Presentation Transcript

1. THE FINANANCIAL CRISIS AND THE REVISION OF THE REGULATION ON FINANCIAL MARKETS

   Alberto Franco Pozzolo Università degli Studi del Molise Unimol Summer School in Scienze politiche Isernia, July 15-20 2013
2. Introduction The financial crisis started in the Summer of 2007 is still having a large impact on the economies of the most advanced countries The causes of the financial crisis and of the following real crisis, the worst since the Great Depression, are still the object of an intense debate There is a large consensus that weaknesses in the institutional and regulatory setting of the financial markets are among the major causes of the financial crisis, although htey are not the only cause Policy actions coordinated at the international level are radically changing the institutional and regulatory landscape of the financial system, with the objective of limiting the risk that a crisis like this may happen again In this lecture, we will try to understand what have been the causes of the financial crisis and what is the rationale behind the major reforms, underlying their strength and weaknesses
3. Plan of the presentation The facts: trends in the financial markets before the 2007 crisis the inception of the crisis and the first policy reactions Lehman’s default from the economic slowdown to the first signs of recoevery from the financial crisis to the sovereign debt crisis The interventions: the framework of the reform of the financial system the links between the banking crisis and the sovereign debt crisis the recent European policies Open issues
4. The pre-crisis period Before 2007: inflation was low and stable economic growth was sustained and stable economists were discussing how the system had reached a stage of "great moderation“ There was also a broad consensus (with a few critical voices) that: the financial risk was low (as evidenced by the risk premia) the supervision of financial intermediaries was sophisticated and effective the deposit insurance greatly limited the risk of bank runs central banks were able to intervene and stabilize the system in the event of a liquidity crisis
5. Macroeconomic causes of the crisis (1) The main macroeconomic causes of the crisis that began in 2007 have been identified in the following: large global financial imbalances the expansionary monetary policy in the United States, in the face of fear of deflation Global imbalances are related to the high level of public and private debt in the United States and strong savings in emerging and oil-exporting In the emerging countries, the high level of savings was due to: the reduced domestic investment opportunities the limited development of financial markets and the limited opportunities for portfolio diversification the desire to insure against the risk of recurrence of a financial crisis like that of the late nineties
6. Macroeconomic causes of the crisis (2) The availability of low-cost financing, secured by inflows of savings from abroad, favored: mortgage financing for the purchase and construction of housing and for the purchase of durables (housing prices in the United States between 1996 and 2007 grew by 124%) the emergence of price bubbles in financial assets (related to low interest rates and low risk premiums) The growth in demand for housing led to an increase in prices, encouraging the growth of consumption through the wealth effect The distortions favored financial loans and investments in sectors with a productivity higher than the actual waiting At the same time, the strong growth in gross foreign assets and liabilities boosted the international contagion that might occur as a consequence of a revision of the portfolio composition by investors
7. Microeconomic causes of the crisis Macroeconomic imbalances have been possible, and perhaps amplified, due to some serious microeconomic distortions : families did not pay due attention to how their savings were invested by financial intermediaries managers of financial companies underestimated the risks of the investments and privileged short-term returns, due to distorted wage incentives (eg, stock options) rating agencies used risk assessment models based on historical data, that are inadequate to evaluate innovative tools with high risks in the tails of the distribution intermediaries had distorted incentives in assessing credit risk, because they could pass it on securitized assets the action of the supervisory authorities turned out to be, ex-post, highly inadequate
8. From the financial crisis to the sovreign debt crisis From the beginning of the financial crisis of 2007, at least 5 different phases can be identified: 2007: the subprime mortgage crisis and the collapse of portfolio investment 2008: the systemic crisis and the collapse of liquidity 2009: the economic crisis, the fiscal stimulus and the working of automatic stabilizers 2010: the sovereign debt crisis 2011: the crisis of confidence in Europe
9. 2007: the crisis of subprime mortgage loans (1) On 16 July 2007, Bear Stearns disclosed that two of its sub-prime hedge funds had incurred huge losses, after a few days the market for asset-backed commercial paper (ACBP) de facto closed trading The German bank IKB, unable to renew its short-term loans, was saved with a plan organized by the Bundesbank and BaFin The collapse of confidence in the interbank market, that is unsecured, led to a liquidity crisis, which prompted the ECB to intervene on August 9 with a presentation of funding to 95 billion euro, followed in December by a new intervention for 300 billion Investors began to liquidate the positions in Residential Mortgage Backed Securities (RMBS), resulting in a fall in prices (fire sales), that amounted in some cases to 80% of the initial value (60% for some tranches AAA) On 16 March 2008, the Fed facilitated the purchase of Bearn Sterns, now bankrupt, by JP Morgan Chase
