Credit Supply Management & Economic Sustainability:

1. Credit Supply Management & Economic Sustainability: The Legislative Bubble-Shrinker

2. Bubbles & Liquidity • Asset bubbles are created by increased credit supply • Available credit generates increased liquidity in market, asset prices rise • Prudent investors --->irrational speculators • Market actors are mostly herd beasts, following the leader and increasing liquidity/increasing volume as consequences of excess available credit

3. The Bubble Pops • The bubble pops: Macro Shock • Reinforced downward spiral: falling prices, underwater assets • Bank losses increase, reserves become depleted as assets depreciate • New loans needed to service old debt • Institutions can fail, cheat, or spend their way out • Overall credit market constricts when it is most needed: not for investment, for solvency!

4. Business Cycle • Business cycle/credit cycle are nearly coterminous, correlation is debated. • Business cycle can be driven by credit availability, credit availability at least partially predicated on demand segment of business cycle (what comes first? The chicken or the egg?) • Whichever comes first, the results are bubbles and corresponding panics. • Prevailing wisdom under Greenspan: “Don’t worry about it”. Almost fatalistic attitude towards mitigating the effects of cyclical fear and greed. • So why should we??

5. Hindsight is 20:20 • Bubbles can and should be mitigated. • Economic inefficiencies arise as evidenced by bailouts, expensive reactionary regulation, credit crunches, recessionary impacts on jobs and compensation. • Sustainable cycles allow the costs to be amortized over longer periods of time: • Preserves margins for lenders • Limits losses by investors • Reduces tax burdens imposed by increased spending

6. CFPA Transparency • CFPA: Transparency • House Bill proposes giving CFPA ability to promulgate regulation for “who deal or communicate directly with consumers in the provision of a consumer financial product, as the Director deems appropriate or necessary to ensure fair dealing with consumers.” • Requires the CFPA Director to conduct an annual financial autopsy regarding bankruptcies and foreclosures, including any specific financial products or services that have caused substantial numbers of them. • Complexity of system makes information asymmetry among market actors a given, widening gap with increased complexity • Trend-based investment leads to higher demands for capital and leads to adverse selection among banks

7. General Transparency • Prevented by CFPA’s disclosure guidelines • General transparency can reduce informational asymmetry • Financial autopsies will likely not stop innovation/loophole mining, but will reduce lag time between the invention of harmful financial products and their elimination from the market or will ensure that they are accompanied by proper disclaimer activity, thus increasing investor awareness of risk.

8. Capital Requirements • Capital Requirements: • Legislation: Off Balance Sheet activities are required to be part of capital requirement computations, includes: Direct credit substitutes like standby letters of credit, repos, asset sales with recourse, interest rate and credit swaps, securities contracts, forward contracts. • Asymmetric risk/reward scenarios in institutional insolvency • Higher capital requirements artificially restrict the amounts lent, position sizes and leverage rates • A lawyer’s definitional playground: will definitions of capital keep up with innovation?

9. Funeral Plans • Funeral Plans for facing potential insolvencies: • Legislation: Required of large & complex financial institutions, or face higher capital standards • Focused on system-wide protection • Reduces asymmetrical risk/reward scenarios when shareholders/management by restricting that activity via adherence to pre-existing dissolution plans. • Reduces overall systemic damage when insolvency of one institution occurs: limits the desperation lending close to insolvency when institutions take on higher yielding, higher risk loans to try to avoid liquidation.

10. House Bill • Credit Risk Retention Act of 2009 (in House Bill): • Requires any creditor to retain an economic interest in a material portion of the credit risk of any loan the creditor transfers, sells, or conveys to a third party--even securitized loans backed by assets.

12. The Obama Plan • An end run around credit-restricting legislation? • Mission: Defeat asset bubbles, prevent catastrophic collapse.

