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Appendix I. Some Preliminary Empirical Analysis
This paper has benefited from comments and suggestions from A. Bhatia, J. Brockmeijer, H. Ferhani, K. Habermeier, D. Marston, A. Narain, and M. Swinburne.
In open economies, moreover, the increase in credit and the resulting consumption boom tends to be underpinned by capital inflows and an over-appreciation of the (real) exchange rate relative to its fundamental level, further relaxing borrowing constraints (Korinek, 2008). As a result of both increases in asset prices and exchange rates, leverage increases while the quality of credit deteriorates.
White (2008) counts the 2001 bursting of the tech bubble as a crisis that should have been prevented by policymakers. However, Mishkin (2008) argues that stock market bubbles pose a risk to the economy only if they are underpinned by a financial accelerator channel that involves assets used as collateral for bank credit.
This tool is in place for commercial banks in the U.S. and Canada. A number of countries across Eastern Europe and Asia have also made attempts to use prudential measures to limit the growth of credit, including through maximum loan to value ratios and variations in reserve requirements. Borio and Shim (2007) provide a survey, identifying 18 countries where prudential rules have been used in this way.
A meeting of the G20 in London on April 2, 2009 decided to re-establish the FSF as the Financial Stability Board (FSB).
Borio and Shim (2007) list 18 cases across Europe and Asia where countries have pursued measures designed to stem accelerating credit growth. In all but two cases (Korea and Norway) these actions were implemented by the central bank, rather than by a separate supervisory agency.
The experience in Spain provides an example that even where macroprudential stabilizers (such as dynamic provisioning) appear effective in protecting the banking system, unsustainable financial imbalances can still build up in the household and corporate sectors.
Progress in the early identification of financial imbalances is a condition for such a revision of policy to be useful. Such progress might build on research by Borio and Lowe (2004) who have found that it is possible to predict banking crisis episodes fairly well based on misalignments—measured by deviations from historical trend growth—in two indicators, namely equity prices and the ratio of private sector credit to GDP. This method may work fairly well as long as there is high correlation across asset markets. Both the IMF and a number of central banks around the world have, over the past year or so, stepped up their research efforts to better understand macro-financial linkages.
The set of banks eligible to receive individual support typically includes all major deposit-taking institutions. In the U.S. this has in March 2008 been extended to U.S. investment banks, through establishment of the Primary Dealer Credit Facility and the Term Securities Lending Facility.
As the Financial Times put it on 10 July 2008, “the problem is that the Fed has little power to regulate the brokers. A promise to lend to them in need without adequate means to ensure that they are prudently managed is entirely unsatisfactory for the Fed”. Ratnovski (2009) formalizes the incentives for banks to gamble for a liquidity bailout and discusses policies to reduce these incentives, including liquidity requirements and greater information about the solvency of the individual firms.
For example, the BOE had to defend its actions in the case of Northern Rock in front of a parliamentary committee that sought to establish whether it might have been possible to resolve Northern Rock more effectively, by taking early action to facilitate a private sector sale, see Treasury Select Committee (2008). The Fed, likewise came under pressure to explain its decisions in the cases of Bear Stearns and Lehman. And it later needed to defend itself against the perception that bonus payments at AIG could have been prevented while AIG was under the Fed’s control.
Noteworthy developments are: the rise of Real Time Gross Settlement (RTGS) and Delivery versus Payment (DvP) for national payment and settlement systems, respectively; and the introduction of Payment versus Payment (PvP) in the settlement of foreign exchange transactions via CLS.
See Committee on Payment and Settlement Systems (2007). Prudential regulators, including the UK FSA have also been involved in this effort. Clearing procedures are more generally of interest both to regulators of securities markets and to central banks.
At the time of writing, efforts to create a central counterparty have intensified, both in Europe and in the U.S.
