1. Freddy Van den Spiegel Vrije Universiteit Brussel Economic Advisor BNP Paribas Fortis The new regulatory framework for banks, and its consequences. Financieel Forum Gent, 27 september 2011

2.

Identified weaknesses of the financial system.

Is the regulatory response the right answer?

- ultimate effect

3.

Ultimate effect.

• Dangerous strategies of banks.

• • Weak capital basisclear improvement.

• • • From 8 to 2%back to 8%.

• • • The never ending story of innovative instrumentsgone?

2. Is the regulatory response the right answer? ultimate effect. 4.

Ultimate effect.

• Dangerous strategies of banks.

• • Weak capital basis.

• • No concern about liquidityclear improvement.

2. Is the regulatory response the right answer? ultimate effect. 5.

Ultimate effect.

• Dangerous strategies of banks.

• • Weak capital basis.

• • No concern about liquidity.

• • Extreme leverageis the leverage ratio addressing the problem?

2. Is the regulatory response the right answer? ultimate effect. 6.

Ultimate effect.

• Dangerous strategies of banks.

• • Weak capital basis.

• • No concern about liquidity.

• • Extreme leverage.

• • Dependence on wholesale fundingrisk partly mitigated through liquidity rules.

2. Is the regulatory response the right answer? ultimate effect. 7.

Ultimate effect.

• Dangerous strategies of banks.

• • Weak capital basis.

• • No concern about liquidity.

• • Extreme leverage.

• • Dependence on wholesale funding.

• • Poor risk management.

• • • Nave belief in modelsbetter models as solution?

• • • stress tests and scenario analysis OK.

• • • Can banks be serious about risk?Remains a delicate issue.

2. Is the regulatory response the right answer? ultimate effect. 8.

Ultimate effect.

• Dangerous strategies of banks.

• • Weak capital basis.

• • No concern about liquidity.

• • Extreme leverage.

• • Dependence on wholesale funding.

• • Poor risk management.

• • Poor governance .

• • • Role of boardsstill unclear.

• • • Wrong incentives (bonuses)improvements.

2. Is the regulatory response the right answer? ultimate effect. 9.

Ultimate effect.

• Dangerous strategies of banks.

• • Weak capital basis.

• • No concern about liquidity.

• • Extreme leverage.

• • Dependence on wholesale funding.

• • Poor risk management.

• • Poor governance.

• • Aggressive growth strategieswill come back sooner or later.

2. Is the regulatory response the right answer? ultimate effect. 10.

Ultimate effect

• Dangerous strategies of banks.

• • Weak capital basis.

• • No concern about liquidity.

• • Extreme leverage.

• • Dependence on wholesale funding.

• • Poor risk management.

• • Poor governance.

• • Aggressive growth strategies.

• • Increasing complexity/opaquenesssome aspects tackled .(resecuritisation)

2. Is the regulatory response the right answer? ultimate effect. 11.

Identified weaknesses of the financial system.

• Dangerous strategies of banks.

• Poorly designed regulatory/supervisory framework.

• • Pro-cyclicality of Basel II and fair value, model driven, external ratings driven, nave belief in banksno fundamental shift. Some improvements like anti-cyclical buffers if implemented.and trading book

2. Is the regulatory response the right answer? ultimate effect. 12.

Identified weaknesses of the financial system.

• Dangerous strategies of banks.

• Poorly designed regulatory/supervisory framework.

• • Pro-cyclicality of Basel II and fair value.

• • Poor supervisory framework.

• • • Forbearance and capturenot tackled.

• • • No cross border framework (even in EU)improvement with EBA, but still weak.

2. Is the regulatory response the right answer? ultimate effect. 13.

Identified weaknesses of the financial system.

• Dangerous strategies of banks.

• Poorly designed regulatory/supervisory framework.

• • Pro-cyclicality of Basel II and fair value.

• • Poor supervisory framework.

• • No stability supervisionESRB should be the answer, benefit of the doubt, and remains undiscovered territory.

2. Is the regulatory response the right answer? ultimate effect. 14.

Identified weaknesses of the financial system.

• Dangerous strategies of banks.

• Poorly designed regulatory/supervisory framework.

• • Pro-cyclicality of Basel II and fair value.

• • Poor supervisory framework.

• • No stability supervision.

• • No crisis managementframework to be developed.

2. Is the regulatory response the right answer? ultimate effect. 15.

Identified weaknesses of the financial system.

Ultimate effect of the new regulation.

The difficult transition and broader economic impact.

16.

BCBS 12 September 2010

17.

The international legislative process.

BCBS 12 September 2010 final agreement.

Capital requirements: gradual increase until 2019.

Capital conservation buffer: up to 2.5%.

Supplementary capital for systemic banks: TO DO.

Counter cyclical buffer: TO DO.

Leverage ratio: 3%, hard rule from 2018.

Liquidity rules: hard rule from 2018.

And supervisors can go beyond the requirements in Pillar 1 or Pillar 2

The new framework. 18.

