Future of Banking Regulations and macro-prudential policies

Transcription

1 Future of Banking Regulations and macro-prudential policies Jón Daníelsson Systemic Risk Centre London School of Economics May 8, 2017

2 Post crisis regulated developments Banks hold much more capital Financial institutions are more restricted Much more compliance Insurance companies and asset managers seen as systemically important (SIFI) and regulated accordingly We regulate (or aspire to regulate) much more holistically Applying an increasingly similar methodology to everybody Convergence in risk models and business practices

3 Why? We had a big financial crisis in 2008 The political leadership (G20) told the financial authorities Do something about finance The authorities have to comply and show action Fear of the unknown unknowns Which is used to justify the regulatory agenda

4 The financial authorities might say: Before 2008 the financial sector misbehaved We admit we were asleep But now are fully on top of the problem And are creating rules that promise: a. Reducing the frequency and severity of crises b. Making the economy more resilient and grow more

5 50 Which is the most likely? GDP over a century 40 GDP % growth year

6 50 Which is the most likely? GDP over a century 4% growth 40 GDP % growth year

7 Which is the most likely? GDP over a century 4% growth GDP % growth year

8 Which is the most likely? GDP over a century 4% growth GDP % growth 2% growth year

9 Helicopter view of what is happening with financial regulations Much more emphasis on measuring risk, all the way from the most detailed activities up to the entire system Use those measurements to control the financial system Regulations (what could be called the regulatory philosophy) is converging to a Basel style worldview All are treated the same: bank, insurance, asset management, pension funds The key question is: Is this a positive development?

10 Macro and micro prudential regulations Macro prudential (MacroPru) Protect the system minimize systemic risk and contain systemic crises Micro prudential (MicroPru) Protect the clients Basel II/III is mostly micro Current bank stress testing is only micro We are now developing macroprudential stress testing (see discussion below)

11 What is systemic risk? FSB-IMF-BIS report to G20 (2009) Risk of disruption to financial services that is: Caused by an impairment of all or parts of the financial system and Has the potential to have serious negative consequences for the real economy Criteria Size Substitutability (the extent to which other components of the system can provide the same services in the event of a failure) Interconnectedness

12 Top down and bottom up Retail clients Government Corporates SMEs Micro Culture Conduct Abuse Asymmetric abilities

13 Top down and bottom up The economy Financial system Government Macro SIFI SMEs Retail clients Government Corporates Micro Culture Conduct Abuse Asymmetric abilities

14 The economy Top down and bottom up Financial system Retail clients Government Government Corporates SMEs Macro Institution Micro SIFI Culture Conduct Abuse Asymmetric abilities

15 The economy Retail clients Top down and bottom up Financial system Government Government Corporates SMEs Macro Institution Micro SIFI TLAC LTV, DTI, * Capital Stress test Basel Processes Culture Conduct Abuse Asymmetric abilities

16 The five key questions 1. Can we measure risk sufficiently well to control the financial system? 2. Does controlling by risk stabilize or destabilize? 3. Should we de-risk? 4. What about the unknown unknowns? 5. Is it desirable to follow a regulatory philosophy that makes the financial system more homogeneous?

17 What drives risk? 2008 happened because of decisions made years earlier In 2003 all the signs pointed to risk being low The authorities and the private sector thought we were safe And so it was perfectly OK to take extra risk But Stability is destabilizing (Minsky)

18 The unknown unknowns The US stock market goes down by $200 billion in one day and nobody cares Potential subprime losses of less than $200 billion, and OMG, it s the end of civilization The risk we know we prepare for known unknowns The risk we don t know is the dangerous type The unknown unknowns are most damaging

19 Risk is endogenous Danielsson Shin (2002) Risk is exogenous or endogenous exogenous Shocks to the financial system arrive from outside the system, like with an asteroid endogenous Financial risk is created by the interaction of market participants The received wisdom is that risk increases in recessions and falls in booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materialising in recessions. Andrew Crockett, then head of the BIS, 2000

20 Market participants are guided by a myriad of models and rules, many dictate myopia Prices don t follow random walks in adverse states of nature Because that is when the constraints bind Endogenous risk is created by the interaction of human beings All with their own objectives, abilities, resources, biases All large market outcomes are endogenous Risk models underestimate risk during calm times and overestimate risk during crisis they get it wrong in all states of the world

