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II. FAILURE OF REGULATION AND SUPERVISION

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II. Failure of Regulation and Supervision

• Recurrence and severity of financial crises • The 2007-09 financial crisis has a number of

lessons, many common to previous episodes • No doubt there were market/private sector

failures; discussed in previous section • But regulation is supposed to correct those

failures…also failed miserably!!! • Monetary Policy also an important culprit

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A Narrative of the crisis (cont.)

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Immediate Causes of the Crisis

• Crisis was caused by an excessive expansion of credit and a price bubble in the housing sector

• The expansion of credit/leverage happened through the growth of secured lending and structured products (not in M2!!!)

• Credit growth fuelled the housing price bubble, leading to weak lending standards, and a large misallocation of resources

Causes of Crises 6 Jorge Roldós

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Source: R. Shiller 9 Jorge Roldós

Deeper Fundamental Causes

• Why did this huge misallocation of resources happen?

• Confluence of a number of forces/factors • We organize the many causes into three

categories: 1. Monetary Policy Mistakes 2. Market/private sector failures 3. Regulatory Failures


1. Monetary Policy Mistakes

• The crisis started after a period of low macroeconomic volatility and very low interest rates (dubbed the “Great Moderation”)

• Fed easing from 2001 until 2004 led to very low short term interest rates (next chart)

• Low risk-premia (for both market and credit risk) the so-called “connondrum” produced very low longer term interest rates

• Prompted a “search for yield” by investors worldwide


Fed’s Easing Beyond Taylor Rule

Source: J. Taylor, 2007 12 Jorge Roldós

1. Monetary Policy Mistakes • Difference between actual policy rates and “optimal” ones

is even larger if one adjusts for cyclically-low risk-premia – Market risk – Credit risk

• Emerging market central banks (especially Asia) reinforced this by intervening in FX markets (to resist appreciation) and accumulating large amount of int’l reserves

• Global imbalances also driven by U.S. financial system intermediating needs of over-stimulated US consumers and under-stimulated surplus countries’ consumers


1. Monetary Policy Mistakes

• Monetary policy models ignored asset prices [more in L-7]

• Difficulties diagnosing “bubble” [L-3], led to policy of “cleaning-after-the-fact”

• Reinforced by “Greenspan put” (an implicit “floor” for asset prices), an invitation not to store enough liquidity for bad times (moral hazard)

14 Jorge Roldós

2. Market/Private Sector Failures

• We can classify the main market/private sector failures into three main classes: a. Incentive problems (a result of imperfect

information/contracts) b. Incomplete markets (say, for “liquidity” in some states

of the world, shorting housing) c. Herding, coordination problems, and externalities

• Perfect financial markets would correct some of these failures; regulation should take care of others


2a. Incentive problems (1)

• A number of incentive problems were created by the shift in the financial system to an “originate-to-distribute” (O2D) model

• Securitization segments the credit process, with the originator of the loans selling them to an arranger, who repackages them into securities assessed by rating agencies

• “Distance” from investor to debtor, and lack of transparency in some of the stages, weakens ability to evaluate/monitor creditworthiness



• Rating agencies are paid for by issuer: incentive to do “ratings shopping”

• Weaker lending standards also related to use of credit scoring models (reliance only on a few indicators, no “soft/character” information)

• Agency problems (shareholders versus managers/traders/bankers) were aggravated by compensation systems: one-sided bonuses linked to short-term returns


2a. Incentive problems (3) • Product complexity and the associated lack of

transparency impeded market and regulatory discipline on the financial system

• Excessive leverage magnified the above incentive problems, with FIs engineering and undertaking a large amount of “tail risk”

• The fact that they kept a large share of that risk—directly or indirectly—on their balance sheets is a sign that they expected a (too-big-to-fail, TBTF) bailout (moral hazard)

18 Jorge Roldós


• Fannie Mae and Freddie Mac were privately-owned companies with a public-policy objective

• When asked to increase their share of low-income house-finance, bought subprime-ABS – Some estimate that, adding the FHA, gov’t mandated

loans amount to almost 2/3 of all junk mortgages • Some pension funds and foreign banks based

their investment decisions purely on ratings, with out further due diligence


2.b Incomplete Markets

• When short-term creditors do not roll-over funds (“run” on the FI), or require higher margins, FIs have to raise funds when markets are closed to them

• In other words, markets for liquidity insurance in “bad times” are non-existent

• Fire-sale externalities can be damaging to FI balance sheets

• Counterparty or network externalities

• Few opportunities to short housing market means prices have tendency to rise excessively (bubbles? [L-3])

• Limits to arbitrage could lead to persistent mispricing of assets (bubbles?) Causes of Crises 20 Jorge Roldós

Bottom line:

• Financial institutions and markets are supposed to correct/control information problems

• Since they are likely to be unable to correct all incentive problems and externalities, there is a role for regulation

