The Cost & Effectiveness of Regulation

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Reforming the regulation of financial institutions and markets is critically important and should provide large benefits to society. The recent financial crisis underlined the huge economic costs produced by recessions associated with severe financial crises. However, adding safety margins and more complex financial regulations to the financial system comes at a price and can have predictable consequences.  The costs of this regulatory edifice are small if it improved regulators’ ability to avert future financial crises. Financial crises can be as costly as wars and waged with the weapons of the past.  The ideal for regulating a complex system is simplify the control framework and make sure the benefits of regulation outweigh the costs.

 

However, adding safety margins in the financial system comes at a price.  Most notably, the substantially stronger capital and liquidity requirements created under the new Basel III accord have economic costs during the good years, analogous to insurance payments.  There is serious disagreement about how much the additional safety margins will cost. The Institute of International Finance (IIF, 2011), bank lobbying group, project that the proposed reforms will reduce annual output in the advanced economies by approximately 3 percent by 2015. Official estimates, particularly those from the Bank for International Settlements (BIS), suggest a far smaller reduction.  The recent IMF recent Staff Discussion Paper, Estimating the Cost of Financial Regulation, by Andres Santos and Douglas Elliott (September, 2012) come closer to the BIS estimates.

 

The IMF study shows that financial reform will likely result in a modest increase in bank lending rates in the United States, Europe, and Japan in the long term. Higher safety margins in terms of capital and liquidity will lead to an increase in lenders’ operating costs, affecting bank customers, employees, and investors. Yet banks appear to have the ability to adapt to the regulatory changes without actions that would harm the wider economy. In response to the estimated rise in regulatory costs, average bank lending rates are likely to increase by 28 bps in the United States, 17 bps in Europe, and 8 bps in Japan in the long term. By comparison, the smallest increment by which major central banks adjust their short-term policy rates is 25 bps, which tends to have a small effect on economic growth. A simple framework is used to estimate the likely increase in lending rates. These rates reflect the cost of allocated capital, other funding costs, credit losses, administrative costs, and several other factors.

 

There are some important limitations to the analysis presented here. Transition costs are not examined, a number of regulatory reforms are not modeled, judgment has been required in making many of the estimates, the overall modeling approach is relatively simple, and regulatory implementation is assumed to be appropriate, not creating unnecessary costs.

 

Financial reform comes at a price. Higher safety margins, particularly in terms of greater capital and liquidity, do add operating costs for lenders. Those costs will be passed on, at least partially, to the wider economy. There is considerable uncertainty about the true cost levels, but the sensitivity analysis demonstrates that reasonable changes in assumptions would not dramatically alter the conclusions.

 

The relatively low levels of economic costs found here strongly suggest that the benefits in terms of less frequent and less costly financial crisis would indeed outweigh the costs of regulatory reforms in the long run, although this study does not attempt to estimate the economic benefits of the regulatory changes. Put another way, banks around the world appear to have a considerable ability to adapt to the regulatory changes without radical actions that would harm the wider economy.  The alternative outcome is a new financial crisis with severe wealth destruction, lost output and jobs.

 

For more on this, follow the link: www.imf.org/external/pubs/ft/sdn/2012/sdn1211.pdf

Risks on new Bank Capital Standards

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Bankers, policymakers and regulators continue to debate on the content of new bank capital requirements rather than setting global standards.  In the view of recent losses by JP Morgan and recent research reports calling for more bank capital, the need for global harmonization of standards takes on a new sense of urgency.

 

Nicholas Veron, in a recent VOXEU communique of May 4^th, The European Debate on Bank Capital is Not Just About Europe looks at the European experience.  European officials are deciding on the legislation to implement Basel III agreement on bank capital, leverage, liquidity and risk management. 

 

Officials, however, have severely underestimated the importance for reaching a global standard for financial regulation.  There are two unresolved issues in Europe: (1) the legislation’s departure from Basel III provisions; and (2) whether member states would be allowed to impose their own core requirements in regards to bank capital ratios. 

 

The first issue exists for both Europe and globally since it is about the definition of bank capital and how it should be applied to subsidiaries.  EU institutions regard global harmonization as overriding good, superseding misgivings about individual provisions or national authority.  Although, EU banking regulations are done at the national level and are not standardized creating a problem to see what is “liked” or “disliked”.  This makes the regulations vulnerable to special-interest groups. 

 

The crisis has changed the dynamics between the EU and global standards.  Institutions are now focused more on content than global harmonization.  This is complicated by a lack of a consistent approach by EU policymakers and the U.S. SEC’s delay in endorsing the proposed implementation schedule for global financial reform.  An American proposal that is compliant with Basel III would encourage EU and other doubters to comply. 

 

Global harmonization would help minimize competitive distortions inside the EU.  The main problem specific to the EU is that banking services remain under national authorities.  This results in a lack of a unified approach to bank supervision/resolution and pegs banks financial health to national authorities.  A more timely U.S. response combined with a unified EU approach could help reduce risk.

 

Although, Basel III requirements do not resolve all financial regulatory issues, a global harmonization of regulatory standards would be far better than our current fragmented system.  Perhaps the losses by JP Morgan Chase might force regulators to focus on implementation of a global standard.  The alternative of a fragmented regulatory environment could be costly.

 

For more on this simply follow the link: http://www.voxeu.org/index.php?q=node/7948

 

Risks from Reduced Asset Quality

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The financial crisis has raised concerns about sovereign debt sustainability has reinforced the notion that no asset can be viewed as truly safe. Recent rating downgrades of sovereigns previously considered to be virtually riskless have reaffirmed that even highly rated assets are subject to risks.  The notion of riskless assets—implicit in credit rating agencies’ highest ratings has created a false sense of security, especially as the demand for these assets increase while supply shrinks.

