Quo vadis bank regulation?

Transcription

1 Quo vadis bank regulation? John Vickers All Souls College, Oxford University LabEx ReFi lectures on Financial Regulation Paris, 24 January 2018

2 Banking reform: plan of talk How did it all go so wrong? Economics of banking reform: capital and loss-absorbency structural reform competition issues Banking reform: job done? 2

3 How did it all go so wrong? 3

4 What caused the banking crisis? Trigger was bursting of US house price bubble Individual banks were both huge and unable to withstand severe economic shocks Financial system highly interconnected both within and between these systemically important banks Risk exposure not clear due to complex derivative arrangements spread fear of unknown exposures 4

5 The financial system and role of banks The financial system supports the wider economy by: providing payments systems providing deposit-taking facilities and a store-of-value system lending to households, businesses and governments helping customers manage risks &c Banks play a central role in all of these functions Banks can be especially sensitive to economic shocks take on credit risk, and market and maturity/liquidity risks operate with (much) more debt than non-financial firms 5

6 Bank funding the leverage question ICB Final Report, September

7 Increase in UK bank leverage in the past fifty years 7

8 Some basic economics of the banking crisis Not so much a perfect storm as severe weather exposing a horribly fragile structure 40x leverage is mad ask Adam Smith No way to operate market capitalism Bank debt largely escaped loss as governments (lacking bail-in tools) averted bankruptcy, but with major fiscal damage Unstructured universal banking made it still worse 8

9 Relative sizes of banking sectors 9

10 Banking system ill-prepared for global financial crisis Individual banks were huge yet unable to withstand severe economic shocks thin equity, debt not loss-absorbent Financial system highly interconnected both within and between systemically important banks no fire breaks Core banking services had to be maintained, so governments forced into providing unprecedented levels of support taxpayer massively on the hook Even so, the disruption in economic activity is having a huge and lasting effect on economic growth and the public finances leading to debt crises in the Eurozone 10

11 Eurozone sovereign debt crisis Ten-year yields. Source: Bank of England, August 2014 Inflation Report, Chart

12 UK actual and potential output Office for Budget Responsibility, Economic and Fiscal Outlook, March 2017, chart

13 UK productivity forecasts and outturn Office for Budget Responsibility, Forecast Evaluation Report, October 2017, chart

14 Economics of banking reform I: Capital and loss-absorbency 14

15 Wider reform of financial services Regulatory architecture PRA & FCA instead of FSA Macro-prudential regulation Shadow banking Market infrastructure Accounting standards Ratings and ratings agencies 15

16 Banking reform issues Loss-absorbency how much equity capital and lossabsorbing debt should banks be required to have? Liquidity Resolution regimes Structural reform should retail and investment banking be separated, and if so how? Competition Other initiatives supervision, corporate governance, sanctions, pay, taxation, 16

17 Independent Commission on Banking Created June 2010 Interim Report April 2011 Final Report Sept 2011 Aims: Financial stability Competition Issues of UK competitiveness and fiscal risks Banking Reform Act

18 Loss-absorbing capacity ICB overview of reform options for financial stability Mild Mild Fails to solve stability problem Structural reform Radical Taxpayer on the hook for UK retail banking Radical Fails to shield retail banking from risks elsewhere, real risk of geographic arbitrage Goes further than needed, real risk of geographic arbitrage 18

19 Capital and loss-absorbency Market system works well only if those who get rewards in good times absorb losses in bad times Standard bankruptcy does not work for systemically-important banks because of the core service continuity imperative, deposit insurance &c So normal hierarchy of loss-absorption (equity debt ) became equity taxpayer, and with wafer-thin equity Huge implicit subsidy and distortion of incentives Moreover, with unstructured universal banks, the home taxpayer is on the hook for the lot, and with no firebreaks 19

20 Is equity costly to banks? Is bank equity costly (1) for banks, and (2) for the economy? Yes Debt/equity tax wedge how big a deal? Debt overhang spill-over benefit to creditors, and to public (contingent) creditor in particular especially if equity is thin But these aren t costs to the economy 20

21 Is bank equity costly to the economy? Is bank equity costly (1) for banks, and (2) for the economy? MM theorem says No for given risks in the economy, why would the aggregate value of claims depend on debt/equity mix? Reality MM, but social costs of bankruptcy argue for more equity so do incentive reasons, including getting the taxpayer off the hook, which is necessary (but not sufficient) for good economic incentives towards risk But how far to go? Answer depends on national (ICB) v global (Basel) perspective 21

22 The great divide on bank capital policy Official view job done Don t increase overall capital requirements across the banking sector any further BoE 2016 decision on systemic risk buffer for large retail banks Most economists view far too much leverage still allowed 33x is grossly excessive No more that 10x (Mervyn King) No more than 7x (2010 FT letter authors) Anat Admati & Martin Hellwig 22

23 UK banks leverage ratios The capital requirements of our largest banks are now ten times higher than before the crisis Governor Carney, 24 June 2016 Bank of England, Financial Stability Report, June 2017, chart B2 23

