Reforming international financial regulation

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This paper is part of a thought leadership series dedicated to ensuring Australia and its next generation of leaders remains fit for the future. Reforming international financial regulation details how regulation is being reformed internationally. The global economic downturn uncovered severe weaknesses in the international framework of regulation and it is paramount that Australia moves with best practice to ensure its regulation architecture remains viable. To achieve this there needs to be a subtle calibration between efficiency and stability – a delicate mix but critical to the future evolution of Australia’s financial services industry.
Australia will face many challenges in financial regulation over the coming decades. Reforming
international financial regulation represents a building block to a greater level of understanding of the international trends and how Australia is placed internationally.

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Reforming international financial regulation

  1. 1. Reforming international financial regulation
  2. 2. Access Economics has a long established reputation for The Institute of Chartered Accountants in Australia (the providing in-depth research and impartial analysis to aid Institute’s) is the professional body representing Chartered the development of sound public policy. Accountants in Australia. Our reach extends to more Founded in 1988, Access Economics is Australia’s than 55,000 of today’s and tomorrow’s business leaders, premier economic consulting firm, specialising in both representing some 44,000 Chartered Accountants and qualitative and quantitative economic analysis. Access 11,000 of Australia’s best accounting graduates who are Economics’ team of highly qualified and experienced currently enrolled in our world-class post-graduate program. consultants provides expert economic advice to Our members work in diverse roles across commerce business, government and industry groups. and industry, academia, government and public practice www.accesseconomics.com.au throughout Australia and in 107 countries around the world. We aim to lead the profession by delivering visionary thought leadership projects, setting the benchmark for the highest ethical, professional and educational standards and enhancing and promoting the Chartered Accountants brand. We also represent the interests of members in government, industry, academia and the general public by actively engaging our membership and local and international bodies on public policy, government legislation and regulatory issues. The Institute can leverage advantages for its members as a founding member of the Global Accounting Alliance (GAA), an international accounting coalition formed by the world’s premier accounting bodies. The GAA has a membership of 700,000 and promotes quality professional services to share information and collaborate on international accounting issues. The Institute is constituted by Royal Charter and was established in 1928. For further information about the Institute visit charteredaccountants.com.au Disclaimer This discussion paper presents the opinions and comments of the author and not necessarily those of the Institute of Chartered Accountants in Australia (the Institute) or its members. The contents are for general information only. They are not intended as professional advice – for that you should consult a Chartered Accountant or other suitably qualified professional. The Institute expressly disclaims all liability for any loss or damage arising from reliance upon any information contained in this paper. While every effort has been made to ensure the accuracy of this document and any attachments, the uncertain nature of economic data, forecasting and analysis means that Access Economics Pty Limited is unable to make any warranties in relation to the information contained herein. Access Economics Pty Limited, its employees and agents disclaim liability for any loss or damage which may arise as a consequence of any person relying on the information contained in this document and any attachments. Copyright A person or organisation that acquires or purchases this product from the Institute of Chartered Accountants in Australia may reproduce and amend these documents for their own use or use within their business. Apart from such use, copyright is strictly reserved, and no part of this publication may be reproduced or copied in any form or by any means without the written permission of the Institute of Chartered Accountants in Australia. All information is current as at May 2010 First published May 2010 Published by: The Institute of Chartered Accountants in Australia Address: 33 Erskine Street, Sydney, New South Wales, 2000 Access Economics Suite 1401, Level 14, 68 Pitt Street, Sydney, New South Wales, 2000 Reforming international financial regulation First edition Reforming international financial regulation ISBN: 978-1-921245-71-8 ABN 50 084 642 571 The Institute of Chartered Accountants in Australia Incorporated in Australia Members’ Liability Limited. 0410-32 ABN 82 113 621 361 Access Economics.
  3. 3. Foreword This paper is part of a thought leadership series dedicated to ensuring Australia and its next generation of leaders remains fit for the future. Entitled Reforming international financial regulation this paper is the second in a series of papers dedicated to broader economic thinking and engagement with Australia’s business community. The Fit for the future series is to bring together business, social, political leaders and thinking on key issues impacting Australia now and in the future. As a leader in the Australian accounting profession the Institute of Chartered Accountants in Australia (the Institute) has a role and responsibility to contribute to Australia’s public policy agenda. It is in this regard that we have teamed up with Access Economics to produce this paper. Reforming international financial regulation details how regulation is being reformed internationally. The global economic downturn uncovered severe weaknesses in the international framework of regulation and it is paramount that Australia moves with best practice to ensure its regulation architecture remains viable. To achieve this there needs to be a subtle calibration between efficiency and stability – a delicate mix but critical to the future evolution of Australia’s financial services industry. Australia will face many challenges in financial regulation over the coming decades. Reforming international financial regulation represents a building block to a greater level of understanding of the international trends and how Australia is placed internationally. The Institute is pleased to have worked with Access Economics on this paper and I trust that you will find it both interesting and thought provoking. Michael Spinks FCA President Institute of Chartered Accountants in Australia 3
  4. 4. Reforming international financial regulation
  5. 5. Contents Executive Summary .......................................................................... 6 1 Background .............................................................................. 9 1.1 Context for reform and Australia’s response . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 1.2 The proposed reforms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 1.3 The reform timeline ....................................................................... 10 1.4 Australia’s obligations and approach to reform. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 2 International regulatory reforms most likely to affect Australia ..................... 11 2.1 Capital and liquidity enhancements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 2.2 Leverage ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 2.3 Procyclicality measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 2.4 Systemic risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 2.5 Products and markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 2.6 Regulatory boundaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 3 How might Australia respond? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 3.1 Incorporate reforms within existing structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 3.2 Re-assign regulatory responsibilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 3.3 Selectively implement reforms ............................................................ 25 3.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 Appendix A Consultations .................................................................... 29 Appendix B International regulation standard-setters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Appendix C Outline of the proposed reforms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Appendix D Reform timeline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Appendix E Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Charts Chart 2.1 Ratio of private credit to GDP in selected countries ............................... 17 Chart 2.2 US private credit as a share of GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Tables Table 2.1 Lessons from past crises regarding appropriate levels of capital .................. 13 Table 2.2 ‘Skin in the game’ reforms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Table A.1 List of stakeholders .............................................................. 29 Table B.1 FSB members . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Figures Figure 2.1 Liquidity ratios ................................................................... 12 Figure B.1 FSB organisational structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 5
