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Rethinking Financial Stability

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Friday, October 13, 2017  03.22PM / By Andrew G Haldane, Chief Economist, Bank Of England 

Speech given by Andrew G Haldane, Chief Economist, Bank of England AND Co-authored with David Aikman, Sujit Kapadia and Marc Hinterschweiger; at the “Rethinking Macroeconomic Policy IV’ Conference, Washington, D.C.; Peterson Institute for International Economics on 12 October 2017 

In this speech, Andy Haldane, Chief Economist, focuses on financial stability. He begins by explaining how the global financial crisis has been a prompt for a complete rethink of financial stability and policies for achieving it. 


Introduction
The theme of this conference is “Rethinking Macroeconomic Policy”. When it comes to financial stability, that theme could hardly be more appropriate. The global financial crisis has been the prompt for a complete rethink of financial stability and policies for achieving it. Over the course of the better part of a decade, a deep and wide-ranging international regulatory reform effort has been underway, as great as any since the Great Depression. 

On cost grounds alone, a systematic rethink and reform of regulatory standards has been fully justified. While the costs of the global financial crisis are still being counted, it seems likely they will be the largest since at least the Great Depression. Two approaches are typically used to gauge these costs of crisis: the cumulative loss of output relative to its trend and the cumulative fiscal costs of supporting the financial system.. 

Let’s take these in turn. 

Chart 1 looks at the path of output relative to a simple measure of its pre-crisis trend in the US, UK, France and Germany after the Great Depression of 1929 and the Great Recession of 2008. In either case, it is debatable whether estimated “pre-crisis trends” were sustainable, as they may have been artificially inflated by credit booms. Nonetheless, it is clear that the output losses from both crises, relative to pre-crisis trends, have been extremely large and long-lasting. 

In the US, the level of output is currently around 13% below a continuation of its pre-crisis trend. Ten years into the Great Depression, output was around 28% below its pre-crisis trend. Even if not quite on the scale of the 1930s, the global financial crisis has imposed a huge opportunity cost on US citizens. In the UK, the losses since the Great Recession, currently at around 16% of pre-crisis GDP, are larger than in the US and indeed larger than those that followed the Great Depression. The crisis opportunity costs for UK and  euro-area citizens have been the highest for at least a century. 

Much the same picture emerges if we look at measures of the fiscal cost of crisis. Again, there are a number of methods for gauging this cost. But one simple metric is to look at the pattern of government debt-to-GDP ratios after the Great Depression and Great Recession, recognising that the larger part of the debt sustainability cost of crisis typically arises from the denominator shrinking than from the numerator rising. Chart 2 plots these debt-to-GDP ratios, again for the US, UK, France and Germany. 

It suggests that, in the decade after the Great Depression, levels of government debt relative to GDP had increased by around 28 percentage points in the US, 9 percentage points in Germany, but actually declined in the UK. Since the Great Recession, levels of debt relative to GDP have increased by, on average, 28 percentage points for the same set of countries. The fiscal cost of the Great Recession, at least on this metric, is larger than during the Great Depression. 

It is against this backdrop that policymakers internationally have engaged in a deep and wide rethink, rewrite and reform of the global regulatory rules of the game. Wide, reflecting the multi-faceted nature of the problems, market failures and market frictions exposed within the financial system during the crisis. Deep, reflecting the severity of the hit to balance sheets, risk appetite and economic activity that the crisis has inflicted and continues to inflict. 

The next section reviews these regulatory reform efforts and their impact on bank balance sheets and market metrics of banking risk. With a number of reforms yet to be fully enacted, it is too soon to be reaching definitive conclusions. Nonetheless, some of the key questions thrown up by these regulatory reforms - conceptual, empirical and practical - are now reasonably clear. We also have almost a decade’s worth of additional evidence and research on which to draw when assessing these issues. 

The following sections discuss some of those issues, drawing on new research and evidence: the calibration of regulatory standards, balancing the costs and benefits of tighter regulation; the overall system of financial regulation, balancing underlaps and overlaps, simplicity and complexity, discretion and rules; the impact of reforms on incentives in the financial system, in particular incentives to avoid regulation; and the evolving role of macroprudential regulation in safeguarding stability of the financial system. 