10. 2007: the crisis of subprime mortgage loans (2) European banks were not directly exposed to the U.S. subprime mortgage market, but were equally affected by the crisis because: many European banks held large amounts of RMBS in their trading book, classified as a warehouse for market-making (whose losses can be hidden for up to 12 months in accordance with IFRS), but in fact consisting of carry-trade positions taken with the aim to boost returns of bond portfolios uncertainty about the value of the assets of these banks made ​​it impossible to renew short-term loans in the interbank markets The ECB rice balls to the lack of liquidity with the extraordinary financing and, subsequently, reducing the quality of collateral required
11. 2008: the systemic crisis and the liquidity fall (1) The rescue of Bearn Sterns had reduced the tensions in financial markets, but new difficulties emerged in June by insurance companies that were covering the credit risk of banks, a choice made to allow lower capital reserves Between July and September the situation of the American public agencies Freddie Mac and Fannie Mae deteriorated further, until they were commissioned On September 12, the bankruptcy of Lehman Brothers opened the most acute phase of the crisis, which became systemic Apart from the direct effect of the failure of Lehman in the derivatives market, the greater consequences derived from the understanding of investors that a global financial institution would not necessarily be bailed out with public money, but it could fail
12. 2008: the systemic crisis and the liquidity fall (2) The sources of funding ran out for almost all banks, making in many cases insufficient also the liquidity injections decided by central banks The absence of limitations in inter-bank exposures had led many banks, including small and medium size, to have large exposures, also in international markets, in excess of their capital In many countries, the extent of the crisis made it necessary public recapitalization of banks Even money market funds, particularly in the United States, were affected by the crisis and suffered a “bank-run" that called for further government intervention In Europe, deposit insurance in many cases proved to be inadequate, making it necessary State coverage
13. 2009: the economic crisis and the fiscal stymulus Since the beginning of 2008, the effects of the financial crisis had begun to spread to the real economy, due to: the collapse in the price of financial as well as real estate assets the increasing difficulty of financing investment and consumption The effect of the systemic crisis of 2008 on GDP growth was strong, boosted by an unprecedented collapse of international trade Financial markets began instead to recover, since the rise in the prices of financial assets enabled banks to improve profitability, returning in some cases to share profits and bonuses But bank funding remained difficult, making in many cases liquidity injections by central banks insufficient to guarantee adequate credit to the private sector
14. 2010: the sovereign debt crisis Aggregate public debt of the euro area in 2011 amounted to 87% of GDP, a level comparable with that of the United States and significantly lower than that of Japan But some euro area countries have levels much higher than average, and the area is not a fiscal union In 2009, the Greek government announced that the level of public debt of the country was much higher than previously announced, creating strong tensions on the market for European government bonds In May 2010, Greece won the first of a long series of financial aid packages, in November 2010 also Ireland obtained aid, and in April 2011 also Portugal The raise in interest rates on Government bonds extended to bank loans Banks, in addition to the losses due to the fall of bod prices, experienced severe problems in medium and long-term funding
15. 2011: the crisis of confidence in Europe (1) In the summer of 2011, the sovereign debt crisis spread to Spain, mainly because of the weakness of the banking system, and to Italy Foreign investors, especially American funds, reduced their exposure to Europe, leading to strong tensions on bank stock prices Faced with increasing funding difficulties and the growing uncertainty on the stability of the European banking system, banks reduced their international positions, causing a widening of the spreads on retail and wholesale bank interest rates across European countries
16. 2011: the crisis of confidence in Europe (2) Restrictive fiscal policies introduced in Spain and Italy favored the easing of tensions on the market for government bonds since the early months of 2012 The agreement on the role of the European Financial Stability Mechanism (EFSF), the European Stability Mechanism (ESM), the approval of the fiscal compact and substantial funding in the medium term the ECB had an additional positive effect on the financial markets The decision in June 2012 to create the European banking union and the statement of the President of the ECB to defend by all means the euro had further positive effects on the financial markets Between 2008 and October 2011, the governments of European countries have pledged more than 4,500 billion euro (36.7% of EU GDP) to support the banking system The aid actually used the end of 2010 and amounted to 409 billion for the recapitalization and support to the value of the assets and 1.2 trillion in the form of guarantees and other subsidies on liquidity