  6. 6. Executive Summary The Global Financial Crisis (GFC) showed that macroeconomic policy and prudential supervision are not sufficient to ward off systemic crisis in the international financial system. In the wake of the crisis, financial regulators and standard-setters are moving to tighten regulations and raise standards across the globe. This report identifies the main reforms under review and the challenge facing Australian authorities to respond appropriately. Capital and Proposed enhancements to capital and Australian banks are well capitalised under the liquidity liquidity standards will oblige banks current Basel II framework. Moreover, Australian enhancements to hold more capital and more liquid banks have raised extra capital (and notably high assets on their balance sheets. These quality Tier-1 capital) to further strengthen their changes will instigate widespread balance sheets. While the level and nature of the deleveraging and lower banks’ return proposed new capital requirements are not yet final, on equity. Consequently, the cost of Australian banks are well down the path to any new bank intermediation is expected to rise. standard. Similarly, liquidity requirements are already The wider spread between banks’ cost being tightened in Australia and should easily meet of funds and their lending rates (ie. any new standard proclaimed internationally. their net interest margins) will be paid by bank customers. Raising the cost of bank intermediation will slow global economic growth. Leverage ratio The proposed unweighted leverage An unweighted leverage ratio affects banks with ratio may alter international perceptions low-risk balance sheets, like Australia’s banks, whose of the capital adequacy of healthy balance sheets generally have large exposure to banks. The leverage ratio is intended to low-risk mortgages. The leverage ratio will show complement existing risk assessment these banks as under-capitalised relative to their models, targeting the problem of international peers when they easily meet APRA’s excessive leverage. However, not risk-weighted capital adequacy standards. Given being weighted to reflect the riskiness support for a leverage ratio from key international of a bank’s assets, the leverage ratio regulators, Australian authorities are working to represents a significant departure from influence the calibration of the ratio so that it does current supervisory practice. not penalise well-managed, low-risk banks. If these efforts are unsuccessful, Australian banks may face a higher cost of borrowing in global capital markets. Some of the resulting impact on Australian borrowers may be mitigated if the RBA targets a lower official cash rate over the business cycle. Procyclicality Procyclicality measures seek to equip APRA’s discretion over minimum capital requirements measures financial systems with regulatory effectively replicates aspects of the proposed ‘shock absorbers’ by requiring financial procyclicality measures, namely, building up capital institutions to build up capital reserves buffers in good times. However, introducing forward- in good times in order to sustain their looking provisioning and credit-linked capital buffers activities during the inevitable bad may not have a positive impact: the former may not times. dampen the credit cycle at all (as exemplified by Spain’s experience); while the latter may compromise the effectiveness of monetary policy – especially when the factors driving credit growth are beyond the RBA’s influence. In addition, investors may shy away from banks whose discretion to distribute earnings is constrained, making it more difficult and/or expensive for them to raise capital. The ability of Australia’s banks to raise equity capital during the GFC contributed to their resilience. Reforming international financial regulation
  7. 7. Systemic risk Mechanisms to address systemic risk Obliging financial institutions to reduce their size, remain conjectural at this stage. Many complexity and links to counterparties reduces and varied proposals have been brought systemic risk. However, there is a cost to be borne in forward. Regulatory options such as reduced economies of scope and potential sharing of structural reforms, taxes on size or risk across markets. Requiring institutions to plan for ‘living wills’ are likely to reduce the size their own demise or dismembering may force them and scope of financial intermediaries to re-assess their counterparty risks, and simplify and and stimulate the growth of ‘shadow reduce their exposures. But it may also induce them banks’. The net impact on systemic risk to move beyond the reach of prudential regulators, is arguable. which could be counterproductive. Australian regulators are amenable to measures for dealing with institutions that are systemically important. The ‘four pillars’ policy is an example. Yet, even with this policy in place, the moral hazard of institutions judged ‘too big to fail’ has been increased by moves to protect Australia’s banks during the GFC. Product Modifications of the securitisation Returns to originators from securitised issues will and market process along with the development of fall as a bigger share of the risks is retained and regulation rules and exchanges/clearing houses internalised through regulatory reforms, including for trade in Over-The-Counter (OTC) revised requirements for retaining ‘skin in the game’. derivatives are likely to reduce systemic This will increase the cost of raising funds through risk. There will be a cost to the issuer in securitisation, particularly for smaller banks and non- the form of reduced returns for a given ADIs. However, other measures are expected to have issue, and clearinghouse users will have a lesser impact owing to the relatively small size of to pay for their use of clearing/trading local markets for the more problematic OTC products systems. There is also a risk of reduced – such as CDS – and the Australian hedge funds innovation in OTC markets as contracts sector. In any case, ASIC is moving in advance of the become standardised, more commonly international timetable and initiatives, including those traded on exchanges and cleared relating to securitisation, due diligence and credit through central clearing houses. rating agencies. Some initiatives may be in place in Australia before international standards are set. Regulatory Re-defining the coverage and Recognising that systemic risk afflicts financial boundaries responsibilities of regulators at markets as well as intermediaries blurs the neat international and domestic levels will division of regulatory responsibility assigned in reduce opportunities for regulatory the Wallis Report. Moves to extend the reach of arbitrage and duplication of regulatory prudential regulation into the ‘shadow banking’ effort. The ‘twin peaks’ model system risks overlap between ASIC and APRA, and will become somewhat blurred as potentially leads ASIC into areas it is insufficiently procyclical measures combine elements resourced to perform. Independent moves by of monetary policy and prudential APRA to adjust capital requirements as part of regulation. Even product and market macroprudential policy potentially confuse and regulation will encounter this blurring conflict with the RBA’s countercyclical monetary effect if prudential regulation is policy. A review of coordinating mechanisms extended to cover securitised issues. among Australia’s financial regulators will be essential as part of the reform process. 7
