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Sound at last? Assessing a decade of financial regulation

What has changed since the financial crisis of 2008 that makes the financial system sound at last? Is regulatory reform going in the right direction?

Speakers

If you would like a hard copy of the report, please write to Nadine Clarke, ([email protected]).

VIDEO & AUDIO RECORDINGS

summary

Bruegel, the Centre for Economic Policy Research, and the European Center for Advanced Research in Economics and Statistics co-hostED this event about the aftermath of the 2008 economic crisis. The legacy of the crisis is stronger and better capitalized banks, as well as regulators and supervisors with increased clout who pay more attention to systemic risk. However, the crisis has also left us with high leverage in advanced economies, especially in terms of sovereign dept over GDP. At the same time, interest rates are at very low levels. All of this, together with the digital disruption of the sector, poses formidable challenges for the banking industry.

This event featured the first report in the IESE/CEPR Future of Banking series report, tackling three important areas of post-crisis regulatory reform: Basel III and its aftermath; resolution procedures to end 'too big to fail'; and expanding the role of central banks with a financial stability remit. The report presents an extensive analysis of the banking sector and the regulatory reforms put in place since the crisis.

At this event, several central messages of the report were discussed:

  • Narrow banking is not the answer to the fragility of the financial system.
  • Regulation should be fine-tuned: there are improvements on all fronts but no framework exists yet to deal with shadow banking and the new digital competitors.
  • Prudential regulation should take a holistic approach, considering and setting requirements for capital, liquidity and disclosure together and taking into account their potential interactions.

All four co-editors of the report report “Sound At Last? Assessing a Decade of Financial Regulation” were present to provide their thoughts on the report as well as Rebecca Christie of Bruegel and Mathias Dewatripont of Solvay Brussels School and ECARES Université Libre de Bruxelles. Xavier Vives started the discussion by presenting the findings from the report.

Since the crisis, regulation and supervision has been improved. Authorities pay more attention to systemic risks, and banks are more capitalized. However, high levels of debt, low interest rates, and potential currency wars are also worrying signs. Regulatory authorities also sometimes lack appropriate political support.  Vives points out that if the crisis were to happen today, the FED would have less power to act today than at the time of the crisis.

The idea to end bailouts is sound, but the view to end bailouts no matter what does not seems unrealistic. Predicting the origins of the next global crisis is difficult, but if the past is any indication the activities that happen on the periphery of the core functions of banks, usually where shadow banks are at the forefront. Emerging markets are another possible origin of the next crisis. Banks must adapt to digital disruption and regulators must also regulate digital currencies if they become systemic. Vives goes over one chapter from the report: “Regulatory Reform: Basel 3 and Beyond”. Vives rejects the idea of banks becoming narrow banks would be a magic bullet to prevent financial crises. A narrow bank is where all the investments of banks would be extremely safe. Regulation should take a holistic approach because of potential interactions between capital, liquidity, and disclosure. Vives advises that stress tests need to be severe, flexible, incorporate a systemic perspective, and not overly transparent. The main lesson from the euro area is effective stress tests can only be implemented when there is a backstop for the banking system. Vives points out that capital requirements are up, but whether the amount of capital requirements is enough is still a matter of debate. Vives also shows that non-banks (shadow banks) have increased their share of investment, and for entities outside the perimeter of regulation authorities require a framework to monitor, assess, and designate (systemic threat or not) them.

From here Patrick Bolton, also a co-editor of the report, continued the presentation on two chapters from the report. The first chapter he discussed was “Resolving too big to fail”. One idea to help prevent too big to fail is to keep operating affiliates untouched and only resolve the bank holding company. This is referred to as single point of entry. An example of how this would work is in the case of Leman Brothers the intervention would have happened only in the USA. Losses from affiliates would be pushed up to the holding company. In order to implement this type of resolution then total loss absorption capacity must be added in addition to the regular capital cushion.

The presentation then changed focus to the expanding role of central banks. Bolton Argues that a bigger role of central banks requires independence and visibility. Bolton rightly points out that a bigger role of central banks requires the need to strengthen democratic acceptability of delegating powers to unelected officials. In models where central bank focuses on price stability and share with other authorities the responsibility of financial stability then coordinating actions must be addressed and there should be open communication between agencies. Mathias Dewatripont presented his thoughts on the report. He agreed with many points of the report. He then focused his presentation on the Eurozone (EZ) with four topics: health of EZ banks, capital markets union, bail-in, and cross border banks. He points out that the US banks are in better shape than the EZ banks. More precise definition is needed of what constitutes a shadow bank. Says that total loss absorption capacity better than bank recovery and resolution. Cross border banks due have advantages like diversification and competition but the disadvantage of too big to fail.

Rebecca Christie provided her thoughts on the report and points out to the accessibility of the report, the radical idea in the report that central banks and fiscal authorities should cooperate. She also spoke on why the direct recapitalization instrument was not implemented.

The remaining two co-editors of the report, Stephen Cecchetti and Jean-Pierre Danthine, joined the panel to provide some thoughts and answer questions. One general remark they made is that banks when left to their own devices will not hold enough capital. The editors do not know what is an optimal level of capital a bank should hold. They explained that the report did not look into details of EZ or American specific, they wanted to take a more general view and instead develop a few ideas that would be useful at all levels. They noted that inn terms of efficacy it would be better for financial agencies and central banks to be under one roof, the encompassing model, but clarity and accountability is more difficult.

Notes by Akira Soto

materials

Presentation by Patrick Bolton

Presentation by Xavier Vives

Presentation by Mathias Dewatripont