21 Two faces of risk When individuals observe and react affecting their operating environment Financial system is not invariant under observation We cycle between virtuous and vicious feedbacks perceived risk as reported by risk models actual risk hidden but ever present

22 9 Prices Endogenous bubble

23 9 Prices 7 Endogenous bubble Perceived risk

24 9 Prices 7 Endogenous bubble Perceived risk Actual risk

25 How often do systemic crises happen? Ask the IMF WB systemic crises database (only OECD) Every 43 years (17 for UK) Best indication of the target probability for policymakers However, most indicators focus on much more frequent events Typically every month to every five months

26 The 43 year cycle of systemic risk actual risk builds up

27 The 43 year cycle of systemic risk actual risk builds up hidden trigger

28 The 43 year cycle of systemic risk perceived risk indicators flash actual risk builds up hidden trigger

29 The 43 year cycle of systemic risk perceived risk indicators flash actual risk builds up hidden trigger improvised responses

30 The 43 year cycle of systemic risk perceived risk indicators flash actual risk builds up MacroPru implemented hidden trigger improvised responses

31 The 43 year cycle of systemic risk actual risk builds up perceived risk indicators flash MacroPru implemented rules ossifying hidden trigger improvised responses actual risk builds up regulatory arbitrage

32 The 43 year cycle of systemic risk actual risk builds up perceived risk indicators flash MacroPru implemented rules ossifying hidden trigger improvised responses The 43 year cycle actual risk builds up regulatory arbitrage

33 The 43 year cycle of systemic risk perceived risk indicators flash MacroPru implemented rules ossifying hidden trigger improvised responses The 43 year cycle actual risk builds up regulatory arbitrage Perceived risk

34 The 43 year cycle of systemic risk perceived risk indicators flash MacroPru implemented rules ossifying Actual risk hidden trigger improvised responses The 43 year cycle actual risk builds up regulatory arbitrage Perceived risk

35 Learning from History: Volatility and Financial Crises (2017) with Marcela Valenzuela (University of Chile) Ilknur Zer (Federal Reserve)

36 Crises volatilities Volatility in markets is at low levels, both actual and expected,... to the extent that low levels of volatility may induce risk-taking behavior... is a concern to me and to the Committee. Federal Reserve Chair Janet Yellen, 2014.

37 What drives risk? 2008 happened because of decisions made years earlier In 2003 all the signs pointed to risk being low The authorities and the private sector thought we were safe And so it was perfectly OK to take extra risk But Stability is destabilizing (Minsky)

38 The volatility crisis cycle Volatility low t = 1 t = 2 t = 3 t = 4

39 The volatility crisis cycle Volatility low t = 1 t = 2 t = 3 t = 4 Appetite for risk

40 The volatility crisis cycle Volatility low Credit t = 1 t = 2 t = 3 t = 4 Appetite for risk

41 The volatility crisis cycle Volatility low Credit Defaults t = 1 t = 2 t = 3 t = 4 Appetite for risk

42 The volatility crisis cycle Volatility low Credit Defaults Banking crisis t = 1 t = 2 t = 3 t = 4 Appetite for risk

43 The volatility crisis cycle Volatility low Credit Defaults Banking crisis t = 1 t = 2 t = 3 t = 4 Appetite for risk Volatility

44 Empirical approach We construct a comprehensive database on historical volatilities from primary sources (1800 to 2010, 60 countries Realized volatility Decomposed with HP filter into low and high volatilities (deviations from trend)

45 Strong and significant support for volatility cycle Low volatility increases the probability of banking crises years in future Low volatility significantly increases risk-taking (credit-to-gdp) High volatility correlated with crisis but not causal

46 Overview Recognition that we did not regulate well before 2007 Initial reaction was to take before 2007 regulations and make them more strict Increased understanding that this is not sufficient or correct Searching for better solutions But considerable regulatory fatigue resistance to changes Basel IV unlikely to happen for many years

47 Non bank drivers G20 called for policies to prevent Too Big To Fail in 2010 G20 in 2011 asked the FSB and IOSCO to prepare methodologies to identify systemically important NBNIs FSB list of global systemically important insurers in 2015 Grappling with asset managers (next slide)

48 Asset managers Maybe largest managers, like BlackRock, Vanguard, Allianz, Asmundi Limits on fund leverage? Limits on liquidity mismatches? Minimum capital? More disclosure? More scrutiny? Stress tests?

