Vice Chairman Stanley Fischer at the Martin Feldstein Lecture, National Bureau of Economic Research, Cambridge, Massachusetts
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Financial Sector Reform: How Far Are We?
Although the recession in
In this lecture I will ask how much has been achieved so far in implementing the ambitious financial sector reform program that was widely agreed at the early stages of the global financial crisis. From among the range of topics in which financial sector reforms have been instituted since 2008, I focus on three: capital and liquidity for banks and other financial institutions, macroprudential supervision, and the problem of too big to fail (TBTF).
What Happened?
The 2007-09 crisis was both the worst economic crisis and the worst financial crisis since the 1930s. Following the collapse of
Former Congressman
The Financial Sector Reform Program
Several financial sector reform programs were prepared within a few months after the
The programs--national and international--covered some or all of the following nine areas:2 (http://www.federalreserve.gov/newsevents/speech/fischer20140710a.htm#fn2) (1) to strengthen the stability and robustness of financial firms, "with particular emphasis on standards for governance, risk management, capital and liquidity"3 (http://www.federalreserve.gov/newsevents/speech/fischer20140710a.htm#fn3) (2) to strengthen the quality and effectiveness of prudential regulation and supervision; (3) to build the capacity for undertaking effective macroprudential regulation and supervision; (4) to develop suitable resolution regimes for financial institutions; (5) to strengthen the infrastructure of financial markets, including markets for derivative transactions; (6) to improve compensation practices in financial institutions; (7) to strengthen international coordination of regulation and supervision, particularly with regard to the regulation and resolution of global systemically important financial institutions, later known as G-SIFIs; (8) to find appropriate ways of dealing with the shadow banking system; and (9) to improve the performance of credit rating agencies, which were deeply involved in the collapse of markets for collateralized and securitized lending instruments, especially those based on mortgage finance.
Rather than seek to give a scorecard on progress on all the aspects of the reform programs suggested from 2007 to 2009, I want to focus on three topics of particular salience mentioned earlier: capital and liquidity, macroprudential supervision, and too big to fail.
Capital and Liquidity Ratios
At one level, the story on capital and liquidity ratios is very simple: From the viewpoint of the stability of the financial system, more of each is better.
This is the principle that lies behind the vigorous campaign waged by
But at what level should capital and liquidity ratios be set? In practice, the base from which countries work is agreement among the regulators and supervisors who belong to the
Following the global crisis, the BCBS moved to the Basel III agreement, which strengthens capital requirements, as opposed to Basel II, which tried to build primarily on measures of risk capital set by internal models developed by each individual bank. This approach did not work, partly because the agreed regulatory minimum capital ratios were too low, but also because any set of risk weights involves judgments, and human nature would rarely result in choices that made for higher risk weights. In
What has been achieved? Globally
* The minimum tier 1 capital ratio has been raised from 4 percent to 6 percent of RWA.
* There is a minimum common equity tier 1 capital ratio of 4.5 percent of RWA.
* There is a capital conservation buffer of 2.5 percent of RWA, to ensure that banking organizations build capital when they are able to.
* A countercyclical capital buffer has been created that enables regulators to raise risk-based capital requirements when credit growth is judged to be excessive.
* A minimum international leverage ratio of 3 percent has been set for tier 1 capital relative to total (i.e., not risk-weighted) on-balance-sheet assets and off-balance-sheet exposures.
* There is a risk-based capital surcharge for global systemically important banks (G-SIBs) based on these firms' systemic risk.
the United States
* The Federal Reserve is planning to propose risk-based capital surcharges for U.S. G-SIBs, based on the BCBS proposal for G-SIBs.6 (http://www.federalreserve.gov/newsevents/speech/fischer20140710a.htm#fn6)
* The relevant U.S. regulators (the Fed, the
* Foreign banking organizations with U.S. nonbranch assets of
Many of these rules do not apply to community banks, in light of their different business models.
One more point on bank capital: The Swiss and Swedish regulators have already gone far in raising capital requirements, including by requiring bail-in-able secondary holdings of capital in the form of contingent convertible capital obligations (CoCos).
In addition to enhanced capital ratios and tougher measures of risk-based capital, the Basel III accord includes bank liquidity rules, another key element of global financial regulatory reform. The Basel Committee has agreed on the Liquidity Coverage Ratio (LCR), which is designed to reduce the probability of a firm's liquidity insolvency over a 30-day horizon through a self-insurance regime of high-quality liquid assets (HQLA) to meet short-term stressed funding needs. The BCBS is also working to finalize the Net Stable Funding Ratio (NSFR), which helps to ensure a stable funding profile over a one-year horizon.
