Why regulate Special features of financial industry Principles for effective regulation Bale 1-3 + Critics Proprietary trading

Proposals for Reforming Fin Regulation Islamic Finance Types of risks Banking Union Efficient markets Regulation = reconnecting the real economy with financial economy

Why banks are regulated Liquidity risk panic (regl. & supervision microprudentielle) Counterparty risk (risky financial products) necessary to have sufficient equity to absorb losses Systematic risk: bankruptcy is contagious, social costs > private costs prevention of systematic risk (regl. & supervision macroprudentielle) Financial crises happen frequently and have a huge negative impact on the o 1. real economy: House price down 35% Unemployment up 7% Stock markets down 35%, 3.5 years to recover to pre-crisis level o 2. Public debt Public debt up 25% of GDP Support and guarantees for banks, resulting in higher debt, lower credit rating and lower fiscal revenues for the country All leading to a vicious circle between public debt and bank crisis

to ensure that markets work efficiently

Information asymmetry

A second special case for regulatory intervention in financial markets arises from the intensity and nature of the informational imbalances or asymmetries that exist between financial institutions and retail consumers of financial services

Regulation Philosophies Liberal: autoregulation Bernanke, Greenspan, Friedman, Ayn Rand Interventionists: Keynesianism (Keynes), Neo-Keynesianism (Samuelson), New Economy (Stiglitz)

Types of regulation regulation to promote financial market integrity regulation of fundraising and securities and derivatives markets, both through exchanges and over the counter. It encompasses disclosure requirements in these areas, approval and oversight of exchanges, and prohibitions on unfair trading practices or market manipulation competition regulation (principally regarding mergers and anti-competitive conduct); prudential regulation ensure (or at least increase the likelihood) that the entity making a financial promise is able to meet it consumer protection regulation ensure that consumers understand the promises made to them, including their risks, to proscribe false or misleading promises or to provide recourse in the event that a promise is not met

Regulatory arbitrage a practice designed to get around regulations encouraged the growth of financial activity and risk taking. In fact, many of the very problems that caused the financial crisis arose in institutions (e.g. mortgage lenders) and instruments (e.g. credit default swaps) that were unregulated. This is a lesson that should have been learned from previous financial crises in developing countries, where the most liberalized and unregulated parts of the financial system were the source of crisis.

Efficient markets (FAMA) Weak (random walk theory, certain practicioniers chartists) semi-strong (abnormally high returns in case of good news and vice versa) strong efficient markets (event studies show the opposite) No regulation needed if markets were efficient But: markets are NOT efficient o Weekend effect: return on mondays the worst of the week cause firms choose the friday to announce bad new (timing effect weekend effect) o January effect: securities prices increase in the month of January more than in any other month securities' prices increase in the month of January more than in any other month. Explanation: individual investors sell stocks for tax reasons at year end (such as to claim a capital loss) and reinvest after the first of the year o Reaction to announcements o Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias

Regulatory Reform Basel Accords Basel I, II

1.

The tier capital ratio was developed to primarily address credit risk and thus disregards other types of risk such as operational risk and market risk. These two types of risk are included in the tier capital ratio calculation of the recently
Tier 1 Capital/ RWA > 4%

2.

3.

There are several deficiencies of the tier capital ratio. First, it relies on a rather arbitrary and only consensus-based risk-weighting of assets. Second, its risk-weighted approach also assumes that asset risk remains constant over time, an assumption that is often made in finance, but that can easily turn out to be wrong. One example is real estate which was misleadingly considered a safe bet right before the Global Financial Crisis 2007-2010 4. Introduction of Common Equity ratio in Basel II Basel III supposed to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage Capital requirements The original Basel III rule from 2010 was supposed to require banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of "risk-weighted assets" (RWA) Basel III introduced "additional capital buffers", (i) a "mandatory capital conservation buffer" of 2.5% and (ii) a "discretionary counter-cyclical buffer", which would allow national regulators to require up to another 2.5% of capital during periods of high credit growth Leverage ratio calculated by dividing Tier 1 capital by the bank's average total consolidated assets Min. Basel III leverage ratio would be 6% for 8 Systemically important financial institution (SIFI) banks and 5% for their bank holding companies Liquidity requirements "Liquidity Coverage Ratio" (LCR) supposed to require a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days the Net Stable Funding Ratio (NSFR) was to require the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress Critics of Basel Accords

