The collapse of Lehman Brothers and bailout of AIG demonstrated how inadequate financial regulators had been in their oversight of the financial system. Since then, banking regulators have been working vigorously to develop policies that provide greater protection against systematic risk. With over 400 banks failing in the United States in the past four years and the recent bankruptcy of a major financial institution like MF Global, the efficacy of these reforms is a concern to world leaders, banking supervisors, and the public at large. This paper outlines the major policy issues and challenges that banking regulators need to address to mitigate systematic risk. It provides a background on the sources of banking failures and the immediate policy response for context.
The global financial crisis (GFC) did not begin with the collapse of Lehman Brothers. There were many precursor policy decisions and events that resulted in the GFC occurring. The creation of asset bubbles, weakening of regulation, and excessive focus on short-term metrics, leverage, and interconnectedness of global institutions all contributed to the GFC.
In retrospect there were clear signs in the early part of the decade that the US was heading from the Dot Com Bubble to a housing bubble. However, beyond a small and sophisticated investor group, many bought into the notion that investment in real estate was low risk activity. This belief stems in part due to cultural convictions (i.e the “American dream”) but also as a result of rising house prices since the late 1980s. The origins of this bubble can be traced to the Tax Reform Act of 1986, which made mortgage interest tax deductible. This policy tool was designed to encourage home ownership; however it also reinforced the idea that home ownership was the best way to enhance wealth. The increased demand for housing resulted in the consolidation of wealth into housing. Many consumers started to believe that housing prices would rise indefinitely and started to use the debt and equity of their homes to finance unsustainable life styles.
Simultaneously, there was an increasing trend towards financial deregulation. The collapse of the Soviet system reassured Americans that the market system allowed for the greatest efficiency and that regulation inhibited this efficiency. Thus, legislation like the Glass-Stegal Act, which had separated commercial banking from investment banking, was repealed through the Gramm-Leach-Billy Act. To enhance return on equity (ROE), commercial banks took on additional risk through financial engineering and lowering lending standards.
These two factors led to the development of subprime lending policies. Consumers were offered mortgages with low initial interest rates that ballooned later in the mortgage term. Many of the consumers who made use of these mortgages had poor financial literacy and were unaware of the downside risk to their actions. They were sold on the American Dream and entered into mortgage agreements with little money down and low interest rates, not realizing that they would later have to carry their debt at a much higher interest rate. Additionally, institutions were incentivized to sell mortgages, but had no responsibility in ensuring the credit quality of their customers. This resulted in the issuance of mortgages to people with less than ideal credit scores, who were now being qualified to buy houses they could not afford.
These subprime mortgages were bundled with prime mortgages and securitized by the banks and sold to other financial institutions. This was advantageous for the banks for two reasons. Firstly, it enhanced the banks’ return on equity (which in turn increased the year-end bonuses of senior management). Secondly, it allowed banks to move the mortgage liabilities off the balance sheet. Tranches of mortgage-backed securities were further bundled and resold as Collateralized Debt Obligations (CDOs).
These CDOs, which had a mix of prime and subprime mortgages, were rated by agencies like Moody’s and Fitch. Often the products were rated as investment grade. It was believed that the financial engineering during the securitization process sufficiently diversified the nonsystematic risk away. However, the rating agencies were unable to adequately assess risk, which may have been due to rating’s agencies being limited by resources, since demand for ratings increased with the prevalence of financially engineered investment products. Alternatively, it could have been a result of the conflict of interest that exists when companies that want to sell investment products hire the rating agencies.
Through financial innovation, investors could purchase insurance for their CDOs by purchasing a Credit Default Swap (CDS). Originally intended to mitigate counterparty default risk, the CDS had evolved into a put/call option that allowed external stakeholders to place a bet on a particular institution’s ability to repay its debt. Banks, financial institutions, hedge funds, and insurance companies all bought and sold CDSs to hedge their risk, and also to opportunistically capture upside potential from debt defaults.