The financial system is dynamic and adaptive. So any financial regulatory regime will itself need to be adaptive if it is to contain risk within this system. In the terms used by Greenwood et al (2017), resilience needs to be “dynamic”. As past evidence has shown, too rigid a regulatory system will soon become otiose. And there are already calls, in some quarters and in some countries, for a rethink and rewrite of regulatory rules on which the ink is barely dry.3 This poses both opportunities and threats. 

The opportunities arise from the need to keep the regulatory framework fresh and agile. With the best will in the world, no one could say with certainty how the far-reaching and interwoven reforms to regulation over the past decade will precisely land. Judging how the financial system might adapt to future trends in financial technology is even harder to predict. As new evidence, incentives and innovation arise in the financial system, the opportunity is created for regulators to learn and adapt the regulatory framework (Carney, 2017a). 

Equally, there are also threats to financial stability from any process of change. History is replete with examples of regulatory standards being diluted or dismantled in the name of enhancing the dynamism of the financial system and the economy. To follow this course unthinkingly would risk repeating regulatory mistakes from the past, recent and distant. Only ten years on from the biggest crisis in several generations, there are already some eerie echoes of those siren voices. With that in mind, we conclude with some thoughts on issues which might be fruitful for future research on regulatory policy. 

International Regulatory Reform
There are already a number of detailed accounts of the regulatory reforms undertaken by international policymakers over the past decade (Carney (2017b), Duffie (2017), FSB (2017a), Greenwood et al (2017), Sarin and Summers (2017), Yellen (2017)). The following is a summarised and simplified account of the state of play. It partitions reform efforts into their microprudential and macroprudential components, recognising that the two often overlap and are usually mutually reinforcing in their impact. 

We focus here squarely on international banking regulation. We do not cover insurance regulation or international accounting standards. We do not discuss regulatory reforms undertaken nationally, such as the “Volcker Rule” in the US (Financial Stability Oversight Council (2011)) and the “Vickers proposals” in the UK (Independent Commission on Banking (2011)). Nor do we discuss international reforms of market infrastructure – for example, clearing – and financial market instruments (FSB (2017b)). Finally, we do not cover changes to banks’ large exposures regime and a range of pay and governance reforms. 

Microprudential Reform
Under the umbrella of Basel III, international reform of microprudential regulation has focused on four key areas: capital, leverage, liquidity and resolution. Taking these in turn:

Reform of risk-based capital standards has focused on increasing the quantity and quality of capital held by banks against their asset exposures. Minimum regulatory requirements for banks’ “core” (common equity) capital have been raised from 2% under Basel II to 4.5% under Basel III, even for the smallest banks. And allowable deductions to core capital have been reduced. On quality of capital, the types of financial instrument eligible as loss-absorbing capital (including for Tier 1) have been tightened considerably. For example, certain hybrid capital instruments are no longer eligible, as they were shown during the crisis to be incapable of absorbing loss in situations of stress (Tucker (2013), Moody’s (2010)). 

These reforms to capital standards have, encouragingly, been implemented in full by nearly all countries internationally (FSB (2017a)). Comparing regulatory capital, pre- and post-reform, is not straightforward. But taking together changes in both the quantity and quality of capital, it has been estimated that Basel III raised risk-based capital standards for globally systemic banks by a factor of around ten (Cecchetti (2015)). 

One of the new elements of the Basel III package was to supplement risk-weighted capital standards with a risk-unweighted leverage ratio. Because this measure does not require banks or regulators to form a judgement on the riskiness of banks’ assets, it is in principle simpler, more transparent and less subject to risk-weight arbitrage (Haldane and Madouros (2012)). Indeed, those were among the reasons a number of countries, including the US and Canada, had a leverage ratio regime ahead of the crisis.4 The Basel III leverage ratio, set at a minimum level of 3% Tier 1, is due to be implemented internationally by 2018. 