In the event, while the settlement of CDS contract written on Lehman’s default has been unexpectedly smooth, the failure of Lehman has caused losses at financial institutions around the world, some of which might have been lower in the presence of a central counterparty, which may have insisted on a more robust margining of contracts. This consideration may also apply to the case of AIG, since AIG was an important provider of protection for credit risky securities.
Austria is an example where the central bank has formal authority in payment system oversight that includes strong powers over system users. According to the central bank law, if an operator or participant does not comply with the regulations issued by the Austrian National Bank in this field, the Austrian National Bank can threaten and impose sanctions both on operators of payment systems and on system participants.
Turner (2009) echoes this point in its discussion of potential drawbacks of assigning prudential responsibilities to the central bank (page 92).
Buiter (2008) has reiterated this argument in relation to the Fed. “It listens to Wall Street and believes what it hears…the Fed is too close to the financial markets and leading financial institutions, and too responsive to their special pleadings, to make the right decisions for the economy as a whole” (pg. 599–600).
Some have noted difference in the speed of policy easing across advanced economies in response to the financial crisis. However, the determinants of these differences are difficult to establish. Differences may have been due to differences in the macro-economic data faced by different central banks. They might also have been due in part to differences as regards whether or not the central bank has a supervisory role. But even if this could be established, it is not clear whether differences in the decisiveness of monetary easing may have been due to biases arising form a potential conflict of interest between supervision and monetary policy or due to better access to supervisory information and a better understanding of the interaction between financial stresses and the macroeconomic outlook.
Sachsen LB had sponsored Ormond Quay, which had to be supported by a line of credit of 17.3 bn euros. Sachsen LB was resolved through a takeover by LBBW, another Landesbank. See BaFin, Annual Report, 2007, page 23.
WestLB’s two special investment vehicles (SIVs), Harrier Finance and Kestrel, were taken back on WestLB’s balance sheet, resulting in an expansion of around 21 bn euros by year-end 2007. See BaFin Annual Report 2007, page 23.
According to the “Aufsichtsrichtlinie,” issued by the BaFin after negotiation with the Bundesbank, the Bundesbank is the only authority to carry out day-to-day supervision, conducting all aspects of both on-site and off-site supervision. This provides the Bundesbank with first-hand information. The BaFin retains the residual right to control enforcement actions brought against individual institutions. The MOU further envisages heightened supervision and enhanced cooperation as regards systemically important and problem institutions.
Under German law the authorities are currently limited to a straight liquidation of a bank or a bail-out that leaves shareholder interests in place. At the time of writing, a temporary change to this situation is being debated by lawmakers.
IKB AG was founded in Düsseldorf in 1949 to grant industrial development aid to German small and medium-sized enterprises. It provided loans to medium-sized customers and helped disburse funds that were being granted under various development programs, including the Marshall Fund. In fulfilling this mission, IKB kept close cooperation with KfW, the main publicly owned banking entity that was tasked with financing post-war reconstruction and that later became the leading entity providing federally funded assistance programs to particular sectors and regions– including, after reunification, the Eastern Lander. Throughout its history IKB has kept a mission to provide loans to German medium-sized companies and close ties with the authorities, with KfW continuing to hold a 38 percent stake until the authorities decided to sell the bank to Lone Star Funds on 21 August, 2008.
The example is Pillar 3 of the Basel II framework that mandates enhanced disclosure for banking firms, to reduce asymmetric information and strengthen market discipline brought to bear by unsecured creditors.
This problem has been referred to as “too many [institutions] to [let] fail.” It is described formally by Acharya and Yorulmazer (2007).
In some countries (including the U.K.), under Basel I the capital targets above the Basel minimum that were prescribed by supervisors differed across institutions. Under the new Basel II approach, Pillar 2 (supervisory review) in principle allows a similar approach, since it is meant to capture risks not captured under Basel I. Systemic risk is not explicitly mentioned as an example, however. Supervisors may in any case use their discretion to subject systemically-important institutions to closer supervision, e.g., through intensive on-site supervision and a larger number of supervisory staff assigned to these institutions. See Turner (2009) for further discussion.
