Regulation since the Crisis:

What has changed and is it enough?

Howard Davies

Director, LSE ICEF Seminar

HSE Cultural Centre

29 November 2010

Six Topics

A. Global Regulatory ArchitectureB. European Regulatory ArchitectureC. Basel 3D. DerivativesE. Bankers’ PayF. Governance

A. Global Regulatory Architecture

The Pre-Crisis Architecture

Six Problems with the System

1. Complexity2. Built on the old three-sector model3. Unrepresentative membership4. US dominance5. No single European voice6. No authority or hierarchy

The Post-Crisis Architecture

B. European Regulatory Architecture

CoRePerAmbassadors (legislative)

FSC Financial Services

Committee

3L3 Committee

EFCEconomic

and FinancialCommittee

Council of Ministers(ECOFIN)

European Parliament

European CommissionCouncil Working Groups

(legislative)

Government Level

(Finance Ministries +Observers from regulatory level)

ESCEuropeanSecuritiesCommittee

ARCAccountingRegulatoryCommittee

EIOPCEuropean Insurance

and OccupationalPensions Committee

EBCEuropeanBanking

Committee

EFCCEuropeanFinancial

ConglomeratesCommittee

AURCAudit

RegulatoryCommittee

Regulatory Level

(Competent Authorities)

CESRCommittee of

European Securities

Supervisors

CEIOPSCommittee of

European Insurance and Occupational

Pension Supervisors

CEBSCommittee of

European Banking

Supervisors

IWCFCInterim Working Committee on

Financial Conglomerates

EGAOBEuropean Group

of AuditOversight

Bodies

Central Bank Level

Outside CommissionCommittee Framework

ECB

BankingSupervisionCommitteeof the ECB

EU: Pre-Crisis

Macro-prudential supervision

Micro-prudential supervision

Source: De Larosière Report, February 2009.

Members of ECB/ESCB

General Council

European Systemic Risk Board (ESRB)(Chaired by President ECB)

Chairs ofEBA, EIA& ESMA

European Commission

European System of Financial Supervision (ESFS)

European Banking Authority

(EBA)

EuropeanInsurance Authority

(EIA)

EuropeanSecurities and

MarketsAuthority(ESMA)

National BankingSupervisors

National InsuranceSupervisors

National SecuritiesSupervisors

+ +

Information on micro-prudential developments Early risk warning

EU: Post-Crisis

So now we have

- A more representative but (probably) less effective overarching body with highly diverse views

- The same complexity below- A little more discipline in the system

through the FSB, but with no new powers- A partial European reform- Weakened US leadership, but no

replacement for it

C. Basel 3

A capital shortage:

The charge:

The response:

Banks were allowed to operate with too little capital. Leverage grew, and revenues were inadequate to cover losses when asset prices fell.

‘Basel 3’ will triple capital in the trading book, outlaw ‘soft’ capital, increase capital backing for securitizations and strengthen balance sheets generally. BUT will the reforms damage the system and make credit scarce and too costly?

Bank Balance Sheets expanded

Source: Silverlake, Capital IQ.

Large-cap banks’ aggregate assets rose to 43x tangible book equity, 2000 – 2007

UK banks leverage grew sharply from 2003 onwards

Source: Bank of England, Financial Stability Report, Issue 24, 28 October 2008.

Major UK banks’ leverage ratio, %, 1998 - 2008

Note: Leverage ratio defined as total assets divided by total equity excluding minority interest. Excludes Nationwide due to lack of interim data.

10

15

20

25

30

35

2003 2004 2005 2006 2007

Leverage ratios, 2003 - 2007

Investment Bank leverage grew

Off-balance sheet vehicles: The Canary in the Coalmine

The charge:

The response:

Credit creation expanded off banks balance sheets, as banks took advantage of regulatory arbitrage opportunities to skimp on capital. Regulatory capital rules parted from the economic reality, as banks had to support these vehicles when they went under.

An economic approach, requiring on-balance sheet treatment of SPVs in future. BUT will this prevent any revival of the securitisation markets and thereby constrain credit unduly?

The growth of securitised credit

Source: The Turner Review. A regulatory response to the global banking crisis. March 2009.

Securitisation issuance trends in the UK, £ Billion, 2000 - 2007

ProcyclicalityThe charge:

The response:

The capital rules tended to accentuate the cycle, allowing banks to hold less capital as asset prices rose, as back-testing revealed low losses and loss given default over previous years.