Policy interests: Bale accords exclude emerging markets from capital obligations and that they do not meet specific needs for emerging markets. Banks in emerging markets are thus put into a difficult position The adoption of Basel I and II requirements will likely improve banks status as transparent and controlled institutions: being reluctant to adopt the Basel requirements would deteriorate banks international recognition Cyclicality of capital ratios: banks proneness to increase banking activities when the economy is booming and to decrease them when the economy is receding. Financial regulators seem willing to allow average capital to asset ratios to fall during recessions to prevent worsening macroeconomic conditions findings that contest the idea of bindingness Regulatory capital arbitrage: especially American banks became increasingly active in arbitraging on high capital levels by using securitization techniques
No guaranty for safe banks: higher levels of capital do not guarantee a safe bank. Lehman Brothers had plenty of tier-one capital, well above the regulatory minimum, yet couldn't survive the gigantically bad lending decisions of its management

Contraproductive effect on economy and risk-taking: Banks hoarding more capital means less for us which could mean the price of credit going up. It could also mean lower returns for shareholders which can either reduce investment for new banks seeking to increase competition, or push lenders into riskier activities Counterproductive effect on competition: Regulation, by erecting barriers to entry, reduces competition. Those banks who are able to meet the regulatory requirements should be even more profitable than before because of lower competition

Seperation of Proprietary trading Return to Glass-Steagall Act (1933) USA: Dodd-Frank reform and Volcker rule separates investment banking, private equity and proprietary trading (hedge fund) sections of financial institutions from their consumer lending arms. Banks are not allowed to simultaneously enter into an advisory and creditor role with clients, such as with private equity firms UK: Vickers legally separate or ring fence the retail banking operations of U.K. -based banks EU: Liikanen banks trading business should be placed in separate subsidiaries, suggesting the greatest risks lie in trading France: separating necessary from speculative financing activities

Critics of seperation of proprietary trading

Ring-fencing will not guarantee that taxpayers are not called upon to save failing banks in the future because global banks collapsing would still lead to economic catastrophe. So the benefits of the ring-fencing measure may be exaggerated. It may help reduce financial instability but it wont solve all banking problems. Ring-fenced banks will have higher costs and they will be passed onto consumers and smaller businesses through higher lending rates. If a ring-fenced bank fails, non-retail depositors are not protected this affects universities, local authorities, health authorities, larger charities or medium sized businesses

How Regulation shoud look like General Principles

Competitive neutrality:

regulatory burden associated with a particular financial commitment or promise apply equally to all who make such commitments barriers to entry and exit from markets and products be no greater than necessary markets be open to the widest possible range of participants

Cost effectiveness:

presumption in favour of minimal regulation unless a higher level of intervention is fully justified; regulatory functions be allocated among regulatory bodies so as to minimise overlaps, duplication and conflicts; the costs of regulation be allocated (albeit often indirectly) to those who enjoy the benefits.

Transparency: Any guarantees and other regulatory promises be made explicit and that all purchasers of financial products be fully aware of their rights and responsibilities It also requires regulation to have clearly stated objectives Flexibility: The level of uncertainty (e.g. technology) clouding the future puts a premium on flexibility. It is critical that the regulatory framework has the flexibility to cope with changing institutions, product structures and delivery mechanisms without losing its effectiveness Regulatory failures have often resulted from regulators falling behind market
developments

Concrete Reforms
Counter-cyclicality Historically, the most significant financial market failure comes when these markets operate with procyclicality. In fact, risk is generated mainly in the booms, even though it becomes apparent in the busts Counter-cyclical bank regulation of provisions and/or capital can be easily introduced, either through banks' provisions or via their capital.

Regulating Bankers Compensation

Bahavioral: A large part of bonuses are tied to short term profits: they are positive in good times but never negative, even when big losses occur rewards for taking a lot risk, but no sanction in case of loss Stability: Bonuses could be used to recapitalize the banks in bad times instead of being paid out immediately and banks saved by the taxpayer Political: high bonuses and high remunerations great wealth accumulation financial actors gain political influence (e.g. financing political campaigns) risk that their regulators become captured, or hired at greater salaries into higher- paying sector jobs.

Simple solution to this problem: fixed salary. Bonuses could either be abolished or accumulated into an escrow account, in which case they could be cashed only after a period equal to an average full cycle of economic activity, if the activity it is compensating remains profitable. Such a change would reduce existing incentives towards shorttermism.

Financial products safety commiussion This commission would assess the benefits and risks of particular products and determine their suitability in general and for particular users. In so doing, it would have strong parallels with the Food and Drug Administration, which evaluates the risks and benefits of new medications Financial markets have innovated, but often these innovations have been damaging for individuals, financial institutions and the whole economy. Defective products can have disastrous effects both on those who buy them and on the economy, as they can create systemic risk.

Reform of rating agencies Better evaluation of complex products (e.g. titrisation/ securitisation) More transparency Decrease conflict of interests (shareholders, compensation etc.) More competition and less concentration on credit risk