Research has documented the detrimental effect of support expectations on market discipline. See for example Nier and Baumann (2006).
Manning, Nier, and Schanz (2009) discuss the central bank’s role in clearing and settlement and the policy issues arising in this sphere.
The failure of major retail systems can also affect the settlement of obligations in a range of markets, whose functioning is important for the economy as a whole.
Fraud on the part of the staff of financial institutions may be able to “bring down the bank.” Perhaps the best known example is the case of Barings Bank, which collapsed in 1995 after one of the bank’s employees lost £827 million (US$1.4 billion), speculating primarily on futures contracts. Shareholders and managers of financial institutions should generally have good incentives to prevent fraudulent activity that result in gains for employees at the expense of shareholders. Despite this, regulation of the processes in place to reduce the incidence of such losses may be needed, especially for institutions that are potentially systemic. The new Basel II framework encourages banking supervisors to step up the oversight of these processes, so as to reduce the incidence of “operational risk”. Oversight of operational risk, more broadly defined, is a particular focus also of the oversight of payment and settlement processes in which commercial banks are involved, see Manning et al (2009).
Aggregate risks can also be present in the absence of price information.
In a carry trade a local currency asset is funded in a foreign currency, typically to take advantage of lower funding costs. Foreign currency funding can lead to an overappreciation of the local exchange rate, which makes this type of leveraged position vulnerable to a depreciation of the local currency.
Ahead of the U.S. Great Depression, the Japanese lost decade and the recent crisis, interest rates are thought to have been unusually low while imbalances built up, exposing borrowers to a tightening of rates.
In the Japanese case, the “evergreening” of loans to insolvent borrowers is thought to have been undertaken in order to postpone the realization of losses and its effect on bank capital.
The build-up of vulnerabilities to macro-systemic risks is not easily detected in real time. Macro stress tests offer a potential diagnostic tool. They may also help decide which group of “leveraged providers of leverage” is most vulnerable to any particular macroeconomic scenario.
Adrian and Shin (2008) describe how risk management that relies on value-at-risk can increase rather than decrease these exposures, since it may indicate balance sheet capacity in boom times, leading to further expansions of balance sheets.
Research by Adrian and Shin (2008) suggests that balance sheets of both investment banks and commercial banks respond to monetary policy action.
See Turner (2009) for a discussion of tools that could be used to constrain household indebtedness.
Large funds may also pose micro-systemic risks, depending on their investment strategy and liquidity profile, as discussed further below.
Partnerships with unlimited guarantee will less often pose a threat to financial stability.
Off-balance sheet structures created in the run-up to the crisis were likewise characterized by illiquid balance sheets, often funding long-term assets in short-term markets, by issuing “asset-backed commercial paper”. While off-balance sheet vehicles were unregulated, whether or not U.S. money market funds can pose systemic risk may depend on the regulations this type of fund is subject to, including importantly the degree to which maturity transformation is permitted. Life insurance companies and pension funds are examples of types of funds that do not ordinarily engage in maturity transformation, since claims on their assets tend to be long-maturity and predictable. Their actions may still have a systemic impact when the investment rules they are subject to result in forced selling.
Hedge fund failures provide a good example. The failure of Amaranth advisors in 2006 was absorbed easily by the market despite its substantial size, since it was holding contrarian positions in natural gas futures, betting that the price of gas was going to fall from March 2007 to April 2007. Long Term Capital Management (LTCM) placed bets on a compression of spreads. These bets were blown out of the water by the Russian default in 1998 and a subsequent rise in spreads across all major bond markets. An unwinding of LTCM’s position would have further increased spreads, hurting the market at large.
A growing literature models and assesses empirically the network effects arising from interconnected financial institutions. Nier et al (2007) explore how the degree of interconnectedness of the system as a whole affects financial stability. They also assess the strength of liquidity effects that arise when banks hold similar assets and fire-sales of one institution leads to markdowns for other institutions.