BCBS 12 September 2010 agreement.

Capital requirements: gradual increase until 2019.

Capital conservation buffer: up to 2.5%.

Countercyclicalbuffer: TO DO.

Supplementary capital for systemic banks: TO DO.

Leverage ratio: 3%, hard rule from 2018.

Liquidity rules: hard rule from 2018.

Criticism

Too little too slow.

Will hurt the real economy: need for impact assessments.

The new framework. 19.

McKinsey.

• EU banks require 1000 bn equity (50%).

• EU banks require 3000 bn long term funding (50%).

• ROE down 4%.

• Impact depends on business line.

• • Retail OK.

• • Trading NOK.

• • Trade finance NOK.

Impact on banks and economy. 20.

IIF study.

Cost of lending: +1%.

Capital requirements (core tier 1): + 1000 bn.

GDP: - 4.4%.

Employment: - 5 million.

BIS study.

Direct impact on GDP negligible.

Overall impact positive because of more stability.

The problem of orderly deleveraging

The difficulty to take into account the vulnerable macro environment .

Impact on banks and economy. 21. 22. Banks exposure to non-domestic Eurozone periphery (Greece, Spain, Portugal, Italy), sovereign and private sector debt, in % of GDP Banking contagion channel: exposure to sovereign and private sector debt 23. 24. 25.

Identified weaknesses of the financial system.

Ultimate effect of the new regulation.

The difficult transition and broader economic impact.

Issues beyond Basel III.

• - cross border banking

26.

Agreement about the need of consolidated supervision.

But requirements also to be fulfilled at sub consolidated and solo level: risk. of inconsistency between solo and consolidated level.

Cooperation between supervisors in colleges, but with which competence?

Specific EU problem .

The future of cross border banking. 4. Issues beyond Basel III. 27.

Specific EU problem.

Integrated financial market as a political goal inconsistent with supervision at member state level.

Freedom of establishment and free delivery of services as basic principles: means no supervision by host countries for branches, even if systemically relevant.

Even for subsidiaries limited competence for host supervisors: risk models approved by home supervisor of group.

Capital add ons at sub-level (Pillar 1 or Pillar 2)?

Member states focused on national interest, given experience with crisis: ring fencing?

Complicated political compromises as a consequence:

• Colleges get legal basis and role.

• New EU supervisory authority (EBA) empowered in case of disagreement between involved supervisors?

• Risk of getting back to fragmentation.

Impact on cross border banking in EU.

• Cross border organization.

• Incentive for cross border banking?

The future of cross border banking. 4. Issues beyond Basel III. 28.

Identified weaknesses of the financial system.

Ultimate effect of the new regulation.

The difficult transition and broader economic impact.

Issues beyond Basel III.

• -cross border banking

• - systemic banks

29.

Definition

Systemic banks are banks which, if they fail, could bring the whole financial system down.

Are not allowed to fail, which creates moral hazard and competitive distortions.

too big to fail, size but also other criteria:

• infrastructure function (public utility).

• interconnectedness.

Not only banks, also other financial institutions and even non-financial institutions (IT).

Also small banks can become systemically relevant (Northern rock).

Useful/indispensable in the financial system?

Importance of systemic banks in the EU.

What about systemic banks? 4. Issues beyond Basel III. 30.

Definition.

too big to fail: not allowed or stricter regulation/supervision?

• proposals of King, Turner, Geithner, Dodd-Franck,

What about systemic banks? 4. Issues beyond Basel III. 31.

Definition.

too big to fail: not allowed or stricter regulation/supervision?

Limit interconnectedness.

What about systemic banks? 4. Issues beyond Basel III. 32.

Limit interconnectedness?

Internally: cross border group organized as a chain of autonomous subsidiaries. But impact on financial integration.

Externally: by means of clearing houses, netting, etc.

What about systemic banks? 4. Issues beyond Basel III. 33.

Definition.

too big to fail: not allowed or stricter regulation/supervision?

Limit interconnectedness.

Public utility?

What about systemic banks? 4. Issues beyond Basel III. 34.

Public utility?

Systemic banks are like public utilities: zero risk tolerance.

What about systemic banks? 4. Issues beyond Basel III. 35.

Definition.

too big to fail: not allowed or stricter regulation/supervision?

Limit interconnectedness.

Public utility?

Narrow banking?

What about systemic banks? 4. Issues beyond Basel III. 36.

Narrow banking?

Big banks with retail deposits should only engage in traditional, simple activities: deposits and loans.

US: Dodd- Frank act: softly back to Glass Steagall.

Still possible given economic complexity?

Who will provide international financial services, given globalization?

simple activities are not always risk free (example S&L).

Diversified activities lead to better risk diversification .

What about systemic banks? 4. Issues beyond Basel III. 37.

Definition.

too big to fail: not allowed or stricter regulation/supervision?

Limit interconnectedness.

Public utility?

Narrow banking?