As mentioned previously, financial institutions were seeking ways to enhance return on equity, for example, by increasing leverage. Thus, many banks started to use additional leverage to enhance their ROE. In addition, many senior managers were driven to enhance short-term financial performance as their compensation packages often included stock options. The issuance of stock options to executives is a relatively recent phenomenon, gaining widespread acceptance since the late 1980s, and was an attempt to minimize the principal agent problem. These two factors led management to excessively focus on the short term.
Lastly, as companies became increasingly more international, they required banking services that were consistent and available globally. To meet this need, banks expanded their global operations and interconnectedness.
Thus, when there was a rapid rise in energy prices in 2007, many Americans consumers realized the extent to which their debt burden was leveraged. This resulted in reduced consumption and an increase of mortgages in arrears and nonpayment. With an increasing numbers of houses falling into bank receivership, banks started to realize that the off-balance sheet liabilities (mortgage backed securities) were incurring real losses. Due to the complex financial engineering involved in creating mortgage-backed securities, it became extremely hard to determine how exposed a particular bank was to subprime mortgage losses. Investors in mortgage-backed securities saw the value of these investments fall dramatically. Thus, Lehman’s collapse was not simply a result of its inability to cover its trading losses, but was also a tangible manifestation of the how the financial regulatory system had failed.
The immediate policy response to the Global Financial Crisis was to insure that global financial system did not collapse. Thus, countries like the US, Canada, UK, and China took coordinated actions to protect the global financial system. In the US, the government nationalized banks and companies like AIG and GM to recapitalize them. It created a $700 billion loan facility through the Troubled Asset Relief Program (TARP) to ensure that there was liquidity in the system. Other countries adopted a combination of similar measures to protect their respective financial systems.
Longer Term Policy Response
Although there has been increased supervision of the financial services sector, in particular relating to incentive pay of employees of financial institutions, many of the contributing factors are still being addressed. Over the past few years, new regulatory requirements have been developed to enhance bank capitalization. In addition, new legislations and rules have been published to enhance investor confidence. There has been an attempt to standardize and make OTC derivatives more transparent, reduce the reliance on credit rating agencies, and to better manage systematically important financial institutions.
At the height of the GFC, banks and financial institutions stopped lending to each other and started hoarding cash. Banks were unable to determine how much sub-prime exposure they had on their balance sheets and were afraid that counterparties would default.
The Basel Committee on Banking Supervision has attempted to address this issue by defining new banking standards. The new banking standard is known as Basel III and attempts to increase the resilience of banks. It does this through several mechanisms. Firstly, it attempts to provide a global standard for liquidity. Secondly, it introduces the leverage ratio as a complement to the risk-based Basel II framework. The leverage ratio protects against risk that may have been underestimated by financial regulators and financial institutions (Carney, et al., 2011).
Thirdly, it raises the quantity, quality consistency, and transparency of the Tier I Capital Base. The new minimum Tier 1 Capital requirement is 6% with at least 75 percent that must be tangible common equity and the remaining 25 percent true loss absorbing capital. Previously, the Tier 1 requirement was 4% but only half of that 4% had to be tangible common equity (Carney, et al., 2011).
Lastly, Basel III introduces two new concepts. The first idea is a capital conservation buffer of 2.5 of risk-weight assets, which is above the minimum capital requirements. The capital conservation buffer enhances a banks ability to absorb losses during a period of stress. The conservation buffer will be complemented by a countercyclical buffer. The countercyclical buffer would vary over time (Carney, et al., 2011).
Basel III attempts to remedy the issues that were experienced during the GFC. However, there are two points to note. Firstly, it took almost ten years to develop and adopt Basel I, more than 5 years to develop and adopt Basel II, and less than 3 years to develop Basel III. Thus, due to the rapid policy development and implementation, there may be unanticipated consequences of Basel III that will need to be resolved as new challenges arise. Secondly, the implementation of Basel III is set to begin in 2013 and to be completed by 2017.