A second new element of the Basel III package was to augment solvency with liquidity-based standards. Banks’ liquidity has long been a pre-occupation of the Basel Committee (Goodhart (2011)). But it took wholesale liquidity runs on the world’s largest banks during the crisis to provide the impetus for internationally-agreed liquidity standards. Under Basel III, these take the form of a liquidity coverage ratio (LCR), designed to ensure banks have sufficient high-quality liquid assets to meet their 30-day liquidity needs; and a net stable funding ratio (NSFR), designed to ensure banks’ funding profiles are sustainable. The LCR has been implemented in full in most countries; the NFSR is due for implementation by 2018.5

During the crisis, a crucial missing ingredient from the financial regulatory architecture was found to be the ability to wind up financial institutions in an orderly fashion – that is, while minimising disruption to financial markets and the economy and without exposing tax-payers to risk (FSB (2014)). A number of measures have been taken or are in progress to fill this gap, including the introduction of more effective national resolution regimes for financial firms and greater cross-border co-operation and co-ordination when dealing with international banks in situations of stress (FSB (2017c)). 

Another element is to ensure banks have sufficient loss-absorbing liabilities which can be “bailed-in” in the event of failure, to prevent losses being shouldered by tax-payers. The Financial Stability Board has agreed standards for such Total Loss-Absorbing Capacity (TLAC) for global systemically-important banks (G-SIBs). These standards are to be phased-in over coming years, to reach a minimum level of 16% from 2019, and 18% from 2022, of the resolution group’s risk-weighted assets, as well as 6% and 6.75% on a leverage exposure basis, respectively. 

Macroprudential Reform
These new or augmented microprudential standards have been supplemented with a set of new macroprudential measures. These focus on safeguarding the stability of the financial system as a whole (Tucker (2009), Bank of England (2009, 2011)). The most significant of these reforms have focused on three areas: macroprudential capital buffers; stress-testing; and shadow banks. 

Historically, capital standards have been static requirements. As part of Basel III, a new time-varying component of banks’ capital was added – the counter-cyclical capital buffer (CCyB). This recognises that risks to the financial system vary over the credit cycle, typically being highest at its peak and lowest at its trough. The CCyB aims to counteract somewhat that time-varying risk profile, with additional capital required during the upswing which can be released during the downswing. There is international reciprocity in the setting of the CCyB to reduce incentives for cross-border arbitrage (BCBS (2010a)). The framework has been implemented in most jurisdictions. 

Similarly, one of the key lessons of the crisis was that some institutions impose greater degrees of risk on the system because of their size, complexity or interconnectedness (FSB (2010)). Basel III recognises the need for these systemically-important firms to carry a structurally higher capital requirement, currently of up to 3.5%, to help mitigate the additional risk they bring to the system. These capital add-ons apply to the 30 designated global systemically-important banks (G-SIBs) and the roughly 160 domestic systemically-important banks (D-SIBs), to be phased-in between 2016 and 2019. 

Stress tests were used by regulators before the crisis to assess whether banks had sufficient capital to withstand an adverse tail event. But these tests tended to be neither comprehensive nor transparent. In 2009, the US authorities undertook a comprehensive stress test of the major US banks and published the results. For banks failing the test, regulatory restrictions on their behaviour were imposed. For some people, this marked the turning point for the US financial system. A comprehensive annual stress-testing exercise is now undertaken in the US.6 More recently, the US has been joined by the UK and the EU, among others.

Finally, one of the striking features of the pre-crisis financial system was the emergence of the so-called “shadow” banking system. In the US, on some definitions, this grew to exceed in size the conventional banking system (Pozsar et al (2010)). Since the crisis, reform efforts have focused on two areas. First, specific reforms have been enacted to sectors which, during the crisis, were found to contain fault-lines - for example, Money Market Mutual Funds (IOSCO (2012)). Second, a framework has been put in place by the FSB to define and measure shadow banking entities, to publish data on them to enhance market discipline and to help authorities identify, and develop policy tools for mitigating, the risks they might pose (FSB (2013a)). The FSB have recently put forward a package of recommendations to address structural vulnerabilities from the asset management sector (FSB (2017d)).

