banking system affects the provision of credit and liquidity to the broader economy and ultimately leads to lost economic output. In the most recent phase of the crisis there has also been significant spillover of risk between the banking sector and sovereigns. Governments in a number of industrialised countries had to increase their debt in order to stabilise their banking systems and economies. As a result, debt-to-GDP ratios in a number of economies increased by as much as 10-25 percentage points. It therefore is clear that the economic benefits of raising the resilience of the banking sector to shocks are immense.

B. Frequency of banking crises

The costs of banking crises are extremely high but, unfortunately, the frequency has been as well. Since 1985, there have been over 30 banking crises in Basel Committee-member countries. Roughly, this corresponds to a 5% probability of a Basel Committee member country facing a crisis in any given year – a one in 20 chance, which is unacceptably high.

Many countries may not have been the cause of the current crisis, but they have been affected by the global fall out. Moreover, history has shown that banking crises have occurred in all regions of the world, affecting all major business lines and asset classes.

Moreover, there tend to be a common set of features that seem to repeat themselves in various combinations from banking crisis to banking crisis.

These include:

1. Excess liquidity chasing yields

2. Too much credit and weak underwriting standards

3. Underpricing of risk, and

4. Excess leverage

In the current crisis, these recurring trends were magnified by:

1. Weak bank governance practices, including in the area of compensation

2. Poor transparency of the risks at financial institutions and in complex products

3. Risk management and supervision focused on individual institutions instead of also at the system level

4. Procyclicality of financial markets propagated through a variety of channels, and

5. Moral hazard from too-big-too-fail, interconnected financial institutions.
C. Benefits of tighter regulation through Basel III exceed the costs

The objective of the Basel III reforms is to reduce the probability and severity of future crises. This will involve some costs arising from stronger regulatory capital and liquidity requirements and more intense and intrusive supervision. But our analysis and that of many others has found the benefits to society well exceed the costs to individual institutions. The Committee’s long-term economic impact analysis found that capital and liquidity requirements could be increased – well above current minimum levels – while still achieving positive net economic benefits.

These findings are not surprising. It is widely accepted that prudent fiscal and monetary policies are the cornerstones of financial stability and sustainable economic growth. Indeed, maintaining conservative fiscal and inflation policies involve a cost – they result in potentially lower short-term economic growth, which is offset by more sustainable long-term growth. Increasing stability of the banking and financial system involves a similar trade-off, where the costs are more than offset by the long-term gain. In particular, it is difficult to imagine a country that can maintain sustainable growth on the foundation of a weak banking system

III. Key features of the Basel III reform package

The Basel III framework is the cornerstone of the G20 regulatory reform agenda and the final Basel Committee rules were issued at the end of last year. This development is the result of an unprecedented process of coordination across 27 countries. Compared to Basel II, it was also achieved in record time, less than two years. The next step, which is just as critical as the policy development, is implementation.

The full potential of Basel III will only be achieved if all Committee-member countries and regions work within the global process, and fully implement the minimum standards. Some countries may choose to implement higher standards to address risks particular to their national contexts. This has always been an option under Basel I and II, and it will remain the case under Basel III.

Why is Basel III fundamentally different from Basel I and Basel II?

First, it is more comprehensive in its scope and, second, it combines micro- and macro-prudential reforms to address both institution and system level risks.

On the microprudential side, these reforms mean:

1. A significant increase in risk coverage, with a focus on areas that were most problematic during the crisis, that is trading book exposures, counterparty credit risk, and securitisation activities;

2. A fundamental tightening of the definition of capital, with a strong focus on common equity.

At the same time, this represents a move away from complex hybrid instruments, which did not prove to be loss absorbing in periods of stress. We also introduced requirements that all capital instruments must absorb losses at the point of non-viability, which was not the case in the crisis;

3. The introduction of a leverage ratio to serve as a backstop to the risk-based framework;

4. The introduction of global liquidity standards to address short-term and long-term liquidity mismatches; and

5. Enhancements to Pillar 2’s supervisory review process and Pillar 3’s market discipline, particularly for trading and securitisation activities.

In addition, a unique feature of Basel III is the introduction of macroprudential elements into the capital framework.

This includes:

1. Standards that promote the build-up of capital buffers in good times that can be drawn down in periods of stress, as well as clear capital conservation requirements to prevent the inappropriate distribution of capital;

2. The leverage ratio also has system-wide benefits by preventing the excessive build-up of debt across the banking system during boom times.

To minimise the transition costs, the Basel III requirements will be phased in gradually as of 1 January 2013.

I would now like to say a few words in particular about two of the newer elements of the regulatory framework, namely the liquidity standards and the leverage ratio. As mentioned, excess leverage and weak liquidity profiles of banks were at the core of the crisis, and they therefore represent a critical part of the Basel III framework going forward.

A. The Liquidity Framework

There is broad support for the liquidity framework introduced by the Committee. Banks and other market participants already use methods similar to the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). Many of the issues that have been raised pertaining to these requirements revolve around the calibration of the ratios, rather than the conceptual basis of the framework.