• But regulation may also fail—and may even aggravate some of the incentive problems it is meant to solve


3. Regulatory Failure

• Regulations failed for a number of reasons: 1. Lack of resources to understand LCFI strategies

and incentive problems, to extend regulation to all relevant parties, and to enforce the existing ones

2. Regulatory “capture” by the industry or politicians 3. Regulatory mistakes or gaps

• Examples from the 2007-09 crisis:


3.a Lack of regulatory resources

• The regulatory “perimeter” (L-8) in the U.S. was restricted, in part because of lack of resources, in part because of underestimation of linkages – Some states did not license mortgage brokers, much less

monitor their behavior – Finance companies largely unregulated

• The complexity of products and business strategies could not be understood by a few regulators checking the balance sheets of LCFIs – Explicit recognition of head of the OCC

23 Jorge Roldós

3.a Lack of regulatory resources

• 1992 legislation allowed Fannie&Freddie to hold less capital than other FIs

• Also determined that their new regulator, an office within HUD with little financial sector experience, was subject to congressional appropriation


3.b Regulatory “capture”

• LCFIs lobbied U.S. authorities to repeal Glass-Steagall Act, allowing commercial banks into investment banking activities

• Investment banks lobbied the SEC to have a voluntary “net-capital” rule, using own risk models; allowed for unrestricted leverage

• Fannie&Freddie mandate to fund low-income mortgages expanded during Clinton (“Affordable Housing”) and Bush (“Ownership Society”) administrations


3.c Regulatory gaps/mistakes

• Basel rules allowed for regulatory arbitrage between the banking and trading books, using guarantees or reducing RWA (L-2)

• A number of explicit and implicit guarantees were underpriced

– Deposit insurance – Too-big-to-fail

• Lack of an orderly resolution mechanism for LCFI and other non-bank FIs


3. c Regulatory gaps/mistakes

• Lack of regulation on liquidity mismatches (L-2/3)

• OTC derivatives markets were allowed to grow without transparency or central clearing

• Regulation focused on individual institutions rather than on systemic risk contribution [L-6]

• Regulators did not internalize that risk-taking is endogenous


Deeper “Fault Lines” (R. Rajan)

• Political-economy arguments: facilitate credit to buy houses when politicians cannot solve problem of stagnant middle-class

• Intersection of politics and finance: although some housing subsidies are OK, when you give a “wall of money” to financiers…

• Global imbalances are a result of overconsumption/financial deepening in US, opposite in surplus countries


III. SYSTEMIC RISK REQUIRES NEW INSTRUMENTS AND INSTITUTIONS

30 Jorge Roldós

III. Systemic Risk Requires New Instruments and Institutions

• Improvement in Supervision and Regulation (Sup&Reg) framework requires a definition of macro-prudential policies and systemic risk

• More fundamental diagnosis of Sup&Reg failures suggest new, improved instruments

• Central issue: regulation has to focus on system (macro-pru), not just institutions alone (micro-pru)

• Sup&Reg framework also requires new institutional arrangements

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A. Definition and Objectives

• The objective of macro-prudential policy is to promote financial stability by limiting systemic risk

• Financial stability means a stable provision of financial intermediation services, i.e. a stable supply and cost of credit, insurance, others

• Realistic: cannot expect to eliminate credit cycles and/or target asset prices

Systemic Risk

• Systemic risk can be defined as “the risk of disruption to financial services that is caused by an impairment of all or parts of the financial system and has the potential to have serious negative consequences for the real economy” (FSB, IMF, BIS, 2009)

• The sources of systemic risk are basically the ones that we identified as causes of the current crisis in the previous section (also BoE, 2009)

B. Macro-Prudential Instruments

• Micro-Prudential regulation based on deposit insurance (DI) and capital regulation [L-2]

• Goal: internalize losses on bank assets to minimize moral hazard and protect DI fund

• Key element: prompt-corrective-action (PCA) to restore capital adequacy ratio (CAR)

• Next we provide two examples of why this framework proved inadequate in last crisis

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An example from Morris and Shin (2008)

• Bank 2 in the next Figure is a very safe bank by Basel I-II standards: 1. Assets are reverse repos, collateralized 2. Liabilities (repos) are matched with assets

• Bank 2 could increase its leverage beyond 30X

• However, Bank’s 2 assets are systemically important, because they mirror Bank 1 liabilities


• If Bank 2 does not rollover reverse repo with Bank 1 (a prudent policy for B2), and B1 assets are illiquid, then B2’s prudent decision is like a run on B1 and causes a fire-sale of assets

• Bank 2 assets are safe (requiring low CAR under Basel for the individual bank) but are systemically important: they should NOT have a low risk weight


• This example shows the importance of interconnectedness of the different Financial Intermediaries (FI), not just banks, in the system

• One tool to identify this interconnectedness is the network approach (to be discussed in L-4 and W-1 of the course)