The bottom line to date: The capital ratios of the 25 largest banks in
At the same time, the introduction of macroeconomic supervisory stress tests in
Macroprudential Policy and Supervision
In practice, there are two uses of the term "macroprudential supervision."8 (http://www.federalreserve.gov/newsevents/speech/fischer20140710a.htm#fn8) The first relates to the supervision of the financial system as a whole, with an emphasis on interactions among financial markets and institutions. The second relates to the use of regulatory or other non-interest-rate tools of policy to deal with problems arising from the behavior of asset prices.9 (http://www.federalreserve.gov/newsevents/speech/fischer20140710a.htm#fn9) For instance, when central bank governors are asked how they propose to deal with the problem of rising housing prices at a time when the central bank for macroeconomic reasons does not want to raise the interest rate, they generally reply that if the need arises, they will use macroprudential policies for that purpose. By that they mean policies that will reduce the supply of credit to the housing sector without changing the central bank interest rate.
Sector-specific regulatory and supervisory policies in the financial sector were used extensively and systematically in
The issue of how monetary policy should relate to asset-price inflation had been on the agenda of central bankers for many years before the
At present, the word macroprudential is used primarily in the second sense--of the use of regulatory and supervisory noncentral bank interest rate tools to affect asset prices. In this sense, the use of the word takes us back to a world that central bankers thought they had left by the 1990s.14 (http://www.federalreserve.gov/newsevents/speech/fischer20140710a.htm#fn14)
Now, from etymology to economics: I want to review my experience with macroprudential policies--in the second sense of noninterest regulatory and supervisory policies--as Governor of the
The banks are the largest financial institutions in
The most successful of these measures was the limit of one-third imposed in
There are three key lessons from this experience. First, the
Second, measures aimed at reducing the demand for housing are likely to be politically sensitive.21 (http://www.federalreserve.gov/newsevents/speech/fischer20140710a.htm#fn21) Their use requires either very cautious and well-aimed measures by the regulatory authorities, and/or the use by the government of subsidies to compensate some of those who end up facing more difficulty in buying housing as a result of the imposition of macroprudential measures. Indeed, it often appears that there is a conflict between cautious risk management by the lenders and the desire of society to house its people decently.
Third, there is generally a need for coordination among several regulators and authorities in dealing with macroprudential problems of both types.
There are many models of regulatory coordination, but I shall focus on only two: the British and the American. As is well known, the
In discussing these two approaches, I draw on a recent speech by the person best able to speak about the two systems from close-up,
After reviewing the structure of the FSOC, Kohn presents a series of suggestions to strengthen its powers and its independence. The first is that every regulatory institution represented in the FSOC should have the goal of financial stability added to its mandate. His final suggestion is, "Give the more independent FSOC tools it can use more expeditiously to address systemic risks." 23 (http://www.federalreserve.gov/newsevents/speech/fischer20140710a.htm#fn23) He does not go so far as to suggest the FSOC be empowered to instruct regulators to implement measures somehow decided upon by the FSOC, but he does want to extend its ability to make recommendations on a regular basis, perhaps on an expedited "comply-or-explain" basis.
Kohn remarks that he does not hold up the
These are important, and difficult, issues. Kohn's proposals clearly warrant serious examination. It may well be that adding a financial stability mandate to the overall mandates of all financial regulatory bodies, and perhaps other changes that would give more authority to a reformed FSOC, would contribute to increasing financial and economic stability.
Financial Reform and TBTF
Diagnoses of what went wrong with the financial system at the start of the Great Recession in
I will start by discussing some of the main steps in the links between TBTF and the crisis, and between the financial sector reform program and TBTF. We begin with the link between TBTF and government intervention: Once investors believe that governments will intervene to prevent large banks from becoming bankrupt, they become willing to lend to these banks at lower rates than they would lend without the implicit guarantee. This could lead to such banks becoming larger than optimal and to encouraging them to take more risks than they would absent expected government intervention to reduce the likelihood of their becoming bankrupt.