13. Acceptable Returns • Moderating credit supply can make for “lower highs” and “higher lows” • But Greenspan believed there was no way to arbitrarily present an acceptable, sustainable return by moderating the credit supply. • BECAUSE of • The subjectivity of “acceptable returns”: dependant on time, place, competition, etc. • There is no predictable mathematical break point for “when a bubble will burst”. • Therefore not worth it to artificially moderate the credit supply

14. Too Big To Fail AIG FANNIE MAE CITI BOA CIT GOLDMAN

15. Introduction • TBTF policy is the primary contributor to the current financial crisis • New legislation proposal of resolution authority is ineffective in ending TBTF • A new bankruptcy process should be established to end TBTF

16. Development of TBTF • FDIC on commercial banks • Allow commercial bank go out of business without damaging the entire economy • Insure only the SMALL depositors funds to prevent financial panic • Leave uninsured lender taking the loss

17. Development of TBTF • Continental Illinois • Insolvency in 1984 • Heavily relied on uninsured lender • 8th largest commercial bank in the nation • Government’s bailout • Sustain confidence in the nation’s banking system • Pledge no uninsured lender would lose money • Begun the Era of TBTF

18. Development of TBTF “We believe it is bad policy, would be seen to be unfair, it represents an unauthorized and unlegislated expansion of federal guarantees in contravention of executive branch policy.” ----- Donald Regan Treasury Secretary

19. Development of TBTF • Financial consolidation • Traditional banking • Security underwriting • Insurance • Real estate • Government safety net • Commercial banks • Investment banks

20. TBTF & Current Financial Crisis • TBTF = Government Subsidy • No fear of failure • Lenders put more money • Increase in credit supply • Decrease in cost of fund

21. TBTF and Current Financial Crisis • TBTF = Unfair competitive advantage • Encourage Americans on borrowing • No incentive to monitor • Incentive to make greater risk in investment

22. TBTF and Current Financial Crisis • Housing bubble • Easy money from lenders • Incentive to take risk

23. Continuity of TBTF • Last administration • TARP program • New administration • Treasury new power to stabilize a failing firms • Common problem • Prevent short-term consequence • Limitation on executive branch

24. Continuity of TBTF • Illiquidity • Cash < Immediate obligations • Rescue can prevent premature liquidation • Insolvency • Value of asset < value of liability • Rescue cannot prevent fire-sale of asset

25. Continuity of TBTF • AIG rescue • $85 million is not enough • Maturity up to 5 years • Interest rate down by 5.5% • Amount up to $150 million • Still no fear of failure • Delay restructuring or merger • Large bonuses – AIG: $165 million

26. End TBTF through Resolution Authority • House Bill and Senate Bill • Department of Treasury shall appoint the FDIC as receiver to dissolve failing firms • Publicly list certain large financial firms subjected to the special treatment • Discretionary administrative resolution by government agencies

27. End TBTF through Resolution Authority • Principal problems • Legally codified guarantee of certain financial firms • The executive power lack the long-settle and clearly interpreted process and precedents • Easily influenced by political pressures

28. End TBTF through Bankruptcy • Myth in bankruptcy • Dissipate the value of the assets • Common negative phrases • Slow actions and procedure

29. End TBTF through Bankruptcy • Market did not distinguish between the • distress resolution procedures • Market instead focuses on the financial distress • itself

30. End TBTF through Bankruptcy • Bankruptcy features • Allow DIP to issue new claims that take priority over other creditors, so that failing firm can obtain new financing • Automatic stay prohibits any collection effort upon its filing, so that the failing firm can preserve assets and prevent financial panic

31. End TBTF through Bankruptcy • Allow DIP to sell assets free and clear of liens and other liabilities, so that the acquirer is more likely to purchase the assets at higher price and in timely manner • Federal judges and judicial branch are free of political pressure and lobby efforts

32. Problem with Current Bankruptcy • Exemption from automatic stay • Derivative contracts • New financial instrument • Lost of healthy asset • Lehman: counterparties canceled more than 700,000 of its 900,000 derivatives contracts • Lost of going concern value • AIG: forced to liquidate assets to generate collateral

33. Proposed New Bankruptcy Process • New chapter bankruptcy law for large financial institutions • Apply automatic stay and avoidance provisions to derivatives contracts • Able to invalidate the provisions in derivatives that make bankruptcy an event of default • Stronger powers to appoint receivers to take over large failing firms

34. Conclusion • Free market and Capitalism • Alan Greenspan is wrong? • TBTF is not free market! • Restore free market • Bad firms die, bad ideas die with it

35. Bank Capital Requirements

36. What is Bank Capital? Bank Capital: • Is bank’s net worth, which equals the difference between total assets and liabilities. • Is a cushion against a drop in the value of bank assets, which could force a bank into insolvency. • Helps prevent bank failure, a situation in which a bank cannot satisfy its obligations to pay its depositors and other creditors. • Helps lessen the chance that a bank will become insolvent if its assets drop or devalue.

