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How regulatory reform shapes the financial cycle

Ambitious regulatory reform has changed the dynamics of the global financial system. Capital ratios of banks have increased significantly, reining in bank credit. Counter-cyclical bank capital rules slow credit expansions by design and yield greater influence to non-banks. Meanwhile, the liquidity coverage ratio has restricted one of the key functions of banks: liquidity transformation. Regulation has also created its own moral hazards. In particular, the preferential treatment of government bonds has boosted their share in bank assets. The neglect of sovereign risk in liquidity regulation constitutes a significant systemic risk as public debt-to-GDP ratios are at or near record highs in many key economies.

IMF Global Financial Stability Report (2018), “Chaper 2: Regulatory Reform 10 Years after the Global Financial Crisis: Looking Back, Looking Forward”, October 2018.
Neyer, Ulrike and André Sterzel (2018):” Preferential treatment of government bonds in liquidity regulation: Implications for bank behaviour and financial stability”, DICE Discussion Paper, No. 301.
Roberts, Daniel, Asani Sarkar and Or Shachar (2018), “Bank Liquidity Provision and Basel Liquidity Regulations”, Federal Reserve Bank of New York, Staff Report No. 852 June 2018

The post ties in with SRSV’s summary lecture on the regulated banking system.
The below are quotes are mainly from the IMF report. Quotes from other papers are referenced explicitly. Emphasis and cursive text have been added.

Key areas of reform

“[The global financial crisis] revealed that the prevailing regulatory framework was unable to contain the buildup of vulnerabilities and tame the incentives of market participants to take excessive risks…At the 2009 G20 summit, the international regulatory community convened to conduct a broad overhaul of the regulatory and supervisory framework…through a series of high-level goals in multiple areas.”

Enhance capital buffers and reduce leverage

“Basel III increased the permanence and loss absorption of banks’ capital In addition, it addressed the definition and composition of regulatory capital: it widened the risks being covered, balanced risk-based measures of capital with a new non-risk-based leverage ratio, and constrained the capital relief that banks could achieve by using their own models to calculate risk weights.”

Reduce financial pro-cyclicality

“Basel III added capital cushions, such as the countercyclical capital buffer and capital conservation buffers, both of which can be drawn down at times of stress to mitigate pro-cyclicality, and capital surcharges for systemic banks, a clear signal from the regulators that banks were not expected to skirt too close to the minimum regulatory standards.”

“The main countercyclical capital tool is the countercyclical capital buffer. This buffer should be activated to lean against the accumulation of systemic risks during periods of financial exuberance, and be released when the cycle turns. At the end of 2017, some jurisdictions had not set the countercyclical capital buffer above zero, despite relatively large credit gaps, a measure of the difference between the current ratio of credit to GDP and its long-term trend.”

“The capital conservation buffer and leverage ratio…should be more binding and limit balance sheet expansion in the upswing of the cycle. Regulation also allows the capital conservation buffer to be used in times of stress. The capital conservation buffer has been introduced very broadly, but progress in the leverage ratio has been more gradual.”

Contain funding mismatches

“Two new regulatory liquidity ratios for banks emerged from the crisis. The first to be implemented, beginning in 2015, was the liquidity coverage ratio (LCR), based on the concept of holding a stock of liquid assets to withstand a high degree of stress for a 30-day period. The other, the net stable funding ratio (NSFR), implemented beginning in 2018, is based on managing the potential mismatch between asset and liability maturities up to a one-year horizon. All Basel member countries have already implemented the LCR…By contrast, implementation of the NSFR has proved to be more demanding because of the discretion needed to ensure its effectiveness in local markets.”

Regulation and supervision of large and interconnected institutions

“Measures to address risks associated with large, interconnected, and complex institutions have largely focused on identifying systemic firms and imposing stricter regulatory and supervisory requirements on them. Global systemically important banks have been subject to a systemic capital surcharge since 2016…Supervisory colleges and crisis management groups have been deployed. All host jurisdictions should have both supervisory colleges and crisis management groups.”