Macro-prudential requirements – which will allow regulators to tighten capital in anticipation of price bubbles bursting – ‘leaning into the wind’. Stress-testing. BUT how do we know when there is a bubble? Why not use interest rates ?

a. Tier 1 Capitala1. BASEL II:- Tier 1 Capital Ratio = 4%- Core Tier 1 Capital Ratio = 2%- The difference between the total capital requirement of 8% and the

Tier 1 requirement can be met with Tier 2 capital

a2. BASEL III:- Tier 1 Capital Ratio = 6%- Core Tier 1 Capital Ratio (Common Equity after deductions) = 4.5%- Core Tier 1 Capital Ratio (Common Equity after deductions) before

2013 = 2%, 1st January 2013 = 3.5%, 2014 = 4%, 2015 = 4.5%- The difference between the total requirement of 8% and the Tier 1

requirement can be met with Tier 2 capital

b. Capital Conservation Bufferb1. BASEL II: - No Capital Conservation Buffer

b2. BASEL III:- Banks required to hold a Capital Conservation Buffer of 2.5%

to withstand future stress bringing the total common equity requirements to 7%

- Capital Conservation Buffer will be met with common equity- Capital Conservation Buffer before 2016 = 0%, 1st January

2016 = 0.625%, 2017 = 1.25%, 2018 = 1.875%, 2019 = 2.5%- The purpose is to ensure that banks maintain a buffer of capital

to absorb losses during periods of stress. When regulatory capital ratios approach the minimum requirement, constraints imposed on earnings distributions

c. Countercyclical Capital Bufferc1. BASEL II:- No Countercyclical Capital Buffer

c2. BASEL III:- A Countercyclical Buffer within a range of 0% – 2.5% of common

equity or other fully loss absorbing capital will be implemented according to national circumstances

- Banks with a Capital Ratio lower than 2.5% will face restrictions on payouts of dividends, share buybacks and bonuses

- Phased in from January 2016 to January 2019- Countercyclical Capital Buffer before 2016 = 0%, 1st January 2016 =

0.625%, 2017 = 1.25%, 2018 = 1.875%, 2019 = 2.5%

d. Capital for Systematically Important Banks only

d1. BASEL II:- No explicit Capital for Systemically Important Banks

d2. BASEL III: - Systemically Important Banks should have loss absorbing

capacity beyond the standards. Work continues in the Financial Stability Board and the Basel Committee

- The Committee and the FSB are developing an integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingent capital and bail-in debt

D. Derivatives

“There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped make the banking and overall financial system more resilient.

The improved resilience may be seen in fewer bank failures and more consistent credit provision. Consequently the commercial banks may be less vulnerable today to credit or economic shocks.”

IMF Global Financial Stability Report

April 2006

Derivatives: The Problem

1. The capital value of global derivatives peaked at $760 trillion in June 2008 (equals last 20 years of global GDP!).

2. Derivatives, supposedly designed to spread and diversify risk, created new risks and caused financial instability.

3. The complexity of products was impossible for regulators, customers and even originators to understand.

4. Opacity created additional risks: when the crisis hit, no one knew who held the losses.

Derivative volumes quadrupled in five years

OTC derivative volume by product type, volume ($ Trillion), Jun 2003 – Jun 2008

Source: The Turner Review. A regulatory response to the global banking crisis. March 2009.

Derivatives: Solutions

1. More capital in the trading book against derivative exposures (see Basel 3).

2. Central Counterparty (CCP). New margin requirements, standardised contracts.

3. (US) Dodd-Frank requires banks to move (some) derivatives out of banks.

E. Bankers’ Pay

Bankers’ Pay: Problems

1. Moral hazard: If the bank is profitable, the managers earn huge amounts, if it fails, the taxpayers pay: Heads they win, tails we lose.

2. Pay incentives drive risk-taking behaviour which can reward individuals in the short-term, but cause the bank losses in the long term.

3. Bankers are simply paid too much.

Bankers’ Pay: Solutions

Different regimes have been introduced by country:

- EU: 60% of bonuses deferred for 3 – 5 years. Retention period for share-based incentives. Upfront cash capped at 20%.

- UK: Additional proposals for disclosure of high earners’ pay. Bonus tax.

- US: No detailed rules. 75% in shares for senior executives.

Why are bankers paid so much?

- Lack of competition?- Winner takes all?- Insider dealing?- Opacity?

F. Governance

Financial Institutions Management and Governance: Problems

1. Bank boards did not understand the risks they were taking on.

2. Bank directors were often too old and too ignorant.

3. Risk management was undervalued.

Financial Institutions Management and Governance: Solutions

1. (UK) Bank directors interviewed by the FSA and assessed for competence.

2. (UK and US) Board-level risk committees now established.

3. Chief Risk Officers report to CEOs.

4. Regulators attention focussed on risk management.

Is it enough?The ‘plumbing’ of the financial system and its regulation has

been overhauled, but problems remain:

Highly complex regulatory structure with no central authority.

Many conflicts of interest. Regulators still struggle to catch up with markets. Global imbalances, which were at the heart of the crisis,

persist.

Regulation since the Crisis:

What has changed and is it enough?

Howard Davies

Director, LSE ICEF Seminar

HSE Cultural Centre

29 November 2010