37. Why is Bank Capital Important? • The amount of capital affects return on investment for the equity holders (owners) of the bank. • Bank capital ends up costing the equity holders because higher capital reserves generate lower return on equity for a given return on assets. • On the one hand, the lower the bank capital, the higher the return for the equity holders of the bank. • On the other hand, larger bank capital reserves benefit the equity owners of a bank because it makes their investment safer by reducing the likelihood of bankruptcy.

38. How Do Banks Raise Capital? Banks can raise capital by: • issuing new equity (common stock), • Issuing bonds that can be converted into equity, • reducing the bank’s dividends to shareholders, which increase the retained earnings that can be put into capital accounts. • Neither option is particularly appealing to existing shareholders because issuance of new equity dilutes their profits and reduction of dividends simply reduces their return on investment.

39. Role of Bank Capital Requirements in the Recent CRISIS and How Higher Reserves Could Have Averted Bank Failures • Higher bank capital reserves could have provided a means of satisfying obligations to pay off depositors and creditors as assets were lost or devalued due to risky investments • Capital is supposed to act as a first line of defense against bank failures and their knock-on consequences for systemic risk by providing a cushion against losses.

40. Rationale for Bank Capital Regulation • The reason behind capital requirements is that when a bank is forced to hold a large amount of equity capital, the bank has more to lose if it fails and is thus more likely to pursue less risky activities. • Reducing a bank’s incentive to take on risky activities is one measure used to reduce moral hazard associated with a government safety net that bails out banks that are too big to fail (normally financed by taxpayers). • On the other hand: • It is possible that requiring investors to hold higher capital requirements could lead banks to seek a greater return on the additional capital in order to generate the same amount of profit, or • Higher capital requirements could drive financing out of the banking sector into less regulated sectors such as insurance or hedge funds.

41. Current Regulation of Bank Capital • Current regulatory capital standards have evolved from principles developed by the Committee on Banking Regulations and Supervisory Practices of the Bank for International Settlements (BIS) in Basel, Switzerland. • International risk-based capital standards were endorsed in 1988 by the Governors of the central banks of the G-10 countries (Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States) - referred to as the Basel Capital Accord or “Basel I.” • The Supervisory Committee has no formal authority but works to develop broad supervisory standards and promote best practices with the expectation that each country will implement the standards in ways most appropriate to its circumstances. • Agreements are developed by consensus, but decisions about which parts of the agreements to implement and how to implement them are left to each nation’s regulatory authorities. • All FDIC insured depository institutions are required to hold minimum levels of regulatory capital, even though the accord requires the U.S. to apply those standards only to large, internationally active banks. • On November 2, 2007, US implemented new Basel II requirements which were mandatory for large, internationally active banking organizations (so-called “core” banking organizations with at least $250 billion in total assets or at least $10 billion in foreign exposure) and was left optional for other banks.

42. Why is International Cooperation Important? • One concern is that banks might have a competitive advantage if they are allowed to hold less capital, allowing them to offer loans at lower prices. • Basel I Accord was developed to have uniform capital measures for large internationally active banks in order to enhance the soundness of the international banking system, and to reduce competitive inequalities among these banks that result from differences in international capital standards. • U.S. banks were required to hold more capital than most of their foreign competitors before the crisis. • U.S. banks are also on a better footing because the U.S. has recapitalized many of them with taxpayer money. Differences in accounting standards: Some bank balance sheets appear up to twice the size under European accounting rules than they would under U.S. standards. European banks are also structured differently. Many are cooperatives or have shareholders such as municipalities that can't raise funds in the same way as institutional shareholders in the U.S.