Resolution regimes of large financial institutions

“Following the crisis, it became clear that the resolution framework for large institutions was inadequate and political support for bailouts evaporated…The adoption by the Financial Stability Board of the Key Attributes of Effective Resolution Regimes for Financial Institutions provided a benchmark for resolution authorities to have the tools to enable them to quickly resolve nonviable systemic financial institutions while maintaining the continuity of functions critical for financial stability and the functioning of the real economy…Most jurisdictions in which Global systemically important banks are domiciled have introduced all, or nearly all, of the bank resolution powers advocated by the Key Attributes.”

Apparent progress

“Capital buffers have increased notably following the global financial crisis. Both regulatory capital ratios (Tier 1 and total capital ratios) have followed a steady upward trend since the crisis, and the global median common-equity-to-asset ratio (an inverse measure of leverage) has increased by more than 2%- points since 2010.”

“By 2017, all [capital] ratios were significantly higher than before the crisis In part, the increase in regulatory capital ratios has been achieved because banks have moved away from assets with higher regulatory risk weights. Considering that the definition of regulatory capital was made more stringent after the crisis, the observed post-crisis increases in regulatory capital ratios are particularly encouraging.”

“The post-crisis increase in capital buffers has been particularly substantial for global systemically important banks, which have increased their regulatory capital ratios by 5%- points or more, compared with 1%-point for other institutions.”

“There are indications that pro-cyclicality of bank credit has also declined. A simple measure—the regression coefficient of real quarterly bank credit growth on real GDP growth, both de-trended—indicated significant pro-cyclicality in a sample of 61 countries in the pre-crisis period. Then its value declined and it became nonsignificant in the post-crisis period.”

“Liquidity buffers have, on average, grown since the global financial crisis, and reliance on wholesale funding is trending downward. In particular, banks’ holdings of cash and government securities, considered to be highly liquid, have increased as a share of total assets.”

Apparent risks

“The Basel Committee on Banking Supervision completed its review of the regulatory treatment of sovereign exposures without changes to existing rules, as no consensus was reached.”

“Within the [Basel III] liquidity regulation framework, government bonds receive a preferential treatment. In particular, they are regarded as highly liquid assets, which means that banks can use government bonds to meet their liquidity requirements without applying any haircuts or quantitative limits, i.e. in liquidity regulation government bonds are treated as liquidity risk-free.“ [Neyer/Sterzel]

“The liquidity requirements…aiming to strengthen banks’ liquidity profiles, do not account for sovereign risk. However, on the European sovereign debt crisis, for example, the credit risk applied to some EU member states increased substantially and the sovereign bonds of these countries could not be easily and quickly liquidated without leading to substantial losses for banks (liquidity risk).
Neglecting sovereign risk in liquidity regulation may undermine financial stability. Banks’ sovereign exposures can act as a significant financial contagion channel between sovereigns and banks…Using a theoretical model, we show that a sudden increase in sovereign default risk may lead to liquidity issues in the banking sector, implying the insolvency of a significant number of banks.” [Neyer/Sterzel]

“What makes banks special? One answer is that banks are skilled at liquidity and maturity transformation (LMT) by funding illiquid, long-maturity assets with liquid, short-term liabilities–in particular, demandable deposits
Since 2013, there has been reduced liquidity creation by banks [that comply with the liquidity coverage ratio]…occurring mostly through greater holdings of liquid assets and lower holdings of illiquid assets…Our results highlight the trade-off between lower liquidity creation and lower run risk from reduced liquidity mismatch of the largest banks.” [Roberts/Sarkar/Shachar]”

“New financial technology (fintech) poses challenges…While fintech—encompassing activities such as big data, automation of loan processing, distributed ledger technology, and new lending and electronic trading platforms—is still small, it has grown rapidly. The regulatory challenge is to support fintech’s potential…while safeguarding against risks that could amplify shocks to the financial system.”


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