Including updates on measuring the impact of regulatory reforms, Libor and short selling

 

Estimating the impact of regulatory reforms

The IMF believes that current regulatory reforms will result in a modest increase in the cost of lending. Average bank lending rates are likely to increase by 28 basis points in the United States, 17 basis points in Europe, and 8 basis points in Japan in the long term according to a recent IMF staff discussion note.

These figures are less than other studies have suggested (Slovik and Cournède 2012; Basel Committee 2010; Roger and Vlcek 2011; Institute of International Finance), which may be explained by the IMF omitting transition costs, but they support the general consensus that the impact of new regulations on lending rates is marginal.

Averaging across all studies, it appears banks may increase their lending spreads by about 15 basis points to meet the capital requirements in 2015 (4.5% for the common equity ratio, 6% for the Core Tier 1 (CT1) capital ratio). The capital requirements at 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio) could increase bank lending spreads by about 50 basis points. The average medium-term impact of Basel III’s implementation on Gross Domestic Product is in the range of −0.05 to −0.15 percentage points. Therefore, the potential reduction in lending and investment following the implementation of Basel III is not predicted to be substantial.

All the studies mentioned above use simple models to estimate changes in lending rates and economic output arising from regulatory reforms. Moreover, they use similar methodologies and make similar assumptions.

Most assume that banks will be able to increase their capital levels gradually (common equity ratio by about 1.2 percentage points per year and the CT1 capital ratio by about 0.5 percentage points each year until 2015). However, in reality a gradual transition is not probable. Regulators and investors are likely to punish banks with low capital levels through greater scrutiny or depressed stock prices, respectively. The scramble by European banks to raise their capital levels by last June to inject confidence into financial markets suggests that a more truncated path is more likely.

These models tend to assume that banks will not have to write down their balance sheets in the future. This assumption seems at odds with the particularly anaemic global economic growth rates, concern over the fragility of some sovereigns, and rising impaired loans in the EU we are seeing currently.

These models generally assume that banks will be able to tap private markets to raise their capital levels at sustainable rates. Thus, funding costs will be neutralised and the nasty impacts of deleveraging will be minimised. But in reality banks are deleveraging and most European banks missed their Q2 2012 financial targets. Central banks are offering liquidity to stimulate lending and raising debt is still expensive.

Another shortcoming is that the models fail to take into account all regulations, considering only those amenable to mathematical modelling. For example the impacts of liquidity regulations are generally excluded. Moreover, the impact on reforms on capital markets and the shadow banking sector are generally ignored, again because they are difficult to quantify.

It is also assumed that regulations will be implemented in an appropriate manner, enabling banks to plan for reform and thereby avoiding unnecessary costs. Delays in adopting legislation, such as CRD IV and Omnibus II, the constant ‘drip feed’ of new legislative proposals in the EU, and the disparate countries implementing their G20 commitments in different ways and on different timetables make it difficult for international banks to undertake considered planning and efficient implementation.

More generally, current models can only capture benefits accruing from the lower volatility of the key macroeconomic variablesto the extent that the new regulation causes such a decline. Even the quantification of these benefits is limited by the linear nature of the models which cannot capture the creation of boom-bust cycles. Andrew Haldane, Executive Director at the Bank of England, believes that it is “not difficult to imagine the economic and financial system exhibiting some, perhaps all, of these features – non-linearity, criticality, contagion”. However, current modelling assumes normal distribution (e.g. VaR models), and that markets are perfectly frictionless, actors are rational and markets naturally find their steady-state equilibrium. Any passing observer of the recent financial crisis may have a few issues with these assumptions.

The models generally accept that having banks hold more capital will be effective. Looking at the Capital Requirements Directive IV specifically, a study from the European Parliament’s Economic and Monetary Affairs Committee (ECON) estimated that the benefits that accrue from higher capital requirements—namely by reducing the probability and severity of financial crises—will far exceed its costs, including higher financing costs for banks and reduced lending in the economy. ECON’s study (and similar cost benefit analyses) rests on the assumption that higher capital requirements will reduce the probability of bank failures. However no empirical study has found this to be the case. Higher capital levels may diminish the severity of financial crises when it happens, but it may not - we don’t yet know for sure.

