The first is new approaches to the regulation of the capital adequacy of banks. These have of course been extensively revised by the introduction of Basel 2, which has aimed to achieve greater sensitivity of capital levels to the different risks which banks are running, and there are certainly benefits to the Basel 2 approach on which the future system should build. It is important to realize that the crisis developed under the Basel 1 regime not Basel 2, and that Basel 2 would have addressed some of the problems which led to it – for instance the failure to distinguish between the capital required to support mortgages of different credit quality. But it is also clear that we will need to adjust Basel 2 in a number of ways. The general direction of travel will be towards higher levels of bank capital than have been required in the past, and in particular capital which moves more appropriately with the economic cycle and more capital required against trading books and the taking of market risk . And looking forward, the FSA believes that a fundamental review is required of how trading books are defined and how risks in trading books are estimated. VAR based approaches were originally developed to model the risks in trading in markets likely to be continually and deeply liquid (e.g. government securities, major currency FX swaps and interest rates derivatives), and were adopted by regulators in the mid-1990s when a high proportion of bank trading was concentrated in such highly liquid instruments. Over the last decade and a half, however, trading books have expanded rapidly to encompass the holding of many debt securities whose markets are imperfectly liquid even in normal times and which became suddenly illiquid when the downturn occurred; this booking of potentially illiquid assets in trading books was indeed in part driven by the lower capital charge there incurred. The FSA will be proposing to the Basel Committee that a fundamental review of the division between the trading and banking books and of the appropriate use of VAR to measure risk is now required. New approaches to the management and regulation of liquidity are equally important. Indeed we need to ensure that the regulation of liquidity is recognized as being at least as important as capital adequacy, a sense which was to a degree lost over the last several decades, with intense regulatory focus and international debates on capital adequacy, but less focus on liquidity – no Basel 1 or Basel 2 for liquidity to match the equivalents for capital. That lack of a defined international standard has reflected the extreme complexity of the liquidity risk, which makes it difficult to achieve effective regulation through generally applicable quantitative ratios equivalent to capital adequacy ratios. Many developed economies did in the past require limits to defined ratios, such as loans to deposits; but it is less clear today that deposits are inherently more sticky than other categories of funding in a world of internet retail deposits and wholesale depositors (corporates, local authorities, charities, etc) with multiple options to redeploy spare funds.3 And the emergence of the originate and distribute securitized credit model has been accompanied by increasing options to manage liquidity through secured funding (e.g. repos), and an increased reliance on liquidity through marketability, making bank liquidity risk assessment crucially dependent on assumptions about the liquidity of specific asset and secured funding markets, which it is difficult to reduce to simple quantitative rules. Measuring and limiting liquidity risk is, however crucial, and reforms to regulation need to include both far more effective ways for assessing and limiting the liquidity risks which individual institutions face and a better understanding of market wide liquidity risks. The FSA’s Consultation Paper on Liquidity published in December, therefore proposes a major reform of our liquidity supervision. It will put in place: At the core of the assessment and guidance will be stress test scenarios, rather than models which seek to infer the probability distribution of risks from the observation of past fluctuations. This reflects the fact that liquidity risk assessment is inherently concerned with low probability but extreme events. And crucially the stress tests will need to cover potential market wide stresses as well as idiosyncratic stresses, reflecting the lesson of the financial crisis that market wide collapses in the liquidity of specific asset or funding markets can have huge impacts which analysis of individual specific risks will not capture. This new regime and the related reporting requirements will greatly enhance our ability to understand emerging liquidity risks in individual institutions and across the whole economy, and to conduct sectoral analysis which can identify outlier business models and management practices. On the basis of this increased understanding, we will keep under review the appropriate balance of quantitative rules, stress test based analyses, and discretionary guidance. We anticipate that the new regime will result in major changes in the extent and nature of maturity transformation in the overall banking system, with banks holding more liquid assets and a greater proportion of those assets held in government securities, an