24 So what s the right answer? ICB recommended 10% minimum equity ratio to riskweighted assets (RWAs) for large retail banks, accompanied by 25x leverage cap. We faced three constraints geographic arbitrage institutional arbitrage from banks to non-banks the problem of transition My blue-skies numbers would differ by a factor of two, but the skies were cloudy Importance of banks having further loss-absorbing capacity (e.g. including bail-in debt) well beyond the equity minimum. Also preference for (insured) deposits. 24

25 The international answer Basel III makes major progress on capital but is unambitious, despite uplift for globally systemic important banks equity capital 7% of RWAs (up to 9.5% for GSIIs) leverage 33 backstop Reform to RWAs agreed in December 2017 BoE s weak 2016 policy on the systemic risk buffer 25

26 SRB % Systemic risk buffer illustration: BoE v ICB BoE ICB Ring-fenced bank assets as % of GDP 26

27 Staff paper justifying(?) the BoE s policy shift Brooke, et al, Measuring the macroeconomic costs and benefits of higher UK bank capital requirements, Bank of England Financial Stability Paper No. 35, December

28 Result due to (untenable?) assumptions Credible resolution strategies will reduce both the likelihood and probable impact of systemic bank failures, leaving the system less reliant ongoing concern capital to do the heavy lifting Very imprudent to rely on untested new instruments Serious doubts about resolution in a systemic crisis BoE results are explicitly focussed on the costs and benefits of higher capital on normal risk conditions (broadly equivalent to the mid-point of the credit cycle) Like designing flood defences for normal weather So BoE s own model implies need for much more equity capital 28

29 UK banks average price-to-book ratios Bank of England, Financial Stability Report, Nov 2017, chart B6 29

30 Economics of banking reform II: Structural reform 30

31 Broad structural options Unstructured universal banking Structured universal banking End universal banking ( Glass-Steagall ) Ban proprietary trading ( Volcker rule ) Functional (retail/investment banking) and geographic aspects 31

32 Economics of separation Helps insulate vital retail banking services where continuity of service is essential from global financial shocks. So deals with some interconnectedness risks Makes it easier and less costly to resolve banks that still get into trouble despite greater loss-absorbing capacity. All part of getting taxpayers off the hook Good for competitiveness (in ICB s UK context) because retail banking can be made safer while (subject to resolvability &c) international standards apply to global activities Sound long-run framework for bank lending to real economy 32

33 ICB ring-fence design Core Deposits and overdrafts to individuals and SMEs Permitted Deposits and payments for any EEA customer Non-financial lending, trade and project finance and advice to EEA customers Excluded/prohibited Any non-eea services Most trading and underwriting of derivatives and debt, asset-backed or equity securities Lending to financial companies 33

34 UK Banking Reform Act 2013 Regulatory objectives to include the continuity of provision in the UK of core services (notably deposit and overdraft facilities) Ring-fencing ring-fenced body = UK institution that does core activities may not do excluded activities (such as dealing in investments as principal) nor contravene prohibitions (e.g. concerning kinds of transaction, non- EEA branches, ownership stakes) ring-fencing rules made by Prudential Regulation Authority on transactions, payments, disclosures, board independence, &c Depositor preference for insured deposits Other elements of Act 34

35 Why not the Volcker rule instead? Proprietary trading should indeed be separated from retail banking But that doesn t go far enough to deliver the insulation, resolution, and public finance benefits of ring-fencing The bulk of global wholesale/investment banking and its risks would still be comingled with everyday retail banking Drawing line between market-making/hedging and prop trading is hard, and more controversial with an absolute ban Don t view Volcker in isolation the US is different in respect of regulation as well as banking systems 35

36 Why not a full break-up? Ring-fencing retains many of the synergies of a broad banking group, while providing insulation for vital economic functions The parent group could still rescue a failing retail bank Full split would create undiversified, correlated, stand-alone UK retail banking sector stability risk So favour structured universal banking, not ending universal banking more robust than unstructured universal banking Electrification of the fence by group restructuring powers UK, US parallels Cf EU 36

37 Liikanen Report on reforming EU banking structure High-level EU expert group reported in October 2012 Separate trading from deposit bank ( UK approach) Plus powers to require further separation if needed for resolvability Loss-absorbency recommendations EC response (2014) and abandonment (Oct 2017) 37

38 Economics of banking reform III: Competition issues 38

39 Crisis concentration in UK retail banking ICB Final Report, September 2011, Fig

40 Some questions about competition and financial stability Is there a trade-off between competition and financial stability? Was there too much competition pre-crisis? Misdirected competition, e.g. to maximise leverage Competition policy in the Crisis Bail-outs and state aid Merger policy and the Lloyds/HBOS question Financial stability measures can promote effective competition The ICB competition recommendations 40

41 Is there a trade-off between competition and control of carbon emissions? Consider a polluting industry without a carbon tax or permit scheme There can be too much competition Less competition means lower output and higher prices, so less pollution So mergers, minimum prices, and even a cartel could be good Competition policy therefore needs to be adapted for polluting industries Right? 41