17. The lessons from the crisis The financial crisis that began in 2007 and the subsequent effect on the sustainability of sovereign debt have highlighted several shortcomings of the institutional and regulatory framework of the international financial system In the meeting held in Washington on 15 November 2008, the G20 countries agreed to “achieve reforms making it more solid financial markets and regulatory structures which avoid future crises”, with an emphasis on international cooperation between national supervisory authorities The lines of reform decided in later years by the Basel Committee and the main supervisors are the result of a series of evidence emerging from the crisis
18. The crisis and the problems of the financial system The crisis has highlighted a number of problems of the previous structure of the financial markets: intermediaries that are too-big-to-fail or too-complex-to-fail the risk of contagion following the failure of intermediaries with a pivotal role in the system (too-interconnected-to-fail) or sharing similar shocks with too many similar institutions (too-many-to-fail) the room for regulatory arbitrage and the growth of the shadow financial system the low of capitalization of financial intermediaries distorted incentives of governance structures the excessive costs of bailouts for taxpayers the lack of international coordination of supervisory authorities the lack of attention to systemic risk and macro-prudential oversight The recent reforms of the financial system go in the direction of limiting these problems
19. Banks that cannot fail Il problema di evitare che vi siano banche che per motivi diversi non possono essere lasciate fallire è alla base delle riforme volte a: ridurre la dimensione delle banche, anche richiedendo una maggiore capitalizzazione alla banche più grandi penalizzare le banche eccessivamente interconnesse, soprattutto a livello internazionale semplificare le strutture di controllo separare le attività più rischiose da quelle più tradizionali (depositi, prestiti e gestione dei pagamenti) semplificare le procedure fallimentari Per ridurre i costi per il contribuente, sono stati aumentati gli incentivi affinché gli azionisti controllino le attività dei managers, imponendo che subiscano il costo di eventuali salvataggi
20. Banks that cannot fail The issue of organizing a system in which there are not banks that cannot be let default is at the root of reforms aimed at: reducing the size of banks, also requiring higher capital ratios to larger banks penalizing excessively interconnected banks, especially in international activities simplifying control structures separating riskier activities from the more traditional ones (deposits, loans and management of payments) simplifying bankruptcy procedures To reduce the cost to the taxpayer, incentives to shareholders and bondholders to monitor the activities of managers have been increased, forcing them to sustain the costs of any bailout
21. Supervisory authorities The responsibility of supervisory activities has been revised in almost all major countries, with a general strengthening of the position of the central banks, whose role has been crucial in the most acute phases of the crisis In particular: coordination between the different supervisory authorities in individual countries has been strengthened the power of individual authorities in case of crisis has been increased the role of macro-prudential supervision has been fostered Supervision has been extended to sectors and activities that were previously much freer lines of the reform based on internationally agreed principles have been passed
22. The reform of the financial system in Europe In Europe, the first step in the process of reform of the supervisory system was inspired by the report of the LarosièreGroup Following the Group’s recommendations, the European supervision of financial markets is organized in the European System of Financial Supervision, consisting of: the European Banking Authority (EBA), which is responsible of coordinating the activities of banking supervision among the EU countries the European Securities and Markets Authority (ESMA), responsible for market supervision the European Insurance and Occupational Pensions Authority (EIOPA) The ECB was also granted the responsibility for macro-prudential oversight, through the European Systemic Risk Board (ESRB)
23. Recent reforms in Europe Three major reforms have been recently proposed in Europe: the Capital Requirement Directive (CRD IV), which incorporates a large extent the reforms proposed by the Basel Committee (Basel III) the Recovery and Resolution Directive the proposal to introduce a Single Supervisory Mechanism (SSM), which gives the ECB the responsibility for the supervision of all banks in the euro area The approval of the European Financial Stability Mechanism (EFSF) and the European Stability Mechanism (ESM) have also increased the role of the European authorities in dealing with banking crises
24. The Capital Requirement Directive (CRD IV) The CRD IV incorporates the indications of Basel III with respect to: liquidity, setting a Liquidity Coverage Ratio from 2015 and considering the introduction of a Net Stable Funding Ratio from 2018 capital, making it more stringent definitions of Common Equity Tier 1 Capital (CERT1), providing for a gradual increase of the regulatory minimum of 4.5% and 6% by 2015 and by introducing buffers to maintain the minimum capital (2.5% ) and cyclical counterparty risk, with higher levels of capitalization and incentives to use central counterparties It also provides for greater harmonization of regulation, by requiring to write of a single rule book for supervisory activities in all EU countries