Supporting this package of regulatory reforms, micro- and macroprudential, have been initiatives to boost the quantity and quality of reporting by financial institutions. These should help in pricing institution-specific risk by financial markets and ratings agencies. Notable initiatives have included: enhanced Pillar 3 disclosures by banks, covering all aspects of the regulatory reform agenda; and the work of the Enhanced Disclosure Task Force (EDTF), a private sector group established by the FSB. Over time, this has led to increased compliance with the EDTF disclosure template (Chart 3). 

Balance Sheet Impact
So what has been the impact of these regulatory reform measures on banks’ overall resilience? One simple set of resilience metrics focusses on bank balance sheet measures of solvency and liquidity. Comparisons of international banks’ balance sheets are made difficult by changes over time in both the definitions of variables and the sample of banks. We consider a panel of international banks, designated as either global systemically-important (G-SIB) by the FSB in 2016, or domestic systemically-important (D-SIB). This gives a panel of 30 G-SIBs and about 160 D-SIBs.8 For each bank, we consider two solvency-based metrics (leverage and risk-weighted capital) and two liquidity-based metrics (a simple liquid asset ratio and the ratio of loans to deposits). These measures do not map precisely to Basel definitions. 

Chart 4 looks at a measure of banks’ Tier 1 risk-weighted capital ratios. For both G-SIBs and D-SIBs in our sample, these have risen significantly over the past decade, almost doubling from around 7-8% to around 13-14%. A very similar picture emerges for leverage ratios (Chart 5). These have also roughly doubled over the past decade, from around 3% to around 6%. On these metrics, there has been a material strengthening in solvency-based standards among systemically-important banks over the past decade. This is also the case for measures of TLAC (see Chart 6 for a sample of UK banks).

Liquidity metrics show a similar pattern of improvement. For example, liquid asset ratios - high-quality liquid assets as a fraction of the total balance sheet – have risen from around 6% in 2008 to more than 8% (Chart 7), though the increase is more muted for D-SIBs. Meanwhile, the ratio of loans to deposits (LTD) has also improved, with lending backed by a larger share of stable sources of funding than before the crisis (Chart 8). 

Market-Based Metrics
A second set of metrics of bank solvency and liquidity focus on financial market perceptions of bank risk. There are a wide variety of potential such metrics, each with their own imperfections, including measures of default such as CDS spreads, bond yields and ratings; measures of volatility, such as option-implied volatilities; and measures of profitability, such as price-earnings ratios. These are summarised and evaluated in Sarin and Summers (2016). 

Chart 9 plots a measure of default – CDS spreads – for a panel of G-SIBs. It shows a familiar pattern of pre-crisis under-pricing of risk; a rapid re-pricing of default risk during the crisis; and a subsequent partial unwind. CDS spreads today sit roughly midway between their pre-crisis and mid-crisis averages.

Bank bond spreads and ratings tell a similar story. Assuming pre-crisis banking risk was materially under-priced, this evidence is consistent with regulatory reform having boosted the resilience of the global banking system. 

At the same time, measures of bank volatility and profitability have seen fewer signs of recovery. Chart 10 plots a measure of the price-to-book ratio of G-SIBs and D-SIBs. This currently lies well below its historic average and little different than unity. Put differently, if we used a measure of banks’ capital ratios using the market rather than the book value of their equity, this would suggest a far smaller degree of improvement in measured bank solvency and resilience (Chart 11), though the effect is less pronounced for D-SIBs. 

Sarin and Summers (2016) reconcile these market movements by appealing to the shifts in the franchise value of banks. Improved solvency standards have decreased the perceived default risk of banks. But coincident with lower risk are lower returns to banks’ activities, due to the combined effects of stricter regulation, misconduct fines, low levels of interest rates and increased competition. This leaves banks a riskier proposition for equity investors than before the crisis, as the residual claimant on profits. But, by and large, improved solvency standards have reduced risk among bond-holders and depositors in banks.  