49 Harmonization I Regulatory philosophy All parts of the financial system to be brought under the regulatory umbrella asset managers, insurance companies, non-bank banks Best understood is banking So apply banking vulnerability analysis to the rest

50 Internal management of risk Some banks use the same methodology for managing risk across the board annual report, regulatory capital, trading floor, risk capital allocations Others use different models and methodologies across operations multiple models and stress tests for risk-taking Dependent on institution sophistication and size, and supervisor preference

51 Harmonization II Models If we regulate by models, the regulators must believe there is one true model Therefore, banks should not report different risk readings for the same portfolio However, forcing model harmonization across banks is pro cyclical So is forcing the same models to be used for everything internally Forcing the same models on non-banks is even worse And pro cyclicality negatively affects economic growth and increases financial instability The rationale is to reduce cyclicality but it can easily achieve the opposite

52 The SIFI paradox Most would argue that SIFIs are not good for clients nor system (micro and macro undesirable) Still they are growing and new are being formed a. Useful in resolving failed institutions (Lloyds, MS, etc. ) b. Governments like national champions (DB, HSBC, Citi, etc.) Regulations have fixed and variable cost, both are growing The fixed cost gives competitive advantage to the largest

53 Healthy financial systems are heterogenous Encourage different models to be used internally and across industry Have different regulations for different parts of the industry Regulate banks differently from insurance companies and those differently from asset managers When some sell we want others to buy Encourage new forms of intermediation Encourage new entrants Shadow banking Parallel banking and fintec is good Just make sure to not regulate them with banking regulators

54 Do we like where we are going? Policy makers know that homogeneity is pro cyclical But We have to do our job, what else can we do? And march towards uniformity The same government agency could regulates banks, asset managers, insurance and parallel banks Using very similar regulatory methodology Because that is easier But we will not say that instead say more consistent, simpler, fairer, cheaper, more reliable, less subjective,... Pity it won t work

55 Regulations and risk controls Any control process, internal and regulatory, can only target known risk We are really good in managing the risk that doesn t matter It is much easier to control the known knowns Because we can easily measure it We ignore the risk we should care about Because it is much harder to model and plug into a control process

56 Risk is multifaceted Some aspects of risk are good, others bad Some risk can be measured, other not Different people and financial institutions care about very different aspects of risk The trader, the CEO, the stockholder, the pension saver, the house buyer, the regulator, the risk manager all see risk very differently Trying to distill risk into a single set of numbers (like VaR) is not helpful And can easily be destabilizing

57 De-risking Fact A lot of risk was being taken before 2008, often in obscure and hidden ways Fact The crisis of 2008 revealed the scale of this risk-taking and the severity of the consequences The usual conclusion We therefore need to reduce the amount of risk in the financial system Question Is that true?

58 Does de-risking make us better off? No The only way the economy will grow is if we take risky decisions With risk comes failure If we de-risk, we de-grow Losses and failures and some crises Are a sign of healthy well-functioning economy

59 Risk models and stress tests Widespread recognition of limitations of risk models The common solution is stress tests (both internal and external) Run a portfolio or a financial institution on a historical or made-up scenario

60 Regulators bank tests US CCAR (Comprehensive Capital Analysis & Review) macroeconomic scenarios from Fed market EU EBA, macroeconomic market shocks (e.g. included credit risk market risk and counterparty credit risk, op risk static balance sheet

61 Pros and cons Pros a. recognition of some risks not picked up by models b. evaluation of risk engines and processes Cons a. often impossible to identify likelihood of scenarios b. an infinite number of potential scenarios c. paralysis by analysis

62 Issues Test the resiliency of each individual institution to an exogenous shock A useful complement to risk models Misses out on systemwide interactions For that, macroprudential stress tests (next slide)

63 Macroprudential stress tests Interaction of all sectors of the financial system banks, asset managers, insurance companies, sovereign wealth funds, parallel banks each with their own cyclicality Jointly model how they interact Capturing feedback loops (like bubbles and fire sales) Ultimately may inform capital determination and other macroprudential rules