Supplementary capital requirements?

What about systemic banks? 4. Issues beyond Basel III. 38.

Supplementary capital requirements?

More capital to compensate for risk of too big to fail.

Does not address real problem.

Role of Cocos?

What about systemic banks? 4. Issues beyond Basel III. 39.

Definition

too big to fail: not allowed or stricter regulation/supervision?

Limit interconnectedness

Public utility?

Narrow banking?

Supplementary capital requirements?

Living wills?

What about systemic banks? 4. Issues beyond Basel III. 40.

Living wills?

Systemic banks must be better prepared for occasional problems: need for contingency plan and resolution plan.

Solution for too big to fail problem if realistic.

Can improve discipline to avoid excessive complexity of groups.

Can potentially be administratively burdensome and theoretical solution.

What about systemic banks? 4. Issues beyond Basel III. 41.

Definition.

too big to fail: not allowed or stricter regulation/supervision?

Limit interconnectedness.

Public utility?

Narrow banking?

Supplementary capital requirements?

Living wills?

Supplementary taxation/levy?

What about systemic banks? 4. Issues beyond Basel III. 42.

Supplementary taxation/levy?

too big to fail is reality. The implicit guarantee of the government has to be compensated?

Is popular given financial situation of governments.

But increases moral hazard .

What about systemic banks? 4. Issues beyond Basel III. 43.

Definition.

too big to fail: not allowed or stricter regulation/supervision?

Limit interconnectedness.

Public utility?

Narrow banking?

Supplementary capital requirements?

Living wills?

Supplementary taxation?

NO EASY ANSWERS.

What about systemic banks? 4. Issues beyond Basel III. 44.

Identified weaknesses of the financial system.

Ultimate effect of the new regulation.

The difficult transition and broader economic impact.

Issues beyond Basel III.

• - cross border banking

• - systemic banks

• - Macro prudential supervision

45.

Global level:FSB/IMF

• International agreements?

US: Financial stability oversight council

• monitoring, regulatory binding recommendations, define systemic institutions

EU: European Systemic Risk Board

• (binding?) recommendations

Member states

• Diversity

Organization of systemic risk supervision 46.

(binding) recommendations.

taxation.

Monetary policy.

Micro prudential supervision.

Market organisation and functioning

Capital controls

Any instrument if enforced by law.

IN THEORY EXTREMELY POWERFUL BUT A HUGE RESPONSIBILITY

Tools and instruments of systemic risk supervision 47.

How to tackle global imbalances/geopolitical issues

How to identify dangerous developments?

The danger of interventions (unintended consequences).

How to decide if conflicting objectives?

Democratic deficit/national reaction if recommendation from supranational level.

Impact on growth.

How to monitor the non regulated sector?

Cordination at global level?

Cordination within EU (monetary politicy, stability pact, ESRB, treaty, member states/EU)?

Legal certainty.

EXTREEM MORAL HAZARD IF SUCCESFUL.

Challenges for systemic risk supervision. 48.

Identified weaknesses of the financial system.

Ultimate effect of the new regulation.

The difficult transition and broader economic impact.

Issues beyond Basel III.

• - cross border banking

• - systemic banks

• - Macro prudential supervision

• - a very long list

49.

The issue of cross border banking

The issue of systemic banks

New IFRS rules.

Better governance

Rating agencies.

Hedge funds/ alternative investment vehicles/shadow banking.

Financial infrastructure: clearing/settlement.

Organisation of prudential supervision.

Organization of stability supervision (macro-prudential).

Role of deposit guarantee schemes.

Organization of early intervention and crisis management. Bail-out/bail-in?

Taxation on financial transactions/institution.

Normalization (reprivatisation) of banking.

4. Issues beyond Basel III 50.

Identified weaknesses of the financial system.

Ultimate effect of the new regulation.

The difficult transition and broader economic impact.

Issues beyond Basel III.

Banks in the new environment.

51.

The difficult transition to normal

• Exit of government support

• Exit of central bank support

• Find new equity

• Find liquidity

• CHANGE OR GET SQUEEZED

• While markets remain vulnerable (sovereign risk)

5. Banks in the new environment. 52.

The difficult transition to normal

The new mathematics of sustainability

• ROE: 8 10%?

• Growth potential: 4%

• Asset growth 4%

• Annual equity need 4%

• Dividend max 4%

• As a consequence, price book value to stick at 1

• • HOW TO GET OUT OF THIS UNATTRACTIVE COMBINATION?

5. Banks in the new environment. 53.

The difficult transition to normal

The new mathematics of sustainability

How to improve the mathematics?

• Cost cutting, the natural reaction

• Clear choices in strategy: geography/activity/customer

• The end of the European universal bank?

5. Banks in the new environment. 54.

The new regulatory framework: the good, the bad and the ugly

The transition will be difficult and bumpy because uncoordinated, and given the macro environment

There is no clear picture about which banking system we want, a dangerous experiment

CONCLUSIONS 55.

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