  8. 8. Responding to the proposals There are three broad responses which Australia could make to the international reform agenda. Specifically, Australia could respond by: > Fully signing up to the reforms but carefully managing their implementation within the existing Australian regulatory structure > Re-defining regulatory responsibilities among Australia’s financial regulators to better reflect the revised approach to systemic risk management emerging from the FSB process > Explicitly repudiating some of the more interventionist proposals on the grounds that they are redundant in an Australian context or potentially compromise the discretion of Australian regulators. Australia needs to decide how to respond to the raft of initiatives likely to emerge from this complex process. There is Australia’s international reputation for sound and effective financial regulation to protect, as well as Australia’s obligations to the G-20 to consider. On the other hand, Australia’s national interest must be guarded when signing up to regulations which may, at least in some cases, compromise rather than enhance the integrity of Australia’s system of financial regulation. In the best case, Australia can accommodate the new requirements within existing structures. There is also the possibility, however, that the global standards oblige us to implement more fundamental changes than might be considered desirable or even necessary. For this reason, the option to reject some or all of the proposed changes should not be foreclosed or dismissed lightly. Reforming international financial regulation
  9. 9. 1. Background The Group of Twenty (G20) countries are reforming Australia is how to calibrate this balance so as to optimise the regulation of their financial systems in the wake of the performance of our internationally respected financial system. Global Financial Crisis (GFC).1 The GFC revealed significant weaknesses in the global framework of financial regulation. 1.1 Context for reform and Australia’s response While it is understood that periodic crises are an inherent Rapid contagion of stresses originating in the United States’ feature of financial systems, the global reach and impact of financial system was met with a co-ordinated response the GFC have forced authorities to re-think their approach from governments around the world. Political leaders from to the mitigation of systemic risks (Caruana, 2010). As a the G20 nations have since announced their intention to member of the G20, Australia will come under pressure to reform global financial regulation in the wake of the GFC. align our financial regulations with the emerging standards While Australia’s experience was benign by comparison with adopted internationally. that elsewhere in the world, our reliance on international The Institute of Chartered Accountants in Australia (the capital markets means that Australia has a vested interest in Institute) has commissioned Access Economics (AE): the robustness of the international financial system and its > To report on the deliberations to date of international regulation. Australian financial intermediaries and markets regulatory agencies and to identify high-priority issues rely on the soundness of their counterparties. The GFC was on their agendas for reform communicated to Australia through stresses experienced by these same counterparties. > To report on the likely responses of international regulators to these high-priority issues The G20 nations have transformed the former Financial > To identify how these responses potentially align or Stability Forum into the Financial Stability Board (FSB) conflict with policies already in place, or under active with a mandate to coordinate the international response to consideration, in Australia regulatory reform. There are a number of different agencies that set standards which individual countries then decide > To analyse the likely impact of proposed reforms on whether to adopt or not (see Sections 1.2 – 1.4 overleaf). The the Australian financial system. FSB comprises senior representatives of national financial The body of this report considers what international authorities (central banks, regulatory and supervisory regulators are most likely to do. The findings are based on authorities and ministries of finance), international financial desktop research complemented by consultations with institutions, standard-setting bodies, and committees of regulatory experts, industry specialists and academics as central bank experts (see Appendix B). well as domestic and international regulators. (A full list The FSB hopes its efforts will spark a ‘race to the top’ – of institutions consulted appears as Appendix A.) as more countries adopt its standards, others will face a The report distils its findings into six key areas considered stronger incentive to follow suit. A decision to stand aside most relevant to Australia (even if they are less relevant to from these reforms could risk a country being treated as a international players). The facts are presented in each area pariah or, worse, becoming a magnet for operators keen and then analysed, highlighting how the proposed reforms to locate where financial regulations are less stringent than align or conflict with policies already in place or planned international norms. Australia would be ill-served by either in Australia. Some comments on the likely timing of each of these outcomes. reform are included for completeness. Australia’s system of financial regulations is among the more The report concludes with an assessment of the options advanced in the world. This is one reason why preconditions open to Australia in responding to the reforms most likely for the GFC, including excessive leverage and lax bank to emerge from international deliberations. Ultimately, the lending standards, did not apply in Australia – at least not on impact on the Australian financial system will turn on how a systemic scale. Australia’s benign experience of the GFC the Australian regulatory authorities respond. has drawn international attention to the robustness of our In choosing their response, Australian authorities will be financial regulations and strengthened Australia’s reputation wise to recall that there is almost always a trade-off between for financial safety and soundness. efficiency and stability in any economic system. To the Hence Australia has much to lose from an inappropriate extent that increased regulation promotes systemic stability, response to the G20 initiatives. On the one hand, we would it generally comes at a cost in terms of lower economic sacrifice a well-earned reputation for financial probity if efficiency (both static and dynamic). The question for we stood aside from international reforms in the belief that 1. The term ‘Global Financial Crisis’ encompasses a sequence of events including the sub-prime mortgage crisis beginning in 2006 and gathering pace in 2007, a subsequent banking crisis, and the collapse of Lehman Brothers investment bank in September 2008. Observers generally regard the demise of Lehman Brothers as triggering the most dramatic phase of the GFC. 9
  10. 10. our system has already achieved ‘world’s best’ regulatory 1.3 The reform timeline practice. On the other hand, there is no evidence that our The sheer number of proposals under review plus the system of financial regulation needs a major overhaul to variety of stakeholders seeking input to the deliberations redress failures exposed by the GFC. Australia’s experience complicate the reform process and will inevitably slow in this regard, like that of a minority of countries including the rate of implementation. There will also be an extended Canada, India and Hong Kong, is precisely opposite to transition period given the weight and complexity of the that in the United States, UK and parts of Europe, most reforms in view. notably Ireland and Iceland. Nevertheless, Australia will Current activities of the international standard-setting benefit from reforms implemented in those countries whose agencies fall into three groups: financial weaknesses were transmitted globally, including to Australia. Failure to play our part in such global reform risks > Completing reviews of the coverage of existing regulations undermining initiatives elsewhere in the world from which > Ensuring that, at a minimum, FSB member nations have Australia stands to benefit. adopted 12 key international standards (that existed prior Calibration of Australia’s response to international financial to the crisis)2 reform calls for some subtlety. Our circumstances are not > Determining new regulations and policies. those of the major economies whose experience of the Details of these activities and the timetable for their expected GFC has been devastating. Yet, while Australia has developed completion dates are presented as Appendix D. through experience and good management an approach to financial regulation that is admired by many, we would not 1.4 Australia’s obligations and approach be well served by complacency. to reform This report lays out the main areas where international As a member of the FSB, Australia is obliged to implement reforms will challenge Australian authorities to devise an reforms agreed by the various standing committees and appropriately calibrated response. Rather than speculating to undergo peer assessment to check on implementation. on what that response might be, the focus is on calling A number of proposals have already been implemented in attention to the issues and how they might play out in practice. Australia or are well advanced in implementation. Other The range of possible responses the authorities might proposals may require Australia to make significant changes take as the reform proposals take shape is also identified. to existing regulatory practice. 