The United States was one of the first countries to attempt reforming financial regulation through legislative means. The Dodd-Frank Law was passed into law in 2010. The United States provides a prime example in how difficult harmonizing national regulations can be. Although the global financial crisis emanated from the United States, and the Obama administration and Congressional Democrats have made financial regulatory reform an important part of their political agenda, the rise of the Tea Party has made implementation of the Frank Dodd bill very difficult. The Dodd-Frank Law provided the legal framework for the overhaul of the US Financial System. However, congressional Republicans have mired implementation of Dodd-Frank with new bills intended to dismantle it. If Republicans are successful in implementing these bills, the efficacy of the Dodd-Frank Bill in preventing future financial crisis will be reduced.
Additionally, legislators and regulators have been disagreeing on interpretation of the law. As an example, the Volcker Rule in the Dodd-Frank Bill prohibits banks from proprietary trading. This simple rule has resulted in a 298 page effort on how to apply this rule by the regulator (Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds, 2012). This suggests that there are substantial challenges in interpreting and implementing the Dodd-Frank Bill at a regulatory level. Finally, harmonization of national regulations across G20 participants is important to minimize arbitrage opportunities. As an example, in the US there are new commodities rules on position limits for 28 commodity items. If these position limits are not implemented in other jurisdictions, arbitrage opportunities can possibly emerge.
OTC Derivative Market Reforms
At the G20 summit in October 2011, world leaders asked the Financial Stability Board to lead the process to reform Over the Counter Derivative trading. The FSB and IOSCO were tasked to develop standards for OTC derivatives by June 2012. In February 2012, IOSCO issued a press release stating that the final report on Requirements for Mandatory Clearing had been issued. The report outlines the recommendations for authorities to follow in establishing a mandatory clearing regime for standardized OTC derivatives in support of the G20 Leaders’ commitments. Although progress has been made and the standards should be in place by June 2012, it remains to be seen how effective financial institutions will be in implementing the new regulatory requirements.
Credit Rating Agencies
A 2010 FSB Report on credit rating agencies advocates less widespread dependence on their ratings (Principles for Reducing Reliance on CRA Ratings, 2010). The report outlines three principles. Principle 1 articulates a reduction in the reliance of credit rating agencies and the development of alternative standards of creditworthiness. Principle 2 advocates for regulation that is designed to encourage markets that are less reliant on CRA ratings and that private sector risk management practices should develop appropriate risk measurement techniques. Finally, the third principle outlines how Central Banks can engage in prudential supervision and reduce their reliance on credit rating agencies. The third principle also describes into how banks, financial institutions, and investment managers can adopt more appropriate measures to determine creditworthiness. Since this report there have no new further policy announcements.
A 2010 FSB Report provided suggestions on how to address the “Too Big to Fail” issue. There were six major recommendations report:
Financial regulatory reform is a topic of intense interest after the Global Financial Crisis of 2008. World leaders, media, and the public have advocated for more stringent regulations, domestic and international, to ensure that this kind of financial crisis doesn’t occur again. The financial crisis was caused by financial institutions taking on excessive risk, the emergence and prevalence of complex over-the-counter (OTC) and derivative financial products. Furthermore, the inability of credit rating agencies to accurately assess the riskiness of these products, the collapse of the US housing market, and the undercapitalization of Systematically Important Financial Institutions (SIFIs) were also contributing factors of the financial crisis. Although some of these issues have been addressed, the collapse of MF Financial and the ongoing European Sovereign Debt Crisis demonstrate there is still much to be done to improve our financial system.
Carney, M., Tucker, P., Hildebrand, P., de Larosiere, J., Dudley, W., Turner, A., et al. (2011). Regulatory Reforms and Remaining Challenges. Retrieved from Group of 30:http://www.group30.org/images/PDF/ReportPDFs/OP81.pdf
Principles for Reducing Reliance on CRA Ratings. (2010, October 27). Retrieved from Financial Stability Board: http://www.financialstabilityboard.org/publications/r_101027.pdf
Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds. (2012, January 13). Retrieved from Federal Deposit Insurance Corporation: http://fdic.gov/news/board/2011Octno6.pdf
Reducing the moral hazard posed by systematically important financial institutions. (2010, October 20). Retrieved from Financial Stability Board:http://www.financialstabilityboard.org/publications/r_101111a.pdf