64 MacroPru objectives a. Prevent excessive risk accumulating b. Contain financial crises when they happen c. Ensure the financial system contributes to growth

65 Effective MacroPru authorities need VoxEU.org (2016) Jon Danielsson and Robert Macrae a. Estimates of systemic risk (and its impact on the real economy) from the early signs of a build-up of stress to the post-crisis economic and financial resolution b. Tools to implement effective policy remedies c. Legitimacy, a reputation for impartiality, and political support

66 Central banks and monetary policy The powers given to central banks are extraordinary for a democratic society Justified by the importance of politicians not manipulating monetary policy for short-term gains But it is relatively straightforward a. One measurement (inflation) b. Two tools (price and quantity of money) Clear objective, target and tools

67 By contrast Micropru is complex and ill-defined Indicators are imprecise and conflicting Surgical tools are ineffective Powerful tools too blunt Identifies clear winners and losers (lobbying and politics)

68 Major financial stress events Very few stress events arise purely from excessive risk Most are strongly influenced by politics a. Wars b. Venezuela c. Transition between political systems d. Populism and anti-globalism The macropru event is only a consequence of something bigger

69 The dilemma of political risk Can a nonpolitical entity legitimately implement macroprudential policies that affect democratic outcomes? Recall Bank of England and Brexit Does the mandate given by the political leadership to the regulator extend to the behavior of the political leadership? If the macropru authorities are not able to incorporate political risk in their analytic frameworks, how effective can they be?

70 MacroPru directions Most are passive, focusing on crisis resolution and fixed rules that hold through the financial cycle Ambitious macroprudential policies aim to lean against the wind in a discretionary manner Discretion to deviate from rules Tighten capital and liquidity requirements during upswings and relax the same rules during and after a crisis Cut through the amplifying feedback loops Discretionary macropru policies aim to be countercyclical If successful, of considerable benefit to the wider economy

71 50% 40% 30% SP 500 annual volatility ECB Systemic Stress Composite Indicator 20% 10% 0%

72 The potential for procyclical macropru VoxEU.org (2016) Jon Danielsson, Robert Macrae, Dimitri Tsomocos, Jean-Pierre Zigrand Minsky argument; Homogenization of the financial system; Most current indicators of systemic risk, only identify perceived risk; Danger of reacting with some time lag to the postulated indicators that are themselves measured with a time lag; When macropru policy is known to the market, banks will schedule risk-taking around indicators, stress tests and expected policy reaction; The authorities should be willing to reduce aggregate risk-taking and leverage during booms and increase it in times of stress.

73 All of these objections call for a procyclical policy response Banks are failing because they already extended too much credit Surely bank capital needs injections rather than allowing the banks capital to absorb losses Helping the City to increase lending now leads to even bigger moral hazard Macropru is discredited because it was supposed to have prevented this credit event in the first place, why should it do better this time?

74 Can models beat the FT?

75 Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion Can models beat the FT?

76 Towards useful risk models Understanding model risk is a precondition for risk models being useful Good scientific practice suggests that risk model outcomes should come with confidence bounds Focus on the unknown unknowns Risk of unknown unknowns usually not to be found in market data But they can be bound

77 Risk models are most useful for controlling traders less useful in internal risk capital allocation e.g. invest in European equities or JPG often useless for micro prudential regulations Traders read things like Basel III as manual for where to take risk dangerous when used for macro prudential policy

78 Policies intended to protect us from the financial system could easily increase instability MacroPru can be pro cyclical Basel can be pro cyclical Shrinking the known risks encourages the unknown ones to grow Monoculture destabilizes the financial system Excessive regulation suppresses growth Excessive regulation increases the rewards for regulatory arbitrage and sows the seeds of the next crisis

79 Next crisis There will be another crisis And that is not necessarily a bad thing Crises are also a healthy consequence of good risk taking Unlikely to be found in 2008 or where the authorities are looking now To speculate

80 Next crisis Fixed income Suppose inflation hits target levels With interest to follow And considering duration of some sovereign and corporate debt And rapidly growing EM corporate USD bond issues The trigger may be Italy