1.2 The proposed reforms The approach of Australia’s regulators to implementing FSB reforms will determine whether regulatory changes achieve The international regulatory response coordinated by the desired improvements to the financial system. Our regulators FSB canvasses a wide range of proposals. Broadly speaking, are accustomed to consultation with stakeholders and this the reforms can be considered under four headings: will be vital if unintended consequences are to be avoided or > ‘Whole of system’ reforms relating to global cooperation, at least minimised. The field is fraught with the possibility of enforcement and monitoring (FSB being the lead misapplied reforms. standard-setter) > Reforms of regulations applying to financial intermediaries (BCBS being the lead standard-setter) > Reforms relating to the regulation of capital markets and instruments (IOSCO being the lead standard-setter) > Reforms relating to the regulation of professional services and ancillary support (IASB and IAIS being lead standard- setters for accounting and insurance, respectively). Details of the proposed reforms are presented as Appendix C. 2. The FSB has determined 12 Key Standards as critical to ensuring sound financial systems. They include standards relating to macroeconomic policy, data transparency, institutional and market infrastructure, and financial regulation and supervision. These standards have been developed by the IMF, World Bank, OECD, IASB, IFAC, CPSS, FATF, IOSCO, BCBS and IAIS. Reforming international financial regulation
  11. 11. 2. International regulatory reforms most likely to affect Australia The GFC showed that macroeconomic policy together with > Procyclicality measures – to reduce the amplitude of prudential regulation of individual financial institutions could the credit cycle and build buffers in excess of minimum not prevent the build-up of systemic risk. This gap in the requirements during good times regulatory framework allowed pressures to accumulate that > Systemic risk – limiting the capacity for failure of large ultimately disrupted the provision of financial services to or interconnected institutions to disrupt the provision of the global economy. The G20 countries have deemed that financial services to the broader economy macroprudential policy is required to fill this void. > Product and market regulation – to address information Essentially, macroprudential policy aims to help dampen asymmetries and incentives for excessive risk-taking that the credit cycle and increase the resilience of financial interfere with the capacity of financial markets to allocate systems in times of stress. The intention is to raise and lower capital efficiently, especially during times of stress capital standards applying to financial intermediaries in a > Regulatory boundaries – (re)defining regulatory countercyclical (‘leaning into the wind’) fashion. The G20 boundaries – cross-border, prudential, disclosure and Working Group 1 (2009) recommended a number of potential macroeconomic – to enhance the effectiveness of macroprudential tools and the BCBS (2009b, 2009c) has regulation and accommodate the increased reach of released consultative documents detailing the measures financial institutions and markets. most likely to be adopted. Working out operational aspects of macroprudential policy 2.1 Capital and liquidity enhancements is a challenge for international regulators. The G20 Working Group 1 (2009) finds a rules-based approach ‘attractive’ During the GFC financial institutions were more affected by but also recognises the value added by informed judgment. problems in capital markets than anticipated. The quantity The ‘rules versus discretion’ debate has a long history in and quality of capital held by financial institutions was monetary policy. It would be incongruous if the conventional insufficient to ensure that banks could continue to provide wisdom that monetary policy should be ‘rules-based’ but intermediary services to the economy. What began as a not ‘rules-bound’ should be tipped on its head in the realm credit crisis quickly morphed into a liquidity crisis and then of macroprudential policy. Moreover, the interaction of the a solvency crisis as banks financial positions weakened. proposed macroprudential tools with monetary policy is not Central banks and governments were required to provide well understood. In Australia’s case, where monetary and capital and liquidity to the market by buying toxic assets. prudential policy are administered by separate agencies, the In some instances governments became equity holders roles of the RBA and APRA may need to be re-cast. of private financial institutions or forced healthier banks to acquire unhealthy banks as a means of providing capital. The GFC revealed that systemic risk is pervasive and afflicts financial markets as much as financial intermediaries. Proposals Financial markets can suffer the equivalent of a ‘bank run’ The BCBS is seeking to improve the consistency, quality and since ‘asymmetric information’ is more ubiquitous than most transparency of capital held by financial institutions and to people thought. Consequently, improved product disclosure shore up their liquidity. To do this, it has proposed a multi- and market conduct regulation also feature prominently on pronged approach including: the reform agenda. The boundaries between prudential and > Redefinition of capital – In order to ensure greater disclosure regulation may also shift in the wake of the reform consistency and transparency in the determination of process with implications for the respective roles of ASIC capital requirements internationally, the BCBS is re-defining and APRA. Tier 1 and Tier 2 capital requirements and abolishing Tier 3 Against this background of international regulatory reform, capital. Of note is the new requirement that Tier 1 capital six key issues emerge for Australian regulators and those comprise common equity and retained earnings only, while they regulate. This list is informed by consultations with local structured capital (or ‘innovative hybrids’) are to be phased and international regulators and market professionals. The six out (currently at 15%) key areas of reform are: > Implementation of stronger risk-adjusted capital > Capital and liquidity enhancements – to raise the level requirements – Financial institutions will be required and quality of capital on an institutions’ balance sheets and to determine their capital requirements with respect to to shore up liquidity in order to better insulate the financial counterparty risk using stressed inputs. This is so that system from episodes of stress capital held is sufficient not only to meet counterparty > Leverage ratio – to cap the build-up of leverage in an default risk but also to address credit valuation adjustment institutions’ balance sheets so as to mitigate damaging risk. Further, stronger margining requirements are episodes of deleveraging and guard against model risk and proposed and longer time periods are to be used for measurement error in risk-based capital adequacy ratios determining whether regulatory standards are met 11
  12. 12. > Employing a Liquidity Coverage Ratio (LCR) and Net the standard ‘in name only’. This will reduce differences Stable Funding Ratio (NSFR) – These ratios will be between jurisdictions, for example, between the US and the used to provide an additional backstop for internationally EU where capital requirements are significantly different, and active financial institutions. The LCR requires institutions will assist the efforts of regulators to monitor global banks. to hold sufficient high quality, liquid assets to sustain a Implementing the new capital rules is likely to raise the 30-day market event while the NSFR, by contrast, seeks to cost of capital globally. Banks balance sheets may not have promote the longer-term resilience of financial institutions adequate capital currently (for example, many European by promoting more stable funding sources. banks only hold 2% risk-adjusted capital in total compared with Australian banks holdings of around 8%). To meet Figure 2.1: Liquidity ratios this higher capital standard, many institutions will have to deleverage or acquire more capital from traditional sources, Liquidity Coverage Ratio such as equity and sovereign bonds. Given that this will occur on a system-wide basis, it is reasonable to expect Stock of High Quality Liquid Assets the global cost of capital to rise. ≥ 100% Net Cash Outflows over 30-day Period If the global cost of capital increases, the rate of economic growth will slow. Businesses will access bank funding at Banks are expected to meet this requirement continuously and hold a stock of unencumbered, a higher interest rate, reducing the amount of debt they