A great deal of empirical work has attempted to measure the premium--in terms of a lower cost of financing--that the large banks typically receive. The results vary, but a representative set of estimates--that of the
Do large banks, with lower costs of financing, take bigger risks? The empirical relationship between bank size and their risk-taking has been examined by Laeven, Ratnovski, and Tong, who find that "large banks tend to have lower capital ratios, less stable funding, more market-based activities, and (to) be more organizationally complex than small banks."27 (http://www.federalreserve.gov/newsevents/speech/fischer20140710a.htm#fn27) From this they conclude that "[l]arge banks are riskier, and create more systemic risk, when they have lower capital and less-stable funding. [They] create more systemic risk (but are not individually riskier) when they engage more in market-based activities or are more organizationally complex."28 (http://www.federalreserve.gov/newsevents/speech/fischer20140710a.htm#fn28)
The key to these results is the recognition that banks have several sources of financing, and that the more they rely on market interest rate-sensitive short-term funding, the less stable they are likely to be. Organizational complexity is certainly an issue: Maintaining managerial control, especially risk control, in a multi-activity bank, where individual rewards may be massive, is extremely difficult--think for instance of Baring's in the late 1990s, or
It could be that large banks can finance themselves more cheaply because they are more efficient, that is, that there are economies of scale in banking. For some time, the received wisdom was that there was no evidence of such economies beyond relatively modest-sized banks, with balance sheets of approximately
The TBTF theory of why large banks are a problem has to contend with the history of the Canadian and Australian banking systems. Both these systems have several very large banks, but both systems have been very stable--in the Canadian case, for 150 years.31 (http://www.federalreserve.gov/newsevents/speech/fischer20140710a.htm#fn31) Beck, Demirguc-Kunt, and Levine (2003) examined the impact of bank concentration, bank regulation, and national institutions on the likelihood of a country suffering a financial crisis and concluded that countries are less likely to suffer a financial crisis if they have (1) a more concentrated banking system, (2) fewer entry barriers and activity restrictions on bank activity, and (3) better-developed institutions that encourage competition throughout the economy.32 (http://www.federalreserve.gov/newsevents/speech/fischer20140710a.htm#fn32) The combination of the first finding with the other two appears paradoxical, but the key barrier to competition that was absent in
Why is the TBTF phenomenon so central to the debate on reform of the financial system? It cannot be because financial institutions never fail. Some do, for example,
Almost certainly, TBTF is central to the debate about financial crises because financial crises are so destructive of the real economy. It is also because the amounts of money involved when the central bank or the government intervenes in a financial crisis are extremely large, even though the final costs to the government, including the central bank, are typically much smaller. In some cases, governments and central banks even come out slightly ahead after the crisis is over and the banks have been sold back to the private sector. Another factor may be that the departing heads of some banks that failed or needed massive government assistance to survive nonetheless received very large retirement packages.
One can regard the entire regulatory reform program, which aims to strengthen the resilience of banks and the banking system to shocks, as dealing with the TBTF problem by reducing the probability that any bank will get into trouble. There are, however, some aspects of the financial reform program that deal specifically with large banks. The most important such measure is the work on resolution mechanisms for SIFIs, including the very difficult case of G-SIFIs. In
Closely associated with the work on resolution mechanisms is the living will exercise for SIFIs. In addition, there are the proposed G-SIB capital surcharges and macro stress tests applied to the largest BHCs (
What about simply breaking up the largest financial institutions? Well, there is no "simply" in this area. At the analytical level, there is the question of what the optimal structure of the financial sector should be. Would a financial system that consisted of a large number of medium-sized and small firms be more stable and more efficient than one with a smaller number of very large firms? That depends on whether there are economies of scale in the financial sector and up to what size of firm they apply--that is to say it depends in part on why there is a financing premium for large firms. If it is economies of scale, the market premium for large firms may be sending the right signals with respect to size. If it is the existence of TBTF, that is not an optimal market incentive, but rather a distortion. What would happen if it was possible precisely to calculate the extent of the subsidy or distortion and require the bank to pay the social cost of the expansion of its activity?35 (http://www.federalreserve.gov/newsevents/speech/fischer20140710a.htm#fn35) This could be done either by varying the deposit insurance rate for the bank or by varying the required capital ratios for SIFIs to fit each bank's risk profile and structure. This, along with measures to strengthen large banks, would reduce the likelihood of
Would breaking up the largest banks end the need for future bailouts? That is not clear, for
In short, actively breaking up the largest banks would be a very complex task, with uncertain payoff.
The Bottom Lines
* By raising capital and liquidity ratios for SIFIs, and through the active use of stress tests, regulators and supervisors have strengthened bank holding companies and thus reduced the probability of future bank failures.
* Work on the use of the resolution mechanisms set out in the Dodd-Frank Act, based on the principle of a single point of entry, holds out the promise of making it possible to resolve banks in difficulty at no direct cost to the taxpayer--and in any event at a lower cost than was hitherto possible. However, work in this area is less advanced than the work on raising capital and liquidity ratios.
* Although the BCBS and the FSB reached impressively rapid agreement on needed changes in regulation and supervision, progress in agreeing on the resolution of G-SIFIs and some other aspects of international coordination has been slow.
* Regulators almost everywhere need to do more research on the effectiveness of microprudential and other tools that could be used to deal with macroprudential problems.
* It will be important to ensure that coordination among different regulators of the financial system is effective and, in particular, will be effective in the event of a crisis.
* A great deal of progress has been made in dealing with the TBTF problem. While we must continue to work toward ending TBTF or the need for government financial intervention in crises, we should never allow ourselves the complacency to believe that we have put an end to TBTF.
* We should recognize that despite some imperfections, the Dodd-Frank Act is a major achievement.
* At the same time, we need always be aware that the next crisis--and there will be one--will not be identical to the last one, and that we need to be vigilant in both trying to foresee it and seeking to prevent it.
And if, despite all our efforts, a crisis happens, we need to be willing and prepared to deal with it.
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