43. Structure of Regulatory Capital • Regulators’ Statutory Authority to Impose Capital Requirements stem from: • (1) International Lending Supervision Act of 1983, and • (2) the prompt corrective action provisions of the Federal Deposit Insurance Act. • The prompt corrective action statute generally requires each federal banking agency to prescribe two capital requirements: • “leverage limit,” and • “risk-based capital requirement” • 12 U.S.C. § 1831o(c)(1)

44. Leverage Limit (“Leverage Ratio”) • Requires FDIC-insured banks to maintain at least a 4% ratio of capital to total assets in order to qualify as adequately capitalized. • Leverage ratio constrains a bank’s ability to take on debt. • If a bank must maintain at least a 4% ratio of capital to total assets, the bank must have $100 in total assets for each $96 in total liabilities. • No international agreement requires a leverage limit. • The leverage ratio is designed, among other things, to curb excessive leveraging of capital, thereby preventing institutions from reducing their risk-based capital to dangerously low levels by investing in assets that require little or no capital to be held against them. • The ratio is also designed to provide a relatively high capital level to compensate for the fact that the Basel I standards do not include a component for interest rate risk, market risk, and other risks faced by depository institutions.

45. Risk Based Capital Requirement • The risk-based standards originated in an effort to correct for some of the leverage limit’s manifest blind spots, notably its failure to take account of credit risk and off-balance-sheet items. • This ratio is designed to reflect the credit risks posed to an institution by various categories of assets in its portfolio and is expressed in terms of capital required against a percentage of “risk-weighted assets” (total assets after their face amounts have been adjusted to reflect their current risk). • Current capital regulations require an institution to hold minimum regulatory capital equal to 8% of its risk-weighted assets. At least 50% of this amount must consist of Tier 1 capital components with the remainder held in Tier 2 capital. • Under this system, lesser amounts of capital are required to be held against lower-risk assets. Bank assets are divided into four risk-weighted categories of 0%, 20%, 50%, and 100%. • Riskier assets are placed in the higher percentage categories. For example, the 0 percent category includes cash and U.S. Treasury securities, while loans are generally in the 100 percent category. Risk-weighted assets, tier 1 capital, tier 2 capital and all three of the aforementioned capital ratios (tier 1 leverage, tier 1 risk-based and total risk-based) are also included in your bank’s quarterly Call Report. • Banks are expected to meet a minimum tier 1 risk-based capital ratio of 4 percent.

46. Components of Capital

47. New Basel Capital Requirements:Final provisions are scheduled for implementation by December 2012 Key elements of capital proposals: • raising the quality, consistency and transparency of the capital base; • strengthening the risk coverage of the capital framework, particularly with respect to counterparty credit risk exposures arising from derivatives, repos and securities financing activities; • introducing a leverage ratio requirement as an international standard; • measures to promote the build-up of capital buffers in good times that can be drawn upon during periods of stress, introducing a countercyclical component designed to address the concern that existing capital requirements are procyclical – that is, they encourage reducing capital buffers in good times, when capital could more easily be raised, and increasing capital buffers in times of distress, when access to the capital markets may be limited or they may effectively be closed; • global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio.

48. New Basel Capital Requirements: Old Standards: New Standards:

49. PROS and CONS of the new Basel Requirements (“Basel III”): Pros: Cons: • Forcing the banks to operate with larger safety buffers • Raising the quality, consistency and transparency of the capital base • Enhancing risk coverage • Supplementing the risk-based capital requirement with a leverage ratio* • Reducing procyclicality and promoting countercyclical buffers • Addressing systemic risk and interconnectedness • All elements of capital would have to be disclosed to improve the transparency of the capital base • Halt banks’ ability to expand in emerging markets and will most likely cause huge holes in capital stocks of Japanese, European financial institutions • Force banks to stop counting minority-owned stakes as part of their equity capital

50. How Does the Wall Street Reform and Consumer Protection Act of 2009 (H.R. 4173) Change Capital Adequacy Requirements? • Stricter Prudential Standards for Certain Financial Holding Companies for Financial Stability Purposes (Section 1104) • Contingent Capital (Section 1116) • Financial holding companies will be subject to stricter standards to maintain a minimum amount of long-term hybrid debt that is convertible to equity • Requirement for Countercyclical Capital Requirements (Section 1255) • Each appropriate Federal banking agency shall, in establishing capital requirements under this Act or other provisions of Federal law for banking institutions, seek to make such requirements countercyclical so that the amount of capital required to be maintained by a banking institution increases in times of economic expansion and decreases in times of economic contraction, consistent with the safety and soundness of the institution