But it is easy to critique these exercises and nitpick; researchers and their models are limited in what they can do for us. Trying to estimate the impact of regulations is a tricky task and fraught with challenges. Undertaking these studies is a good exercise in itself and should be supported. However, Adair Turner, Chairman of the FSA, also advocates more qualitative analysis be undertaken in tandem with formal impact assessments, given the inherent complexity of financial markets and the limitations of quantitative modelling.

What is clear is that no one yet fully understands the impact of these reforms and this is concerning. Some suggest resolving the issues through designing better models, reducing the complexity of financial markets and/or constructing simpler regulation. But this cannot happen overnight.

Perhaps some consideration should be given to other more radical ideas. In a speech delivered on 14 September, Thomas Hoenig of the US Federal Deposit Insurance Corporation (FDIC) called on policy makers to “go back to basics”. After reading the entire 1,000-plus page Basel III proposal, Hoenig encourages regulators to “step back” and “rethink” the whole regime. He believes that Basel III will not improve outcomes for the largest banks “since its complexity reduces rather than enhances capital transparency”.

Basel III should increase capital levels significantly over the previous regime but it does so “using highly complex modelling tools that rely on a set of subjective, simplifying assumptions to align a firm's capital and risk profiles”. Hoening suggests that much of its complexity derives from the complexities and conflicts embedded in the combination of commercial banking and broker/dealer activities.

He argues that a ratio of tangible equity to tangible assets would serve the system better, as a “simple measure” which would serve as a “demanding minimum capital requirement”. This approach would be more transparent and enable investors to compare the capital position of firms. Moreover, it would make it easier for policy makers to quantify the impacts of reforms in the future. Also, bank executives would be able to understand regulations better and restructure their businesses. He believes that international capital rules which are simple, understandable and enforceable, would also generate less regulatory arbitrage and gaming and potentially make the financial system safer.

Would such a dramatic re-direction in the current global approach bring the full benefits Hoenig envisages? It seems and worthy of further consideration, given uncertainties about whether even the Basel III measures will protect our markets from the turmoil of further bank failures.


 

Regulatory Round-up

The LIBOR scandal has been under the spotlight this month; the International Organization of Securities Commissions (IOSCO) announced the establishment of a Board Level Task Force on Financial Market Benchmarks on 14 September. The task force is mandated to identify relevant benchmark-related policy issues and develop global policy guidance and principles for benchmark-related activities of particular relevance to market regulators. The ECON Committee also published the responses to its consultation on market manipulation. The consultation looked for feedback on what measures should be taken to ensure integrity and quality of all benchmarks; to improve investor confidence in light of the scandal; and to increase transparency around the operation and governance of benchmarks. Next week the UK Government’s Wheatley Review will publish its final proposals, which are likely to influence international developments.

With the November implementation date of the Short Selling Regulation (Regulation (EU) No 236/2012) approaching rapidly, ESMA published a Question & Answers (Q&A) to help promote common supervisory approaches and practices amongst national supervisors. The Q&A seeks to provide clarity on the requirements of the new regime to market participants and investors.

The Basel Committee on Banking Supervision (Basel Committee) revised its core principles for effective banking supervision on 14 September. The individual core principles have been enhanced, in particular to strengthen supervisory practices and risk management. They also reflect key advances in regulatory thinking in recent years including:
  • moving towards risk based supervision;
  • considering financial system risks more broadly (macro prudential regulation);
  • adopting effective crisis preparation and management strategies, together with orderly resolution frameworks and other measures to mitigate the impact of bank failures; and
  • fostering robust market discipline through sound supervisory practices in the areas of corporate governance, disclosure and transparency.
The Basel Committee principles are likely to percolate down to all aspects of national supervision of banks in the coming years.