high quality assets as a defence against the can take on, and ultimately reducing the rate of economic potential onset of severe liquidity stress. expansion. The extent to which this affects a given jurisdiction will depend on the current capital held by banks, the capital required and the rate of transition required by Net Stable Funding Ratio the BCBS. The BCBS has indicated that it intends to begin implementation in 2011 and will finish by 2012; however, Available Amount of Stable Funding this timing is subject to the Quantitative Impact Statements > 100% Required Amount of Stable Funding (QIS) currently being completed by regulators in various jurisdictions, including Australia. The NSF standard is defined as a ratio of the available amount of stable funding to a required amount of In addition to capital adequacy requirements, liquidity stable funding. This ratio must be greater than 100%. requirements being considered by the BCBS will likely ‘Stable funding’ is defined as those types and amounts change the composition of financial institutions’ assets. of equity and liability financing expected to be reliable The BCBS is still determining what the appropriate definition sources of funds over a one-year time horizon under of high quality, liquid assets should be: conditions of extended stress. The amount of funding required of a specific institution is a function of the ‘... the Committee is assessing the impact of both a liquidity characteristics of various types of assets narrow definition of liquid assets comprised of cash, held, off-balance sheet contingent exposures, and/or central bank reserves and high quality sovereign paper, the activities pursued by the institution. as well as a somewhat broader definition which could include a proportion of high quality corporate bonds Source: BCBS (2009b) and/or covered bonds(BCBS, 2009b:7).’ Implications If a narrower definition is accepted, Australia may have The key implication for financial institutions is that more difficulty meeting this requirement from its domestic capital, more stress-testing and less opportunity for sources. It has been widely noted that the Australian regulatory arbitrage will exist under the new international government debt market is not deep enough to meet existing standards. This is expected to result in moves to strengthen criteria for liquid assets, as acknowledged by APRA last year: capital bases, including through deleveraging and buying risk-free sovereign bonds. If financial institutions need to ‘We are currently working with industry and the Reserve retain significantly more capital on their books, they will not Bank to find a pragmatic solution that reconciles the be able to lend as much. This may, in turn, induce a decline concern with the realities of Australia’s relatively small in global economic growth. Government bond market (APRA, 2009a:8).’ Greater consistency and transparency globally will reduce Conceptually, a wider definition of acceptable debt securities opportunities for regulatory arbitrage. The BCBS has been would solve the problem and Australian regulators are careful not only to define what types of capital are suited mindful of this in considering how international standards for each tier but also to specify the characteristics, so that might be implemented in Australia. institutions and more lenient regulators cannot implement Reforming international financial regulation
  13. 13. Examples The Bank of England (BoE) undertook its own retrospective stress-testing exercise to understand what levels of capital might be appropriate under a revised regulatory regime (see Table 2.1). The BoE’s work broadly suggests that capital requirements for Tier 1 may sit around 8%. Table 2.1: Lessons from past crises regarding appropriate levels of capital Source Description Capital requirement Past international financial crises (BoE calculations) Based on experiences of Sweden, 8.5% Tier 1 Finland, Norway and Japan Macroeconomic downturn scenario (BoE calculations) Stress-test variables include GDP growth, 9% – 10% Core Tier 1 CPI inflation and unemployment Turner Review (Financial Services Authority) Through-the-cycle fixed minimum 4% Core Tier 1 At the top of the cycle3 6% – 7% Core Tier 1 US stress tests (Federal Reserve) For 19 largest US banks to survive a 8.1% Tier 1 deeper and more protracted downturn than Consensus forecasts Source: Bank of England (2009) The impact in Australia would not be as severe since Australian banks already maintain stronger capital balances Australian banks are well capitalised under the current and meet APRA’s stricter requirements on capital definition. Basel II framework. Moreover, Australian banks have Nevertheless, some additional capital may need to be raised. raised extra capital (and notably high quality Tier-1 While Australian banks held around 8% Tier 1 capital during capital) to further strengthen their balance sheets. the GFC, the move to allow only equity holdings or retained While the level and nature of the proposed new capital requirements are not yet final, Australian banks are earnings as Tier 1 capital may reduce Tier 1 capital levels well down the path to any new standard. Similarly, to 4.5 – 5.7% for the major Australian banks (Takáts and liquidity requirements are already being tightened in Tumbarello 2009: 11). Australia and should easily meet any new standard APRA has already commenced a round of consultations on proclaimed internationally. a range of proposals consistent with the BCBS. These include proposals to broaden the coverage of its ‘going concern’ requirement to all ADIs, increasing its ‘name crisis’ time period from five days to one month (consistent with the LCR) as well as incorporating a three-month market disruption scenario for its stress-testing regime (APRA 2009, 3). 3. The Turner review explains that the dynamic capital mechanism ‘is expected to generate an additional buffer equivalent to 2%-3% of core Tier 1 capital at the top of the cycle’. However, ‘it should remain open to supervisors to require a further discretionary buffer above this’. 13
  14. 14. 2.2 Leverage ratio At this time, consultations are under way to refine the design Excessive leverage is the underlying source of asset price of the leverage ratio, including how it would work as a bubbles and was a major cause of the GFC. The build-up supplement to risk-weighted measures and how to adjust for in leverage in the banking system during the lead-up to different accounting treatments. In time the BCBS envisages the GFC occurred both on-balance sheet and off-balance moving towards a Pillar 1 treatment of the leverage ratio, sheet. The extent of the leverage and its implications for the ‘based on appropriate review and calibration’ (FSB, 2009c, stability of the banking system were not well understood BCBS, 2009b). – rapid financial innovation and the growth of the ‘shadow Implications banking’ sector obscured the extent of the exposure. The leverage ratio is intended to supplement risk-based As the GFC progressed, a clearer picture emerged of the capital measures, not to supersede them. Opposition is true nature of the exposure and the interconnectedness of strong in Europe but the European Union is considering financial institutions. This revelation raised concerns about the introduction of leverage ratios. Moving to a Pillar 1 the level of leverage to the point where banks came under treatment would facilitate the impact of the leverage ratio pressure from the market to deleverage, adversely affecting being incorporated into the calculation of the overall capital credit availability to the broader economy. The resulting requirement. This helps to ensure the leverage ratio does not sudden contraction in credit transformed what might have make overall capital requirements unreasonably high. It also been a mild economic downturn into a global recession. assists in controlling – via a capital buffer – for any effects of a leverage ratio on the procyclicality of capital levels. Proposals The BCBS recommends introducing a leverage ratio. If a leverage ratio is enforced, it will limit the build-up of It is intended to: leverage in the banking system by constraining individual institutions capacity to build leverage. It will not prevent ‘Put a floor under the build-up of leverage in the the market forcing complying banks to reduce their level of banking sector, thus helping to mitigate the risk of leverage below the standard. Nor will it address excessive the destabilising deleveraging processes which can leverage building up outside regulated entities. damage the financial system and the economy. The leverage ratio in its proposed form is likely to penalise institutions in jurisdictions that have adopted Basel II Introduce additional safeguards against model risk risk-weighted conventions, even though it is meant as a and measurement error by supplementing the risk supplement to the latter measures not as a replacement. based measure with a simple, transparent, independent Regulators in countries that have already adopted Basel II, measure of risk that is based on gross exposures including Europe and Australia, question the need for such (BCBS 2009b:7).’ a measure. The proposal has support in the US but is opposed by the Germans and France. Notably, the leverage ratio will not be adjusted for risk; A non-risk weighted leverage ratio is significant for Australian it will be calculated based on gross exposure, not net banks since they typically hold relatively high levels of home exposure; and derivatives and off-balance sheet items mortgages among their assets. The high quality of most of will attract a 100% credit conversion factor. these mortgages would not be recognised by an unweighted Most OECD countries use risk-based Basel II capital leverage ratio as proposed. In any case, the ratio will be measures. The US has been slow to adopt Basel II and is one difficult to ‘parameterise’ and the BCBS is seeking comments of the few countries to use a (non-risk based) leverage ratio. on how to reconcile the conflicting approaches of the risk- Advocates of a leverage ratio say it clearly shows the weighted and unweighted leverage ratios. maximum loss a bank can take on assets before running out The BCBS proposal for a leverage ratio does provide some of capital. Also, the risk-weighted approach of Basel I and II additional insurance against model risk and measurement has been blamed for contributing to the GFC, by promoting error. The GFC left many banks exposed to their off-balance capital arbitrage and the inappropriate use of derivatives sheet vehicles, through, for example, guaranteeing lines (Blundell-Wignall et al 2010:18). However, Basel II was not in of liquidity (eg. Bear Stearns). Some institutions that sold place at the outset of the GFC and has been improved as a protection using credit derivatives were left with crippling result of the testing times experienced in 2008-09. exposures (eg. AIG). Gross exposure is more transparent Critics of the leverage ratio say it does not take account of than net exposure, eg. for counterparty and operational risks the risks of different business models and funding sources, (eg. Lehman Brothers). creating a perverse incentive for banks to take on more risk. Reforming international financial regulation
  15. 15. Examples Blundell-Wignall, Wehinger and Slovikl (2009:21) provide an example of the impact of imposing a lower group leverage ratio upon a financial conglomerate comprising a commercial bank and an investment bank. They show that the riskiness of the conglomerate falls, but this does not eliminate contagion risk from the investment bank to the commercial bank. They also note that European banks have relatively low levels of capital and US banks have higher levels. The introduction of a leverage ratio would force significant capital raising or deleveraging upon European Banks – with attendant risks for credit availability and economic growth. Gros (2010) illustrates some of the limitations of the leverage ratio using the example of Deutsche Bank, which reports its balance sheet under both US-GAAP and IFRS. At the end of 2008, the IFRS version showed about €2 trillion of assets and the US-GAAP version showed €1 trillion. Equity was roughly similar, so the leverage ratio was halved by applying the US-GAAP treatment. Goldman Sachs’ leverage ratio at the time was around 15 under US-GAAP and 72 under IFRS.4 An unweighted leverage ratio affects banks with low-risk balance sheets, like Australia’s banks, whose balance sheets generally have large exposure to low-risk mortgages. The leverage ratio will show these banks as under-capitalised relative to their international peers when they easily meet APRA’s risk-weighted capital adequacy standards. Given support for a leverage ratio from key international regulators, Australian authorities are working to influence the calibration of the ratio so that it does not penalise well-managed, low-risk banks. If these efforts are unsuccessful, Australian banks may face a higher cost of borrowing in global capital markets. Some of the resulting impact on Australian borrowers may be mitigated if the RBA targets a lower official cash rate over the business cycle. 4. The SEC has announced a work plan that would delay transition for US companies to IFRS until 2014, although some companies may change before then (Reuters 2009). 15
  16. 16. 2.3 Procyclicality measures up capital buffers above the minimum requirement in Market participants tend to behave in a procyclical manner, good times, to be drawn upon in times of stress. A range expanding their balance sheets when liquidity is relatively of possible methods to achieve this is intended to be cheap and plentiful, and contracting their balance sheets provided to supervisors and banks when restrictive monetary policy starts to bite. This > Excess credit growth – excessive credit growth leading exacerbates volatility in the credit cycle. The financial system up to the GFC exposed the banking sector to large losses can amplify these tendencies rather than acting as a shock and amplified the downturn. The BCBS is in the early absorber (eg. through practices such as leveraging and stages of developing measures to ensure banks build up deleveraging, and potentially also through mark-to-market countercyclical capital buffers when there are signs that accounting). Despite the ‘Great Moderation’ of economic credit growth is excessive. growth and inflation in recent decades, credit growth has become even more volatile. Implications The measures proposed by the BCBS to counter Proposals procyclicality are intended to be complementary. The first The BCBS proposes to introduce a number of measures two measures address information asymmetry by providing intended to help the banking system counteract stakeholders with better estimates of banks’ exposures. destabilising, procyclical elements in the financial system. The other two measures aim to prevent banks’ financial The key objectives are to: positions from being compromised. Removing the cyclicality from the estimation of the PD ‘Dampen any excess cyclicality of the minimum should help to mitigate procyclicality of the credit cycle. capital requirement Under the Basel II framework, supervisors and banks Promote more forward looking provisions are already able to apply higher PDs. When APRA asks a financial institution to increase its capital – for whatever Conserve capital to build buffers at individual banks and reason – the prudential regulator is effectively substituting the banking sector that can be used in stress a higher PD to model the capital requirement. However, retaining discretion to choose between a downturn PD Achieve the broader macroprudential goal of protecting or a through-the-cycle PD may dilute the effectiveness the banking sector from periods of excess credit of the measure. growth. (BIS 2010b:7).’ Forward-looking provisioning, based on an EL approach, increases the stock of provisions when actual losses are low To achieve these objectives, the BCBS advocates adopting a and helps banks weather episodes of above-average losses. range of complementary measures to alter liquidity, capital This approach clearly is less procyclical than the IL approach. and loan-loss provisioning requirements when asset prices, Loan loss provisions should reflect all expected losses loan growth or leverage depart from their long-run trends. from existing loan portfolios. The rapid deterioration in the > Cyclicality of the minimum capital requirement – the credit quality of US sub-prime mortgages, and the resulting probability of default (PD) estimates used in calculating losses to investors in products securitised against portfolios banks capital requirements decrease during favourable of these assets, were features of the GFC. EL reduces the credit conditions, and increase when conditions sour. The volatility of bank income statements when actual losses BCBS is exploring the use of highest average PD estimates significantly differ from long-run norms. over the cycle and historical averages of PD estimates over An EL approach makes sense from an economic perspective time to replace procyclical PD estimates and a risk-management perspective but not necessarily > Forward-looking provisioning – current accounting from an accounting viewpoint. Accounting bodies produce standards require provisioning based on ‘incurred losses’ statements that allow investors to value a company at (IL). Prudential regulators and other stakeholders also a specific point in time. The BCBS has sought to secure require information on an institutions capacity to withstand support from the IASB for the shift to an EL approach. losses in the future. Consequently, the BCBS advocates Capital buffers can be built up either from internal sources moving towards an ‘expected loss’ (EL) approach (profits) or external sources (capital markets). The BCBS > Capital conservation – banks continued to distribute proposal constrains a bank’s discretion to distribute profits capital to shareholders and employees during the GFC to shareholders and employees when the bank’s capital even though it may have materially damaged their level falls within a buffer range above its minimum capital financial condition and, collectively, their actions may requirement. This helps prevent irresponsible distributions have weakened the resilience of the financial system. that compromise the financial health of a bank. It places A framework will be introduced to ensure banks build depositors’ interests ahead of those of shareholders, Reforming international financial regulation