 

The International Monetary Fund Global Financial Stability Report (GFSR) Safe Assets: Financial System Cornerstone? (April 2012).  Report looks at the role of safe assets; the effects of different regulatory, pol­icy, and market distortions; and potential future pressure points.

 

Safe assets have varied functions in financial markets, including as a store of value, collateral in repurchase and derivatives markets, key instruments in fulfilling prudential requirements, and pricing benchmarks. Without distortions, safety is priced efficiently, reflecting demand-supply dynamics.

 

The demand and supply imbalances in global markets for top rated assets are not new. Prior to the crisis, current account imbalances encouraged safe asset purchases by reserve managers and sover­eign wealth funds. Now, demand is being driven by periods of uncertainty, the lack of clarity about regulatory reforms, increased collateral needs for over-the-counter (OTC) derivatives transactions and the use of such assets in central bank operations.

 

Conversely, on the supply side, GFSR report estimates the number of safe sovereigns may decline by $9 trillion by 2016, or 16 percent.  Shortages of safe assets could also lead to more short-term spikes in asset volatility, and shortages of liquid, stable collateral. If collateral became too expensive, funding markets would be compelled to accept lower-quality collateral, raising funding costs. The shrinking supply of safe assets, now limited to high-quality sovereign debt, coupled with growing demand, can have negative implications for global financial stability. It will increase the price of safety and compel investors to move down the safety scale as they scramble to obtain scarce assets. Safe asset scarcity could lead to more short-term volatility jumps, herding behavior, and runs on sovereign debt.

 

In the case of banks, the preferential treatment of sovereign debt in banking regulations can increase the use leverage. The upward bias to capitalization ratios can lead to overestimation of the capital buffer available during periods of market stress. Under current regulations, banks’ holdings of debt issued by their own governments—and in the case of the European Union, of the debt of any sovereign in the Union—are commonly assigned zero risk weights. 

 

To mitigate the risks to financial stability, policymakers need to strike a balance between flexibility, the soundness of financial institutions and the costs associated with a too-rapid acquisition of safe assets.  Specifically, the careful design of some prudential rules could help increase the differentiation in the safety characteristics of eligible safe assets and limit potential runs on individual types of assets.  On the supply side, desirable policies include improving fiscal fundamentals and encouraging the private production of safe assets through improved securitization practices.  These efforts can remove impediments that may inhibit safe asset markets from moving to a new price for “safety.”

For more on this follow the link:  http://www.imf.org/external/pubs/ft/gfsr/2012/01/pdf/c3.pdf

 

Systemic Risks in the Shadow Banking System

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

The role of alternative investments in the financial intermediation process has moved into the background as Basel III, Dodd-Frank and other proposed reforms are thought to solve all problems.  However, these reforms do not address all the issues, in particular the role of asset managers in the intermediation process and the role of derivatives.  Zoltan Pozsar & Manmohan Singh, two IMF economists, in The Nonbank-Bank Nexus and the Shadow Banking System (IMF Working Paper WP/11/289, December 2011) look at the role of asset managers.

 

The current view of financial regulation does not incorporate the rise of asset managers as a source of funding through the shadow banking system.  Asset managers are sources of demand for non-M2 types of money and serve as source collateral “mines” for the shadow banking system.  Banks receive funding through the re-use of pledged collateral “mined” from asset managers.  This has allowed asset managers to replace traditional creditors, primarily household retail deposits, as a key funding source to the banking system. 

 

In this process, asset managers, normally long-term investors, transform the maturity of the long-term assets into short-term liabilities (similar to bank retail deposits).  This follows the tendency to use these short-term liabilities to boost returns.  Asset managers receive cash collateral in return for the securities they loan.  It’s a gain for both parties since the cash they receive helps them to manage their funds liquidity needs (however they act like wholesale funds).

 

Using this methodology, the US shadow banking system reached $25 trillion in 2007 and declined to $18 trillion in 2010, higher than earlier estimates.  The authors suggest regulators incorporate the re-use of pledged collateral when defining prudent bank liquidity and leverage position ratios.

 

The lack of sufficient disclosure will become apparent during a period of a collateral crunch to the financial system (lack of acceptable collateral).  This will lead to greater funding stresses during a credit squeeze.  According to the authors, there was approximately US$ 5.8 trillion in off-balance sheet items of banks used for collateral mining and collateral re-use.  This is down from nearly US$ 10 trillion at the end of 2007.   The size of the number should be of concern, especially with events in Europe.

 

Monitoring the shadow banking system will warrant closer attention beyond current regulatory parameters.  Regulatory reform is focused on fortifying the equity base of the banking system and limit leverage through caps and capital adequacy requirements.  Pozsar and Singh note that the present framework of financial intermediation and data collection does not fully incorporate asset managers as funding sources for banks through the shadow banking system.  Non-bank sources of funding are thought to be sticky like retail deposits.  They note a number of weaknesses in current data availability: a broader definition of bank leverage, a breakdown of non-bank funding sources and a closer look at dealer’s ability to borrow and re-pledge collateral from various sources. 

 

They suggest an improvement in the current regulatory framework by increasing incentives for banks to move away from wholesale short-term funds into retail deposits and term funds.  Otherwise, the shadow banking system will fill the role, especially for riskier activities.  Other changes they suggest incorporating the unregulated shadow banking system more into Basel III and Dodd-Frank.  Lastly, making changes in the flow of funds data to incorporate derivatives, off-balance sheet transactions and breaking down short-term funding sources for better monitoring.  The use of off-balance sheet sources of funding should be included in risk management monitoring.  

     

For more on this follow the link: http://www.imf.org/external/pubs/ft/wp/2011/wp11289.pdf