It is important to emphasise the Committee’s goal in establishing the liquidity framework: to require banks to withstand more severe shocks than they had been able to in the past, thus reducing the need for such massive public sector liquidity support in future episodes of stress. The success of the framework should not be measured in terms of whether it will have zero cost. Instead, the better measure of success is whether the framework corrects pre-crisis extremes at acceptable costs.

Banks that take on excessive liquidity risk should be penalised under the new framework, while sound business models should continue to thrive. With these objectives in mind, the Committee will use the observation period to review the implications of the standards for individual banks, the banking sector, and financial markets, addressing any unintended consequences as necessary.

In this regard, the Committee’s focus is now on ensuring that the calibration of the framework is appropriate. Certain aspects of the calibration will be examined and this will involve regular data collection from banks. Any adjustments should be based on additional information and rigorous analyses. Moreover, relying just on banks’ experiences from the crisis is not sufficient, as it embeds a high level of government support of banks and markets. Hence, the analysis will need to include both quantitative bank experience and additional qualitative judgement. It is worth emphasising that a number of effects of the framework are indeed intended. For example, with regard to the pool of liquid assets, the rules are meant to promote changes in behaviour.

Contrary to popular perception, they are not about promoting the hoarding of government debt, but about creating incentives to reduce risky liquidity profiles. This can be achieved, for example, by pushing out the average term of funding or increasing the share of stable funds.

In other cases, banks did not price liquidity appropriately throughout the firm, and correcting risk management deficiencies will in turn improve liquidity profiles. In fact, the initial response we have observed in some countries that have already implemented comparable liquidity ratios suggest that these are the types of strategies that are being pursued.

Also contrary to what many have claimed, the new standards should help promote greater diversification of the pool of liquid assets held by banks. Bank holdings of liquid assets continue to be dominated by exposures to sovereigns, central banks and zero percent risk-weighted public sector entities. These assets comprised 85% of banks’ liquid assets according to the Committee’s most recent quantitative impact study. By recognising high quality corporate and covered bonds – subject to a limit – the liquidity framework will help promote a further diversification of the liquid asset pool.

B. The Leverage Ratio

Many banks entered the crisis with excessive leverage. This increased the probability of bank failures. It also exacerbated the effects of the crisis on broader financial markets as many banks rushed to de-leverage once the crisis hit. The objective of the leverage ratio is to serve as a back-stop to the risk-based measure.

The Committee’s calibration work shows that bank leverage was a highly statistically significant discriminator between banks that ultimately failed or required government capital injections during the crisis and those that did not. Moreover, at the height of the crisis, the market gravitated towards simple leverage based measures to compare banks.

The leverage ratio also serves a macroprudential purpose. We have seen during this and prior crises the cyclical movement of leverage at the system-wide level. Leverage, which tends to build up prior to crisis periods, is subsequently unwound when a crisis occurs. This cyclical aspect exacerbates both the upswing phase and the downturn.

In addition, what can appear to be very low risk assets at the institution level can ultimately create incentives for the build-up of risks at the broader system level. The leverage ratio serves to limit excessive concentrations in such asset classes. As with the liquidity framework, the Committee has a process in place to assess the impact of the leverage ratio on business models. It will take actions if necessary to make sure that the design of the leverage ratio will achieve its objectives. As I stressed earlier, it is important that all countries and regions continue to work within this global process.

IV. What still needs to be done to ensure longer-term banking sector and economic stability?

Over the past three years, much has been achieved by the global regulatory community to respond to the crisis. This policy work is now substantially complete. But to ensure longer-term banking sector and economic stability, consistent and timely global implementation of Basel III is critical. In addition, a key remaining area of policy development work is focused on dealing with systemically important banks (SIBs). Finally, we will also need to stay attuned to bank-like risks that emerge in the shadow banking sector.

V. Implementation of Basel III

The Committee has put in place mechanisms to help ensure more consistent implementation of its standards. This applies not only to Basel III but to other global standards agreed by the Committee. The efforts of the Committee are reinforced through additional institutional arrangements introduced at the level of the Financial Stability Board (FSB) and the G20.

Going forward, the Committee’s Standards Implementation Group will play a critical role in conducting thematic peer reviews of member countries’ implementation of standards and sound practices. Implementation involves not only introduction of the standards in legal form, but also rigorous and robust review and validation by supervisors. We therefore are also introducing processes to ensure the integrity of key elements of the framework.

An example of this is the review of banks’ risk weightings, which should include the use of test portfolio exercises. As we have painfully learned from the recent crisis, the failure to implement Basel III in a globally consistent way will again lead to a competitive race to the bottom and increase the risk of another crisis down the road.

VI. Addressing the Too-Big-To-Fail (TBTF) problem

During the crisis, the failure or impairment of certain banks sent shocks through the financial system. This had an adverse knock-on effect on the real economy. Supervisors and relevant authorities had limited options to prevent or contain problems effecting individual firms and this led to wider financial instability. As a consequence, public sector intervention to restore financial stability during the crisis was necessary, as was the massive scale of these responses.