incentive for banks to encourage more retail time deposits and less instant access, less reliance on short term wholesale funding, and as a result, a check on rapid and unsustainable expansion of bank lending during favourable economic times. The third key priority is to ensure that in future financial activities are always regulated according to their economic substance not their legal form. One of the striking features of the years running up to the crisis, as I stressed earlier, was that a core banking function – maturity transformation – was increasingly being performed by institutions which were not legally banks, but the off balance sheet vehicles of banks, (SIVs and conduits), investment banks and mutual funds. To different degrees in different countries these near banks or shadow banks escaped the capital, leverage and liquidity regulation which would apply to banks. In the case of SIVs they also escaped the degree of disclosure and accounting treatment which would have applied if the economic activities were performed on balance sheet. In future it is essential that if an economic activity is bank like and poses a significant risk to consumer or financial stability, regulators can extend banking style regulation. And essential that accounting treatment reflects the economic reality of risks being taken. Applying these principles will have more implications for legal powers and regulatory structures in some other countries – and in particular in the U.S. – than in the UK. European approaches to the bank capital adequacy have always applied to investment banks: the requirements set down for trading book capital were in retrospect inadequate, but in Europe investment banks did not lie outside a regulatory boundary In the USA, with a fragmented regulatory structure, there is a greater need to look at structures and powers. But across the world regulators need to continually assess how evolving industry structures and institutional roles are changing the nature of risk, both for individual institutions and for the whole system, and if necessary to adapt the coverage of prudential regulation over time. This will at times require judgments about the appropriate treatment of institutions which have some of the risk characteristics of banks but not others. Two examples: To conclude, let me return to my opening thought. We are in the middle of an economic downturn which, to a far greater extent than any since the 1930s, is the result of developments which were to a degree internal to the global financial system. Developments in the banking and near bank system which had been lauded as improving allocative efficiency and financial stability have in fact caused serious harm to the real economy. The changes which we need to make to create a sounder system for the future will be profound. Their guiding principle should be that they should create a banking system focused on the delivery of the value-added functions of banking which are so essential to a market economy. 1 Even the banks which were largely doing “originate and distribute” would often however have to warehouse significant quantities on balance sheet before packaging and distributing, and could be left with liquidity strains and future potential losses if liquidity suddenly dried up (e.g. Northern Rock) 2This assumption seems also at time to have been based on a misunderstanding of the inference that could be drawn from a credit rating, with high ratings treated as carrying the inference of liquidity, rather than simply lower credit default. 3Loan to deposit ratios limits continue however to be used in some emerging economies. A number of emerging economies e.g. India, also continue to use reserve asset ratios as monetary policy instruments, with significantly liquid balance sheets a resulting byproduct. 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New approaches to capital adequacy
Looking forward, however, we need to go beyond the avoidance of unnecessary pro cyclicality and to create a system which introduces significant counter cyclicality, requiring banks to build up substantial capital buffers in good economic times – ratios well above absolute minimum levels – so that they can run them down in bad. Such an approach makes sense from a micro- prudential point of view, reducing the risk of bank failure. But it is also desirable from a macro prudential and macroeconomic perspective: it will tend to place at least some restraint on overrapid expansion in the boom, and it will reduce the danger that impaired capital makes it more difficult for banks to lend in recessionary times, thus making the recession worse. Ideally such a regime must be agreed at international level, and the FSA is working closely within the Basel Committee on Banking Supervision and the Financial Stability Forum to design the details. There are many of those details to be worked out; whether the buffer requirements will be defined in formulaic terms, as in the Spanish dynamic provisioning system, or by regulator discretion; and how to deal with the complexity of different economic cycles in the different countries in which a cross border bank may operate. But the principle is clear.New approaches to liquidity
Regulation by economics substance: shadow banks and near banks
Conclusion
Friday, 23 January 2009
Posted by Britannia Radio at 22:30