• Another approach is through the measurement of Co-VaR, co-movement of bank portfolio returns whenever another bank is under stress (a “tail risk” event, L-5 and W-2)

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An example from Hanson, Kashyap, and Stein (2011)

• Financial intermediaries (FI) amplify or magnify business cycles

• In the boom phase, asset values increase and so does equity (by a multiple), inducing pro- cyclical behavior (as in the FA + Firesales)

• Pro-cyclicality means borrowing more to take advantage of the higher value of assets (or quality of loans): the endogenous response of risk-taking is important

assets

equity

debt

assets

equity

debt

assets

equity

debt

increase in value of

securities Final balance

sheet increase in

equity

initial balance sheet

After q shock

new purchase of securities

new borrowing


• Hanson, Kashyap, and Stein (HKS, 2011) argue that the problem is not just with capital adequacy ratios (CAR) at the individual level per se

• The problem with the micro-prudential approach is with prompt corrective action (PCA): regulator does not care whether bank adjusts via the numerator (raise equity) or the denominator (lower assets)

Equity ECARAssets A

= =


• If bank adjusts by shrinking assets, causes fire-sale and/or reduction in lending to real economy

• Macro-prudential sup&reg objective then is to minimize the social costs of balance-sheet shrinkage (“fire sales” and “credit crunches”)

• This alternative theory of regulation does not rely on the existence of deposit insurance and suggests it has to be applied to more than just deposit-taking institutions

A Set of Macro-prudential Tools

• In line with their proposal to focus the regulatory system in restricting socially excessive balance-sheet shrinkage, HKS(2011) discuss six sets of tools that can be useful: 1. Time-varying capital requirements (in L-3) Higher (lower) in good (bad) times Exceed the market-imposed standard in bad times

2. Higher-quality capital (in L-2) Common equity better than preferred stock


3. PCA targeted at dollars of capital (not CAR) Relative to lagged assets As in the U.S. Supervisory Capital Assessment Program

4. Contingent Capital (in L-2) Contingent Convertibles Capital Insurance Economize on equity, requires regulatory “blessing”


5. Regulation of Debt Maturity and Asset Liquidity (L-2) Limit runs Contain fire-sale externality

6. Regulation of the Shadow Banking System (in L-8) Collapse of ABS market very damaging in this crisis Any institution that acquires ABS and funds them with

short-term debt Avoid “margin spirals” Impose similar capital requirement on a type of credit

exposure/asset (Geanakoplos, 2010)

Other Macro-Prudential Instruments

• There are a number of other macro-prudential instruments to be adopted – In the time dimension (in L-3) – In the cross-section dimension (in L-4, L-5)

• Also a number of different taxonomies (by BIS, IMF, others)

• We will discuss issues related to the effectiveness of some of these instruments, which have been already used in many EMs

Cross-border Bank Resolution

• Problem: LCFI operate globally but resolution regimes are guided by local legal framework

• “Living wills” would be very useful tool • IMF recently proposed a framework of

“enhanced coordination” to deal with problem • Ideally countries with major financial centers

would agree to the enhanced framework in the near future (in L-6)

C. Framework for Macro-Prudential Regulation and Supervision

• Macro-Prudential Sup&Reg is much harder in practice than in principle

• If somebody has to do it, is central banks • This may complicate monetary policy and

require broader objectives; models (in L-7) • Different countries are setting up different

institutional “architectures” to carry out this important function (in L-6)

Framework for Macro-Prudential Regulation and Supervision

• U.S. and E.U. have already established their systems, led by a “Financial Stability Oversight Council” (FSOC) and the “European Systemic Risk Board” (ESRB); others in EMs

• Both gather main regulators/supervisors with central bank officials

• In case of U.S., Office of Financial Research (OFR) has authority to request info from FI

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AThe E.U. new financial architecture ESRB in charge of macro-prudential policy recommendations

European Banking Authority

European Insurance and Occupational Pensions Authority

National supervisors (including supervisory colleges)

ECB National

Supervisors (non-voting) National

central banks

European Supervisory Authorities

European Commission

Macro-prudential oversight Micro-prudential supervision

European Systemic Risk Board European System of Financial Supervision

Representative of EU finance

ministries (non-voting)

European Securities and Markets Authority

Risk warnings Macro-prudential recommendations

EU-wide technical supervisory standards Coordination of supervisors (also in crises)

Rules versus Discretion

• Rules are desirable, especially to provide support in application during upswing and vis-à-vis powerful LCFI

• However, constrained discretion is probably the maximum one will be able to achieve

• To be successful, will need to be transparent and accountable

Final Thoughts

• Transparency can go a long way towards reducing systemic risk

• Tightening of micro-prudential is likely to push activities to non-bank financial intermediaries: macro-prudential policy needs flexibility and authority to regulate and supervise them

• International harmonization and cooperation (including info sharing) are critical

Thank you

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