The fallout from the crisis underscores the need to put in place additional measures to reduce the likelihood and severity of problems emerging at systemic banking institutions. The Committee, in close cooperation with the FSB is working to address the financial system externalities created by Systemically Important Banks (SIBs).

To achieve this broad objective, policy tools are being designed to:

1. Reduce the probability as well as the impact of an SIB failure;

2. Reduce the cost to the public sector should a decision be made to intervene; and

3. Level the playing field by reducing too-big-to-fail competitive advantages in funding markets.

The Committee has developed a methodology that embodies the key components of systemic importance. These are size, interconnectedness, substitutability, global activity and complexity.

The methodology can serve as a basis for the differentiated treatment of systemic institutions without needing to specify a fixed list of such institutions. Common equity is the key when it comes to going concern capital as it is available to absorb losses with certainty, thus reducing the probability of failure.

The Committee also continues to study the role that going-concern contingent capital could play in its framework for SIBs. Strong resolution and recovery frameworks play a critical role in reducing the impact of failure by facilitating the orderly wind-down of a global bank.

In this context, the Committee is reviewing the role that bail-in debt could play in complementing Tier 2 capital to provide additional resources that can mitigate the systemic impact of banks at the point of non-viability.

The Committee’s work on systemically important banks is part of the broader effort of the Financial Stability Board (FSB) to address the risks posed by SIFIs.

The Committee is working closely with the FSB through this process, and expects to consult on proposals to address the risks of globally systemic banks around the middle of the year.

VII. Shadow Banking

The final area where further work is needed is shadow banking. Shadow banking was a key mechanism through which the crisis was propagated. SIVs, money market mutual funds, the securitisation process, and bank liquidity lines to off-balance-sheet exposures all served to amplify the impact of the crisis on banks. While it is clearly important to address issues in the shadow banking sector, its existence should not detract from the fundamental need to strengthen the resilience of the banking system itself.

The banking sector remains at the centre of the credit and liquidity intermediation process. This is true even in economies that are more reliant on capital markets. Moreover, significant parts of shadow banking were created, sponsored or financed by the banking sector and these include SIVs, ABCP conduits, MMMFs, certain securitisation structures, and hedge funds. Finally, much of the shadow banking sector depends on the financing and liquidity support of the banking sector.

Basel III goes a long way to closing the gaps in exposure to shadow banking. It does this in several ways:

1. By addressing the capital treatment for liquidity lines to SIVs and other types of off-balance sheet conduits;

2. By addressing counterparty credit risk;

3. By including off-balance sheet exposures in the Basel III leverage ratio; and

4. By incorporating a range of contractual and reputational risks arising from the shadow banking sector into the liquidity regulatory and supervisory standards.

Thus, stronger, consolidated banking regulation and supervision will go a significant way towards containing the risks of the shadow banking sector. In addition, to the extent that bank-like risks emerge in the shadow banking sector, they should also be addressed directly. Supervisors should take a system-wide perspective on the credit intermediation process.

To the extent that bank-like functions are carried out in the shadow banking sector and pose broader systemic risks, they should be subject to appropriate regulation, supervision, and disclosure. In particularly this is the case where activities combine credit intermediation, maturity or liquidity transformation, and leverage.

The FSB, the Basel Committee and the Joint Forum of Banking, Securities, and Insurance Supervisors will monitor developments closely and promote appropriate responses as circumstances dictate.

VIII. Other Basel Committee initiatives

The Committee is also conducting a fundamental review of the trading book. It is fundamental in the sense that it will help inform basic questions such as how to address the line between the banking and the trading book and how to improve upon the current VAR based framework for measuring trading risks. We will consult on this issue as the work progresses, which I expect will be around the end of this year

Other issues on the Committee’s agenda include further work on cross-border bank resolution issues and updating of large exposure standards, as well as a revision of the Core Principles for Effective Banking Supervision. It is critical that we incorporate the lessons of the crisis into a revised set of Core Principles, which will serve as the basis for enhanced country level reviews through the IMF and World Bank.

IX. Conclusion

The policy work for developing the Basel III framework has for the most part been completed.

The reforms are significant and bring together micro and macro lessons of the crisis.

The Committee has now moved to the next phase: implementation.

One of the regulatory lessons of the crisis is that it is critical that all countries and regions now follow the global implementation process. By definition, it will be hard to predict the cause of the next crisis.

Many risks are still looming on the horizon, and all countries need to continue the process of building their capacity to absorb shocks – whatever the source.

The banking sector’s shock absorbing capacity must be much stronger than it has been in the past, and the implementation of our standards must be more globally consistent and robust.

Conference on Basel III, Financial Stability Institute, 6 April 2011
Basel III: Stronger Banks and a More Resilient Financial System
Stefan Walter, Secretary General, Basel Committee on Banking Supervision

Best Regards,

George Lekatis
President of the Basel iii Compliance Professionals Association (BiiiCPA)