“By and large” because, accompanying these changes in banks’ capital standards, has been a move towards putting losses from default onto bond-holders. This can be seen in the evolution of the implied “support ratings” given to banks by rating agencies. In 2010, holders of the major UK banks’ debt enjoyed around 4 notches of implied ratings uplift owing to expectations of government support (Chart 12). By 2016, that had fallen to less than one notch of support. A similar pattern is evident among other global banks. 

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Calibrating Regulatory Standards
Is the calibration of these new regulatory standards too tough, too lax or just right? That has been among the most animated of the regulatory debates over the past decade. One standard for comparison is historical experience. There has been a significant evolution in the levels of both capital and liquidity ratios of the major banks over the past century. Chart 13 plots a measure of the leverage ratio for the UK and US banking systems over a long historical sweep,10 while Chart 14 plots a simple measure of the liquidity ratio for UK banks over the past half-century (see also Jordà et al (2017)). 

Both solvency and liquidity ratios have exhibited a long, downwards drift. Between the end of the 19th century and the troughs prior to the financial crisis, leverage ratios fell by around three quarters in the US and the UK. Liquid asset ratios among UK banks underwent an even larger fall in less than half the time. Given the scale of these falls, even with the regulatory reforms of the past decade, levels of capital and liquidity in the banking system are at levels significantly below those 100 and 50 years ago, respectively. 

On the face of it, this gives grounds for questioning whether even these revamped regulatory standards are sufficient to withstand likely future shocks. We should, however, probably be cautious about jumping too quickly to that conclusion. Over the past century, there has been significant change in the structure of the financial system, including in the structure, scale and scope of financial regulation and the safety net. Those changes could mean that simple, historical comparisons of regulatory standards are misleading. 

Admati and Hellwig (2013) provide a comprehensive and lucid account of the case for higher capital standards. Their argument centres on the fact that the impact of higher capital standards on banks’ overall cost of capital needs to take account of the lower risk that arises from this shift - the Modigliani-Miller offset (Modigliani and Miller (1958)). It needs also to distinguish between any private costs to banks from tighter regulation and the social benefits this confers, with the latter the key public policy yardstick. 

When it came to re-calibrating regulatory standards for capital and liquidity after the crisis, international regulators engaged in a detailed, quantitative exercise which sought to weigh these social costs and benefits of tighter regulation, drawing on existing empirical evidence. The Long-Term Economic Impact (LEI) study, published by the Basel Committee in 2010, is a useful starting point for discussion of the appropriate calibration of regulatory standards (BCBS (2010b)). 

The main conclusion from this work was that, under conservative assumptions about likely economic costs, there were positive economic benefits to society from a sizeable increase in the capital banks were required to maintain. The study did not settle on an optimal level of bank capital. But the results presented were consistent with societal benefits peaking at a Tier 1 risk-weighted capital ratio of between 16-19%.11 This is north of most global banks’ current capital ratios. 

The range of published estimates in the LEI study reflected different assumptions about the persistence of the effects of crises on GDP, an area of particular empirical uncertainty in the academic literature. A contemporaneous study by Miles et al (2013) concluded that optimal capital requirements were likely to be higher – perhaps around 20% - if account was taken of the offsetting risk and cost of capital effects of higher solvency standards (the Modigliani-Miller offset). 


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About the Author
Andrew G Haldane - Chief Economist and Executive Director, Monetary Analysis, Research and Statistics at the Bank of England and is a member of the Bank’s Monetary Policy Committee. He also has responsibility for research and statistics across the Bank. Andrew has an honorary doctorate from the Open University, he is an honorary professor at the University of Nottingham, a visiting fellow at Nuffield College, Oxford, a member of the Economic Council of the Royal Economic Society, a fellow of the Academy of Social Sciences, and a member of the Research and Policy Committee at Nesta. Andrew is the founder and a trustee of Pro Bono Economics, a charity which brokers economists into charitable projects, and a trustee of National Numeracy. 

Andrew has written extensively on domestic and international monetary and financial policy issues and has published over 150 articles and four books. In 2014, TIME magazine named him one of the 100 most influential people in the world.  

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