25. The Recovery and Resolution Directive On 6 June 2012, the European Commission adopted a legislative proposal on the procedures to follow to rescue and resolve troubled banks The aim of the Directive is to create a regulatory and institutional framework able to: limit the effects on the financial stability of the system ensure that shareholders adequately contribute to the recovery processminimize costs to taxpayers
26. The Single Supervisory Mechanism (SSM) Following the deliberations of the Summit of Heads of State and Government of 29 June 2012, on September 12th 2012, the European Commission put forward a proposal for the creation of a banking union On 12 December, the EU finance ministers agreed on a package of measures establishing a single supervisory mechanism of credit institutions According to the proposal: the tasks of banking supervision are attributed to the (ECB) the system of representation within the EBA is redefined
27. The supervisory responsibilities of the ECB Based on the decisions of the European Council: from 1 March 2014 or 12 months after the entry into force of the legislation if the date has passed, the ECB is responsible of the effective functioning of the unique surveillance mechanism and will exercise direct supervision of euro area banks the tasks of monetary policy and supervision of the ECB will be strictly separated supervisory activities will be differentiated depending on banks size and the ECB will exercise it in cooperation with the national supervisory authorities The monitoring mechanism is only the first step towards banking union, which will also include: a single rule book a common system of deposit guarantee a single resolution mechanism for crisis
28. The European Financial Stability Facility (EFSF) The European Financial Stability Facility (EFSF) is a private law fund approved by the countries of the euro area on May 9th 2010, with the purpose of providing financial assistance to member states The EFSF can issue bonds, secured by guarantees provided by the euro area Member States, or other debt instruments on the financial market to raise the funds necessary to: provide loans to euro-zone countries in financial difficultiesrecapitalize banks buy in the primary market sovereign debt of member states Grants are awarded conditional on the acceptance of a national stability plan, agreed with the European Commission and the IMF After the agreements of 2011, the EFSF had a total capacity of € 1.000 billion, but at the end of June 2013 it has ended its original mandate and will no longer finance new programmes, after having granted a total of € 162 billion to Ireland, Portugal and Greece
29. The European Stability Mechanism (ESM) (1) The European Stability Mechanism (ESM) is an intergovernmental organization with headquarters in Luxembourg, that was settled in July 2012 The ESM has a subscribed capital of 700 billion euro, of which 80 billion actually disbursed Initially, the ESM function were limited to: issue loans to provide financial assistance to countries in need buy government bonds on the primary and secondary market, subject to conditions including the acceptance of a macroeconomic adjustment program
30. The European Stability Mechanism (ESM) (2) As of 1 July 2013, the European Stability Mechanism (ESM) is the sole and permanent mechanism for responding to new requests for financial assistance by euro area Member States The guideline of the ESM direct recapitalization instrument will be finalized as soon as the abovementioned legislative proposals have been finalized with the European Parliament Recapitalization will be an operative tool within the components of the Banking Union legislation, most importantly the Bank Recovery and Resolution Directive (BRRD) and the Deposit Guarantee Scheme Directive (DGSD)
31. The European Stability Mechanism (ESM) (3) Decisions to grant ESM assistance through direct recapitalization will be taken by mutual agreement, conditional on the fact that: the requesting ESM Member is unable to provide financial assistance to the institutions in full without very adverse effects on its own fiscal sustainability providing financial assistance to the requesting ESM Member is indispensable to safeguard the financial stability of the euro area as a whole or of its Member States the institution is (or is likely to be in the near future) in breach of the capital requirements the institution has a systemic relevance The limit for the amount of financial assistance available for direct recapitalization is € 60 billion, but it can be reviewed by the Board of Governors, if deemed necessary
32. The European Stability Mechanism (ESM) (4) There will be a clear pecking order for recapitalization operations and private capital resources will be explored as a first solution An appropriate level of write-down or conversion of debt will have to take place in line with EU State aid rules The contributions of the requesting ESM Member and the ESM will follow a burden-sharing scheme, requesting ESM Member to intervene together with the ESM, depending on the size of the intervention necessary to meet the minimum capital requirements
