Bank regulation, lending, and financial markets

Asian Development Bank Institute, October 16, 2015

Douglas J. Elliott (delliott@brookings.edu)

www.brookings.edu/experts/elliottd.aspx

The views expressed in this presentation are the views of the author and do not necessarily reflect the views or policies of the

Asian Development Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of Directors, or the governments they

represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any

consequences of their use. Terminology used may not necessarily be consistent with ADB official terms.

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Agenda

• Causes of the global financial crisis

• Categories of potential solutions

• Basel III

• Cost-benefit analysis of Basel III

• Key effects on Emerging Markets

• Macroprudential policy

• Shadow banking

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Causes of the global financial crisis

• Mistakes by almost everyone

» Wall Street

» Institutional and retail investors

» Regulators

» Rating agencies

» Governments and central banks

» Home buyers

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Causes of the crisis (continued)

• 25 good years led to low risk aversion

• This is a classic Minsky-type financial crisis, endogenous to the financial system, without a major external shock

• Whatever the causes, the crisis also revealed a wide range of weaknesses in financial practices and regulation

» Excessively low capital and liquidity

» “Light touch” regulation and reliance on markets

» Financial products that were opaque, ill-designed, and/or otherwise not resilient

» Too little regulatory attention to non-banks

» Bad compensation and other incentives

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Categories of Potential Solutions

• Bigger and higher-quality buffers at individual institutions

» Capital

» Liquidity

• “Technical” fixes to market practices

» Securitization

» Ratings

» Derivatives

• Macroprudential policy (structural and cyclical)

• Improved regulatory designs and supervision practices

• Radical reforms

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Basel III

• Increases minimum levels of capital

» Higher capital as % of RWA

» Substantially higher RWA for securities (Basel 2.5)

» Somewhat higher RWA for other items

• Improves quality of capital – more tangible equity

• Creates global liquidity requirements

» Liquidity Coverage Ratio (LCR)

» Net Stable Funding Ratio (NSFR)

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Cost-Benefit Analysis

• Higher buffers come at a cost

• Equity IS more expensive than debt, especially on a private basis. Modigliani-Miller theorem only partially applies

• Improved liquidity increases bank costs and reduces revenues

• Most of the higher costs from capital and liquidity improvements will be passed on by the banks

» Higher costs or reduced availability for products

» Shift of business to non-banks

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Cost-benefit analysis (continued)

• Capital and liquidity costs are an important component of the price of loans and other financial services

• My 2012 studies for the IMF estimated an effect, all else equal, of 0.41 percentage points on pre-tax Return On Assets, compared to a long-term average of 1.0% ROA

• Impacts of these regulations on the real economy will depend on how banks specifically react to them

• How banks adapt to the new rules is complicated by the existence of multiple overlapping constraints

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Effects on Financial Market Liquidity

• Rules affecting banks and major broker/dealers will make financial markets less liquid

» Leverage ratio

» Liquidity Coverage Ratio

» Net Stable Funding Ratio

» Structural constraints (Volcker Rule, e.g.)

• Lower dealer inventories increase transaction costs and volatility

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My guesses on market liquidity

• Changes in liquidity to date are not very concerning, but the impacts are likely to be considerably bigger over time

» LCR and NSFR do not apply yet and some capital rules are being phased in

» Customer and competitor reactions force banks and large dealers to move in phases

» Monetary tightening is likely to reduce market liquidity

• I am not strongly worried about adverse effects on financial stability from lessened market liquidity

• My real concern is that decreases in efficiency may add many basis points of costs to very large markets from ill-calibrated requirements.

• I suspect an integrated review of these requirements could reduce these costs substantially with little loss of safety

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Key effects on Emerging Markets

• Basel III will mostly not affect EM

» Capital levels are already higher in general

» Most drastic effects are on sophisticated products

• But there are some areas of concern

» Liquidity, especially when financial markets are small

» Trade finance

» Infrastructure finance

• Basel process would benefit from more EM involvement

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Macroprudential policy

• Need for macroprudential policy is clear – focusing only on individual financial institutions misses too many important interactions and wider problems in market structures

• Structural macroprudential policy focuses on systemic issues that do not vary much with time

• Cyclical macroprudential focuses on financial market cycles and I believe it is a necessary approach

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Macroprudential – Lessons from US history

• Macroprudential policies are feasible even in a US context

• Political support can be mustered even for macroprudential tightening

• Macroprudential and monetary policy blend together

• Cyclical macroprudential policy can affect credit supply as intended

• Different economic sectors can be targeted

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Macroprudential – Lessons from US history (continued)

• Macroprudential policy may be easiest when measures appear technical

• A major mistake can make future macroprudential policy much harder

• Macroprudential policy may be most easily done through a single body

• See www.brookings.edu/research/papers/2013/09/13-macroprudential-policy-lessons-american-history-elliott

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Shadow banking

• Global financial crisis emphasized the importance of non-banks in credit intermediation and other financial services

• We do not have a good idea of how to regulate non-bank credit intermediation

• Focus has been on substantially tightening regulation of banks

• Result will be a big shift of business away from banks

• Much more needs to be done to explore this

• China shows some of the trade-offs and the difficulties: http://www.brookings.edu/research/papers/2015/04/01-shadow-banking-china-primer-elliott-kroeber-yu

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Conclusions

• Financial regulatory reforms are taking us a good way forward to a safer system

• Much remains to be done and we will never achieve perfection

• Financial cycles would remain even if regulation and supervision were as good as possible

• Emerging markets will be less affected in the short run by global regulatory reforms, which focus on more sophisticated financial systems

• Shadow banking is going to be a continuing regulatory problem