42 Is there a trade-off between competition and control of carbon emissions? Wrong Address negative externalities by environmental regulation Don t forgo the benefits of competition Don t grant fat rents to polluters Apply competition policy as normal Does the same apply to policy to address the negative externalities from risk-taking by banks? 42

43 Indeed more so? In a systemic crisis, not only do banks &c not compensate those who suffer from risks going bad but their creditors are bailed out, for fear of yet greater damage So instead of polluter pays, we then have polluter is subsidised? Ending the TBTF subsidy is only part of what s needed there s still the negative externality to address Implications for the ex ante incentives of banks and investors generally 43

44 Or are banks different? Unlike the textbook polluter, banks are multi-product So a major issue is the mix of what they do, not just the level The direction as well as the rate of activity including inventive activity Wider issues concerning the direction of inventive activity Liabilities and assets Investment and retail banking 44

45 Misdirected retail product innovation Volcker and the ATM Collective action problem for desirable system innovations Profitable exploitation of unsophisticated consumers may benefit the savvy but deters good innovation as the mistakes of unsophisticated can create rents that distort competition (Campbell, AER 2016) PPI, interest rate hedging products UK banks lost (capital ) Unarranged overdrafts UK banks won case on unfair contract terms 45

46 Misconduct provisions by UK banks Belinda Tracey et al, Bank capital and risk-taking: evidence from misconduct provisions, Bank of England staff working paper 671, August

47 Was the Lloyds/HBOS merger bad for financial stability too? HBOS had much more than a liquidity crisis Rather than separate the bad bank, it got merged into Lloyds A cautionary tale for the public interest in merger policy BoE/FCA report on The Failure of HBOS plc, Nov

48 Peltzman s prescience on state aid Governments, more or less everywhere, have guaranteed, de facto or de jure, the banks liabilities, so that the banks cost of acquiring them is essentially identical to the government s own cost of debt. The putative motive for this subsidy is to use the banks as the Government s agents for providing a cheap, liquid substitute for government money. The quid for this quo is that banks should refrain from using their access to the government guarantee simply to maximize profits.... However, banks in many countries have been demonstrably unable to be bound by that restraint.... It is still unclear whether resolution of this agency problem will entail transfer of many more banks to state ownership. (1989) 48

49 EU state aid policy for banks Right for competition policy not to thwart bank rescue aid The alternatives were even worse Ex post approach to state aid, e.g. Lloyds divestiture of TSB RBS commitment to divest Williams & Glyn replaced by alternative package of measures (approved in Sept 2017) EC Banking Communication of August 2013 Bank Recovery and Resolution Directive, January 2015 No SRF contribution unless 8% of total liabilities have been bailed in 49

50 State aid and recapitalisation of banks in future European Commission Fact Sheet, June

51 Pro-competitive financial regulation ICB competition recommendations (in addition to financial stability measures) pro-competitive financial regulation, create challenger, easier switching Regulation should promote effective competition, especially on switching, transparency and barriers to entry Opportunity to put competition at the heart of financial regulation with new regulator, Financial Conduct Authority Legislation amended to give the FCA the objective and duty of promoting effective competition 51

52 Creating a strong and effective challenger Challengers an important aspect of competition since 2000 Offered better rates on overdrafts and deposits Gained switchers while large banks lost market share Only two challengers left most have left market Lloyds divestment required by European Commission as consequence of aid received from government during crisis ICB recommended that Government seek agreement with Lloyds to ensure the emergence of a strong challenger Plan to sell 631 branches to Co-op Group collapsed in 2013 TSB floated as separate entity June 2014 IPO 52

53 Demand-side competition: ease of switching Effective competition requires easy comparison and switching Current accounts very difficult to compare (esp. on price) People very rarely switch, despite gains on offer Average customer keeps PCA 26 years Fear of payments failing is biggest switching deterrent Perception that switching is not easy ICB recommended redirection service to reduce switching risk Started in September 2013 Switching up 19% in first year Competition and Markets Authority inquiry

54 Overview of the CMA 2016 remedy package: Open Banking Competition and Markets Authority (2016, paragraph 161) 54

55 Good v bad competition In banking markets as elsewhere, what matters is not competition in the abstract but competition to provide what customers want effective competition The underlying problem [when markets fail] is not competition but the frameworks including consumer protection and financial regulation in which competition takes place. To blame competition would be to misdiagnose the problem. A more comprehensive analysis is needed. In short, a distinction is needed between good competition to serve customers well, and bad competition that exploits customer unawareness or, for example, creates a race to the bottom on lending standards. (ICB) 55

56 Bank reform: job done? The job is now substantially complete Mark Carney to G20 Leaders, November 2014 I don t think so: Basel III is too weak, e.g. on leverage BoE has softened its position on capital requirements Europe has so far ducked serious structural reform US policy uncertainty So lots of unfinished business 56

57 Has Banking Reform Gone Far Enough? No