33. The Liikanen report The definition of the new supervisory architecture of the European banking and financial system is still under development In February 2012, the Commissioner for the Internal Market and Financial Services Michel Barnier has commissioned a group chaired by the Governor of the Bank of Finland Erkki Liikanen to prepare a report on the reform of the European banking system The report, published on October 2nd 2012 proposes four main lines of action: separation of proprietary trading from traditional activities adequate rescue and resolution mechanisms adequate capitalization requirements mechanisms setting incentives for a well functioning corporate governance
34. Proprietary trading According to the Liikanen report, proprietary trading should be separated from traditional banking activities The separation, similar to what is required by the Volker Rule contained in the Dodd-Frank Act in the United States, would isolate traditional banking activities, whose cessation could create negative systemic effects, from the risk related to trading activities Assets held for trading should be owned by units with separate capitalization and unrelated to trading activities on behalf of customers To give an idea, Barclays, BNP Paribas, Deutsche Bank, Nordea, Royal Bank of Scotland and Société Générale have more than 30% of total assets in the trading book The explicit and implicit guarantees on deposits – which are estimated to have the effect of increasing by 3 degrees the ratings of the banks – would thus be limited to traditional activities
35. The recovery and resolution plans The Liikanen report also emphasizes that it is essential to provide for effective and realistic the recovery and resolution plans In this regard, it considers crucial that a set of bail-in instruments are defined in advance Such convertible securities should be placed outside of the banking system, preferably in the hands of long-term, risk-neutral investors The degree of capitalization of banks should be increased and the treatment of risk in the internal models should be made more severe The relationship between risk-weighted assets and total assets should be scrutinized, since it is at the moment very heterogeneous and lower for banks with a broader portfolio of marketable securities and derivatives
36. Corporate governance The concerns expressed in the report Liikanen in relation to corporate governance issues relate to: the under-representation of stakeholders on the boards of banks the excessive power of the president and directors with respect to those responsible for risk management the lack of transparency of intra-group relationships the insufficient controls on the adequacy of professional administrators the low level of sanctions for misbehaviors
37. The objectives achieved through the reforms Part of the objectives of the European reform of the regulation of financial markets are in the process of being achieved through the actions already undertaken or planned: strengthening the capacity of banks to absorb systemic and idiosyncratic shocks, especially in the areas most exposed to these risks is obtained through greater capitalization, separation of activities, specific requirements for SIBs reducing the pro-cyclicality in regulatory requirements is achieved by means of pro-cyclical buffer reducing the risk of speculative bubbles in financial markets is the objective of macro-prudential supervision eliminating bank runs, especially in the wholesale markets, is the objective of the short-term loans granted by the ECB and the medium-term loans granted by the ESM ensuring the ability to quickly and effectively resolve distressed banks with limited costs on taxpayers is the objective of the recovery and resolution directive
38. Objectives still debated Among the goals that are still the subject of intense debate are the ways to: increase the robustness of markets and non-bank intermediaries enhance the ability of risk management and improve the incentives of managers and supervisors A crucial aspect that have not yet been agreed upon is the degree of centralization of procedures for the supervision and intervention within the banking union
39. Some open issues on the banking union The European banking union is a crucial step in the reform process in order to: break the vicious circle between banking crisis in sovereign debt crisis facilitate the resolution of the failures of multinational banks, contributing to the completion of the single market Two key components of a banking union are: a common framework of supervision a mechanism to administer the crises In the current debate, three important aspects are still discussed: the configuration of institutions that must be created for deposit insurance and resolution procedures the allocation of costs (the burden sharing) of bailouts by governments and the related implications for the fiscal union the management of the transition phase and the allocation of costs already incurred
40. Open challenges The banking union will dramatically reduce the effects of the negative externalities of the failure of a financial intermediary, decreasing the degree of systemic risk International coordination seems however still insufficient compared to the high interconnection of the global financial system Despite the substantial success of the actions taken to tackle the financial crisis, some of the solutions proposed seem to push towards greater market segmentation rather than towards coordination of supervisory authorities To avoid such a result, it is crucial to take strong actions in order to: reduce the scope for regulatory arbitrage strongly increase the degree of transparency of the markets and the degree of exposure to the risk of each agent improve the system of governance and to align the incentives of managers and shareholders