The case of HIH, one of the largest insurance companies in Australia, is sometimes used as a example of an insurance company that posed systemic risks. The collapse of HIH did, in fact have an adverse effect on the economy, but this was because of its near monopoly status as the supplier of insurance to the construction and medical sectors. The collapse of HIH had virtually no impact on other financial institutions or financial markets (Herring and Carmassi, 2007).
This is in line with the recommendation by the Paulson Blueprint, see Department of the Treasury (2008).
It is sometimes argued that “two pair of eyes” are useful in supervision. But “two pair of eyes” can also be created within an organization, by assigning a greater number of staff. This will in general also be more efficient, since it leads to better flow of information across all relevant staff. When there are competing objectives, separation of resource across different agencies may be more useful.
As Herring and Carmassi (2007) point out, the U.K.’s role as a major financial center ensures that supervisory initiatives taken in the U.K. engage the interest of financial institutions and supervisors elsewhere.
A trend towards financial conglomerates can increase opportunities for risk-taking behavior by financial institutions and can make financial institutions too complex to manage, to monitor and to resolve. In response to these challenges, some commentators in the United States have questioned the U.S. Gramm-Leach-Bliley Act of 1999. This Act removed the separation of commercial and investment banking that had been introduced by the Glass-Steagall Act of 1933, in response to the U.S. Great Depression. There is currently active debate as to whether setting up new boundaries between banks and investment banks is an appropriate response to the recent crisis or whether this may go too far, see for example Turner (2009).
It may be possible to implement such a change when the integrated regulatory model is the starting point. Some of the proposals made by Turner (2009) are a step in this direction. The Swiss authorities have already made attempts to do this, e.g., by going beyond Basel II standards, in an effort to contain systemic risk arising from UBS and Credit Suisse.
The Swiss regulatory model initially retained a separate insurance regulator. The model has become fully integrated in 2009.
In Germany, the integrated regulator (BaFin) and Bundesbank have joint responsibility for the prudential supervision of banks. See section II. for further explanation.
As in Switzerland, in Finland full integration was achieved in 2009, when the new Financial Supervisory Authority (FIN-FSA) took on supervision across all sectors, including also insurance.
The desire for greater focus on prudential regulation and conduct of business regulation, respectively, is cited in the Paulson blueprint as a reason against recommending this model for the U.S., see Department of the Treasury (2008).
Herring and Carmassi (2007) identify two versions, one of which is close to the model described here. The other was adopted by Australia, where the micro-prudential supervisor, the Australian Prudential Regulation Authority is located outside the central bank—that retains a macroprudential objective—and another independent authority, the Australian Securities and Investment Commission, performs conduct of business regulation. Using the classification developed here, this model is more aptly characterized as a “hybrid” model between the two alternatives (SIR and twin-peaks). See below for further discussion.
Congruence of goals (consumer protection) argues for assigning this responsibility to the market conduct regulator. Congruence of tools (prudential regulation) argues for housing all prudential supervision with the prudential and systemic risk regulator.
Austria created a single integrated regulator (FMA) in 2002. In the wake of the crisis at BAWAG, there have been changes to the relationship between the single regulator, FMA, and the Austrian National Bank which now move the Austrian model closer to the Twin Peaks approach. Since January 2008 the law charges the Austrian National Bank with all aspects of the supervision of banks and financial conglomerates. However, the FMA still has all enforcement powers.
There is such an MOU in the Netherlands between the central bank (DNB) and the market conduct regulator (AFM).
Both the case where the central bank is doing “too much” and where it is doing “too little” are further explored below, in the context of hybrid models.
This is perhaps with the exception of Lehman, where the market’s expectation might have been disappointed. Nier and Baumann (2006) provide evidence of the detrimental effect of public support expectations on market discipline.