  17. 17. creditors and employees. It would apply at a consolidated deregulation also may raise the average rate of credit growth level, although supervisors could also apply it to specific over the long run. parts of the group. Most monetary policy frameworks target a macroeconomic The restrictions on distributions are intended to be graduated variable, usually a measure of inflation, but allow central in such a way that the buffer range does not become a new banks discretion to consider other information in setting (higher) minimum capital requirement. However, it is not policy (interest rates). It is envisaged decision makers would clear how this would be achieved. The restriction will make enjoy similar discretion with capital buffers. banks less attractive to investors than companies in sectors Targeting credit growth may create tensions with inflation- without such restrictions. targeting monetary policy. Official interest rates are the Introducing a countercyclical element to calculating the primary tool monetary policymakers use to target inflation, capital buffer will help to reduce the amplitude of the peaks but they also affect credit growth. In times of moderate and troughs in the credit cycle. The BCBS proposes using economic growth and inflation, but excessive credit growth, macroeconomic variables as indicators of excessive credit the capital rationing implied by raising capital buffers is likely growth. The further the indicator variable deviates from its to constrain economic activity and place downward pressure long-run trend, the greater the impact on the size of the on inflation. The typical monetary policy response would capital buffer above the minimum requirement. Trend breaks be to reduce interest rates but this will increase demand for in official credit data complicate the issue. Innovation or credit and confound the objectives of the capital buffer. Examples Chart 2.1: Ratio of private credit to GDP in selected countries Ratio 2.5 2.0 1.5 1 0.5 0.0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 United States United Kingdom Switzerland Spain Germany Source: BoE (2009) The Spanish ‘dynamic provisioning’ model – provisioning for expected losses – for capital adequacy has been employed since 2000 and has received considerable attention (BOE, 2009). Chart 2.1 above shows that, despite employing procyclical buffers, the growth of private credit relative to GDP has not become obviously smoother in Spain. Nonetheless, dynamic provisioning may have contributed to the resiliency of Spanish banks during the GFC. 17
  18. 18. Chart 2.2: US private credit as a share of GDP Share of GDP 250 200 150 100 50 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 US Household and corporate sector US Financial sector Source: BCBS 2009a Then Federal Reserve Governor Ben Bernanke (2004) APRA’s discretion over minimum capital requirements famously remarked on the decline in macroeconomic effectively replicates aspects of the proposed volatility over the preceding twenty years and the prosperity procyclicality measures, namely, building up capital that it brought, noting that ‘writers on the topic have dubbed buffers in good times. However, introducing forward- this remarkable decline in the variability of both output and looking provisioning and credit-linked capital buffers inflation the Great Moderation’. For a central banker this may not have a positive impact: the former may not reduced variability in output and inflation indicated policy dampen the credit cycle at all (as exemplified by Spain’s success. The extreme growth of credit being created – as a experience); while the latter may compromise the share of GDP, credit doubled during the later stages of the effectiveness of monetary policy – especially when Great Moderation – was not seen as a sign that something the factors driving credit growth are beyond the RBA’s was amiss. Post-GFC, this dichotomy indicates additional influence. In addition, investors may shy away from banks measures need to be considered if policymakers wish to whose discretion to distribute earnings is constrained, return to the Great Moderation. (BCBS 2004). making it more difficult and/or expensive for them to raise capital. The ability of Australia’s banks to raise equity capital during the GFC contributed to their resilience. Reforming international financial regulation
  19. 19. 2.4 Systemic risk US investment banks may prefer to revert to their original The GFC highlighted the risks posed by systemically form to avoid the tougher regulatory regime and commercial important institutions and the high costs of dealing with banks may court riskier clients to replace their revenue- those risks. Systemic risks stem from the size and complexity generating proprietary trading desks. However, non-operating of institutions and their relationships with other parts of the holding company (NOHC) structures have been in use in financial system. These characteristics of ‘too big to fail’ Australia for many years and have wide acceptance, with institutions made them hard to handle during the GFC and major institutions operating banking, insurance and funds are presenting reformers with stiff challenges after the GFC, management arms. delaying agreement on reforms. Taxes on size are problematic as they require authorities to The FSB has proposed a variety of options to mitigate provide a transparent definition of systemic importance – the risks posed by institutions deemed too big to fail. and an implicit guarantee of institutions so defined. These are essentially aimed at: Moreover, some institutions that may not pose a significant systemic risk in normal conditions may suddenly become > Reducing the size and complexity of firms, by direct potentially toxic during periods of market turmoil regulation or providing incentives to institutions to (eg. Northern Rock). And cross-border banks may be change their structure systemically significant in some countries and not in others. > Enabling authorities to rapidly break-up or wind-down systemically important institutions, including across Living wills offer an alternative, one that can be applied to all national borders. financial institutions if need be, to avoid singling out those that may be too big to fail. Undertaking such an exercise can Proposals also help institutions to gain a better understanding of their In the US, calls to limit commercial banks activities reflect exposures to their counterparties. a view that government has a role in protecting depositors’ Examples funds, but should not bail out risk-taking investment banks The consequences of not having the right tools to deal and their ilk. The ‘Volcker plan’ would prevent commercial with the failure of a systemically important institution banks from taking stakes in hedge funds and private equity were illustrated during the GFC by the Lehman Brothers firms and limit the trading they do on their own books to bankruptcy. Attempts to find a buyer for Lehman Brothers meeting the needs of their clients (eg. for hedging). failed and the US Treasury did not have the power to close it Other proposals for tighter regulation of large firms and down. In an unprecedented move, the International Swaps supervision of non-financial firms, and giving the government and Derivatives Association held a ‘netting trading session’ power to shut down failing institutions, are also being pushed on a Sunday afternoon, ‘to reduce risk associated with a by President Obama’s team. In addition, imposing taxes on potential Lehman Brothers Holdings Inc. bankruptcy filing’ the largest US financial firms has been mooted. when US markets reopened on Monday. The existence of a In Europe, a different approach focusing more on supervision living will, for example, could potentially have expedited the and increased capital requirements is being advocated. In netting process, helped authorities to identify and ring-fence the long-run Europe is trying to encourage consolidation – other weak points in the system and reduced the panic including universal banking – across its 27 member states. selling of financial institutions’ shares that followed Lehman Brothers bankruptcy. In the UK, the FSA has pushed for banks to draw up ‘living wills’ and the most systemically important institutions to set aside extra capital. The FSB (2009c) also favours systemically Obliging financial institutions to reduce their size, important cross-border operations being required to prepare complexity and links to counterparties reduces systemic ‘living wills’. Australian regulators too are amenable to the risk. However, there is a cost to be borne in reduced idea of introducing resolution plans agreed in advance. economies of scope and potential sharing of risk across markets. Requiring institutions to plan for their own Implications demise or dismembering may force them to re-assess Measures that reduce the size or interconnectedness of a their counterparty risks, and simplify and reduce their financial institution will, by definition, reduce the systemic exposures. But it may also induce them to move beyond risk attaching to it. It is to be hoped that losses from the reach of prudential regulators, which could be shrinking banks (eg. economies of scale in back-office counterproductive. Australian regulators are amenable functions and in costs of raising capital), will not greatly to measures for dealing with institutions that are outweigh potential gains from reduced systemic risks. systemically important. The ‘four pillars’ policy is an example. Yet, even with this policy in place, the The implications are pronounced for US investment banks moral hazard of institutions judged ‘too big to fail’ forced to change their structures to holding companies has been increased by moves to protect Australia’s during the GFC in order to qualify for government funds. banks during the GFC. 19
  20. 20. 2.5 Products and markets These reports have advanced further regulatory proposals The GFC revealed that information asymmetry in capital which are now being assessed and coordinated by IOSCO, markets was far greater than generally assumed. As the along with the Bank for International Settlements’ Committee GFC progressed, some sectors of the market struggled on Payment and Settlement Systems (CPSS) and the OTC to allocate capital at all, let alone efficiently or rationally. Derivatives Forum. These recommendations include: While information issues affect all transactions in financial > Facilitating the standardisation of CDS contracts to assist markets to varying degrees, markets where the complexity the development of central counterparty (CCP) clearing of products or lack of transparency is prevalent – such as houses and to encourage industry initiatives to enhance securitisation and OTC derivatives – have received most operational efficiencies attention in international deliberations. > Developing an appropriate regulatory framework for CCPs Securitisation is an important innovation that reduces the as well as implementing it amount of capital lenders are required to hold to support > Monitoring of CDS to be made more transparent through their lending. It increases competition among lenders the collection of data including post-trade price, volume and allows a wider range of borrowers to access capital. and open-interest data which should be fully disclosed However, the GFC revealed that a lack of transparency > Encouraging the co-operation of national market regulators and incentive problems need to be addressed before to facilitate information sharing and co-ordination. securitisation can thrive again. IOSCO also plans measures to manage systemic risk arising OTC markets are where professional market participants in financial markets. These measures are yet to be disclosed. execute individually negotiated transactions, rather than the standardised contracts traded on exchanges. Thus Implications financial product innovation flourishes in OTC markets Both sets of reforms focus on reducing volatility in the and most of the derivatives used for hedging and insuring market and internalising risks in financial instruments. individual financial exposures are traded there. Despite This will reduce returns to originators of structured these benefits, the high losses associated with failed credit products and investors willing to hold the riskier tranches. default swaps (CDS) during the GFC revealed deficiencies However, it will also deliver benefits to the financial system in the transparency, counterparty risk and processing of by lowering systemic risk through improvements in transactions in some OTC derivatives markets. transparency and accountability. Proposals Realigning incentives along the securitisation supply chain A number of reports published overseas, including the and increasing transparency throughout the process will International Organisation of Securities Commissions help mitigate problems posed by asset-backed securities. (IOSCO) report (2009d) and the European Commission’s By requiring issuers and sellers to retain the riskiest portion De Larosière Report (2009), make recommendations of the issues, a strong incentive is provided to undertake regarding the reform of securitisation. Some of the principle better risk assessment before the product is issued. It recommendations include: should provide confidence to the market and build trust > Refining incentive structures at all points along the in the product. securitisation value chain by mandating ‘skin in the Improved disclosure enables investors to make better game’ for originators and improving transparency of decisions. It may come from within (greater investment all verification and risk assurance practices undertaken in in-house credit analysis) or without (improved ratings by the various parties methodology and better incentives for CRAs). It should > Requiring independence in the provision of professional result in products that are easier to understand, and hence services and advice more popular with investors and regulators alike. Such > Improving risk management throughout the process ‘plain vanilla’ products are likely to become favoured by encouraging the development of analytical tools assets for financial institutions required to hold more, for investors higher quality capital. > Revising investor suitability requirements and defining OTC derivatives will become more standardised as the what a ‘sophisticated investor’ is for each market proposals are implemented and risk will be reduced > Mandating continuous disclosure. as system infrastructure improvements allow greater Reforming international financial regulation
  21. 21. transparency and ease of monitoring. Introduction of force counterparties to standardise all instruments, capital CCPs will encourage a shift to electronic trading (which requirements will reflect whether counterparty positions are offers greater price transparency, faster, simpler trading, ‘on exchange’ or not, resulting in more innovative or tailored confirmation of trades and supervision), quicken the deals requiring a greater amount of capital. settlement process and netting of positions to reduce operational and credit risk, and reduce counterparty risk. Examples The imposition of new regulatory requirements and Preliminary indications of what might be involved with ‘skin platforms will involve costs, however. As with any exchange in the game’ requirements are shown in Table 2.2. In Australia traded platform, OTC market participants will have to pay to ASIC is yet to issue new guidelines to the securitisation trade on CCPs. Further, many current OTC products cannot industry. The Australian securitisation industry is expecting be standardised or will be less efficient for their users in IOSCO’s taskforce on unregulated markets to announce its a standardised form. While regulators do not intend to standard for ‘skin in the game’ in the near future. Table 2.2: ‘Skin in the game’ reforms Jurisdiction Restriction European Union Restriction on regulated credit institutions (the ‘buy’ side), retention of 5% of issue and four options as to how to achieve this. United States Restriction on regulated creditors/securitisers (‘sell’ side), 5 – 10% retention depending on credit underwriting standards. Australia (Australian Proposed that the originator/sponsor retain all tranches with credit rating of B or lower. Securitisation Forum) An expected loss approach would ensure the capture of unrated deals/tranches. Returns to originators of securitised issues will fall as a bigger share of the risks is retained and internalised through regulatory reforms, including revised requirements for retaining ‘skin in the game’. This will increase the cost of raising funds through securitisation, particularly for smaller banks and non-ADIs. However, other measures are expected to have a lesser impact owing to the relatively small size of local markets for the more problematic OTC products – such as CDS – and the Australian hedge funds sector. In any case, ASIC is moving in advance of the international timetable and initiatives, including those relating to securitisation, due diligence and credit rating agencies. Some initiatives may be in place in Australia before international standards are set. 21

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