Around the end of 2008, the Swiss regulator FINMA strengthened capital adequacy requirements and introduced a minimum leverage ratio, for Credit Suisse and UBS only. The Swiss leverage ratio defines the proportion of Tier 1 capital to total assets and is set at a minimum of 3% at the consolidated level. For the calculation of this new parameter, the balance sheet is adjusted for a number of factors, including the deduction of the Swiss domestic loan book. The Swiss authorities also decided to introduce a more general leverage ratio, which will come into effect at a later date.
Designation of payment systems is envisaged in the Paulson Blueprint, Department of the Treasury (2008).
It can be argued that, de facto, in the U.S. the Fed was able to “designate” all investment banks in the wake of the Bear Stearns takeover and after the Lehman failure, by drawing up an MOU with the SEC, quickly embedding Fed officials with all major broker-dealers and finally subjecting the remaining firms to supervision by the Fed, with the firms acquiring the status of bank-holding companies.
The introduction of special resolution regimes also faces a number of important legal obstacles since special resolution regimes can affect the property rights of shareholders.
Jacome (2008) documents how the absence of special resolution regimes has reduced the effectiveness of crisis resolution in a number of Latin American countries since the mid-1990s. Interestingly, according to Jacome (2008), the introduction of special resolution regimes in the region was pioneered by Argentina, which alongside Brazil, is the only country in Latin America where the central bank is the main prudential regulator of banks. The special resolution framework empowered the central bank and helped in containing a banking crisis that was sparked by contagion in the wake of the Mexican devaluation in 1994.
A transition to the new Basel II rules was ongoing from 2007 in many of the sample countries. As noted, Spain was operating a dynamic provisioning regime since 2000.
See Turner 2009, page 89, for further discussion.
Before it was broken up into separate Dutch and Belgian institutions, Fortis Bank was a Belgian legal entity, that was supervised on a consolidated basis by the Belgian Banking, Finance and Insurance Commission (BFIC). In addition, Fortis was subject to supplementary supervision as prescribed in the EU directive on the supervision of financial conglomerates. Such supplementary supervision is meant to cover areas such as the shareholding structure of the parent company, the reliability of directors and management, the organizational structure of Fortis, its investment policy, risk concentration and intra-group activities. This supplementary supervision was exercised jointly by the BFIC and the Dutch Central Bank (DNB), and was governed by their agreement ‘Framework for the exercise of the supplementary supervision of Fortis dated February 28, 2002. Under the terms of this document, the BFIC was designated the coordinator of the supplementary supervision.
In Germany, of the total loss (US$56 billion as of Q2 2008), losses absorbed by the Landesbanken and IKB amounted to US$36.2 billion, against US$19.8 billion for other German institutions. The average loss ratio (losses/total assets)*100 for these two groups of institutions was 4.43 and 0.48, respectively, that is, higher by a factor of 9 for the former group. One potential explanation is that for the former group, market expectations of public support might have been high, reducing the force of market discipline.
The takeover of HBOS by Lloyds TSB was announced on September 18, 2008 and required the U.K authorities to waive competition rules.
RBS received an injection of public capital that was announced towards the end of the period, on October 13, 2008, at a time when a more comprehensive plan had already been announced, on October 7.
Dexia also affected Luxembourg and France, but was supervised by the Belgian authorities. The Austrian BAWAG failure had occurred before August 2007. The Austrian Erste Bank received a capital injection, announced Oct 30, 2008.
Under the plan set up in the Netherlands, the Dutch ING group accepted a capital injection on October, 19 2008. Aegon, a life insurer, also received a capital injection, announced on October 28, 2008. In France, a number of institutions accepted capital support under a comprehensive scheme by the end of 2008. In Portugal, a small private bank, BPN, was resolved in November 2008. It’s difficulties appear to have been related to management irregularities.
At the time of the Nordic crisis, the Finnish model was not yet integrated. The Banking Supervision Office was part of the Ministry of Finance.