Financial Market Trends: Current Issues in Financial Markets: Exit and Post-Financial Crisis Issues

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Current Issues in Financial Markets: Exit and Post-Financial Crisis Issues

THINKING BEYOND BASEL III: NECESSARY SOLUTIONS FOR CAPITAL AND LIQUIDITY
2 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010
A. Introduction
The consultative documents entitled “Strengthening the Resilience of the
Banking Sector” (henceforth referred to as ‘Basel III') and “International
Framework for Liquidity Risk Measurement, Standards and Monitoring” are a part
of the Basel Committee’s ongoing work in response to the crisis. This paper
reviews the proposal, and asks whether they provide a basis for reform that will
help to avoid crises in the future.
Sudden changes in asset quality and value can quickly wipe out bank capital.
Where short-term wholesale liabilities fund longer-term assets, failure to roll over
short-term financial paper, or a ‘run’ on deposits, can force de-leveraging and asset
sales. Banking crises associated with such changes are often systemic in nature,
arising from the interconnectedness of financial arrangements: banks between
themselves, with derivative counterparties and with direct links to consumption
and investment spending decisions. In history, banking crises have been associated
with major economic disruption and recessions. It is for this reason that policy
makers regulate the amount of capital that banks are required to hold, and require
high standards of corporate governance, including liquidity management,
accounting, audit and lending practices.
This paper first looks at the Basel system historically, and then summarises
all of the key problems with it – all of which contributed in some part to its failure
to help to avoid the recent global financial crisis. In section C the paper
summarises the recent Basel III proposals, and section D critically analyses them.
Section E sets out the liquidity proposals and a brief critique. Finally section F
provides a summary and draws implications for the financial reform process.
B. The Basel system historically
Basel capital
weighting in place
from 1992
Capital regulations under Basel I came into effect in December 1992 (after
development and consultations since 1988). The aims were: first, to require banks
to maintain enough capital to absorb losses without causing systemic problems,
and second, to level the playing field internationally (to avoid competitiveness
conflicts).
A minimum ratio of 4% for Tier 1 capital (which should mainly be equity less
goodwill) to risk-weighted assets (RWA) and 8% for Tier 1 and Tier 2 capital
(certain subordinated debt etc).1 The Basel I risk weights for different loans are
shown on the left side of Table 1.
OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010 3
A ‘revised framework’ known as Basel II was released in June 2004 (BCBS,
2004) after many issues with Basel I, most notably that regulatory arbitrage was
rampant (Jackson, 1999). Basel I gave banks the ability to control the amount of
capital they required by shifting between on-balance sheet assets with different
weights, and by securitising assets and shifting them off balance sheet – a form of
disintermediation. Banks quickly accumulated capital well in excess of the
regulatory minimum and capital requirements, which, in effect, had no
constraining impact on bank risk taking.
Basel I and II fail to
stop global crisis
As the centrepiece for capital regulation to avoid crises the Basel approach
has failed in its 1st and 2nd formulations and the world is still dealing with the after
effects of the greatest financial crisis since the Great Depression.
Pillar 1 of the Basel II system defines minimum capital to buffer unexpected
losses. Total RWA are based on a complex system of risk weighting that applies to
‘credit’, ‘market’ (MR) and ‘operational’ risk (OR), which are calculated
separately and then added:
RWA= {12.5(OR+MR) + 1.06*SUM[w(i)A(i)]} (1)
where: w(i) is the risk weight for asset i; and A(i) is asset i; OR and MR are
directly measured and grossed up by 12.5 for 8% equivalence; and credit risk is the
sum of the various asset classes, each weighted by its appropriate risk weight. A
scaling factor applied to this latter term, estimated to be 1.06 on the basis of QIS-3
data (but subject to change), was envisaged for the transition period, which was
supposed to start for most countries in January 2008. Banks were to be able to
choose between: first, a simplified approach (for smaller institutions without the
capacity to model their business in risk terms) by using the fixed weights shown in
column two of Table 1; second, an approach based on external ratings (shown in
the column three in Table 1); and third, an internal ratings-based (IRB) approach
for sophisticated banks, driven by their own internal rating models (see the right
side of Table 1).
Basel II, more
detailed, reduced
weights
The simplified Basel II approach is more ‘granular’ than Basel I, but retains
its basic features. It is striking in light of the financial crisis that the simplified
approach shows the Basel Committee cutting the risk weight to mortgages by
some 30% (from 50% to 35%) and much more in the sophisticated version. The
weight for lending between banks was only 20% under Basel 1, kept the same
under the simplified Basel II, and is likely to be cut by 20 to 30% under the
sophisticated approach.
Complex modelling The IRB approach requires banks to specify the probability of default (PD)
for each individual credit, its loss-given-default (LGD), and the expected exposure
at default (EED). This requires highly-complex modelling and aggregation, and
offers banks with the necessary expertise the possibility of deriving more risksensitive
weights. This approach requires the approval of the bank’s supervisor.
Table 1. Basel I and Basel II risk weights and commentary
Risk Weights Under Basel I and Basel II (Pillar I), %
BASEL I BASEL II BASEL II BASEL II Advanced: Internal Ratings Based (IRB)
Simplified Standardised 2004-05 QIS 4 2004-05 QIS 4
Standardised based on Avg % chg Median %
External in portf. Chg in portf.
SECURITY Ratings MRC MRC Basel II Advanced IRB
Most Government/central bank 0 0 0 0 Comes close to letting banks set their own
AAA to AA- 0 Pillar 1 capital, with supervisory oversight.
A+ to A- 20 Risk weights depend on internal estimates
BBB+ to BBB- 50 of a loan's probability of default; loss-given-
BB+ to B- (& unrated) 100 default; exposure to loss. These are based
Below B- 150 on the banks' own complex risk models,
Other public (supervisors discretion) 0-50 0 0 0 relying on subjective inputs and often on
Claims on MDBs 20 0 -21.9 -29.7 unobservable (e.g. OTC illiquid securities)
Most OECD Banks & Securities firms 20 20 <90days Other -21.9 -29.7 prices.
AAA to AA- 20 20 Pillar 2 provides for supervisory oversight.
A+ to A- 20 50 With stress testing, and guidance from
BBB+ to BBB- (& unrated) 20 50 supervisors, banks can be made to hold
BB+ to B- 50 100 capital for risks not adequately captured
Below B- 150 150 under Pillar 1.
Residential Mortgages-fully secured 50 35 35 -61.4 -72.7 Pillar 3 is disclosure and market discipline
Retail Lending (consumer) 100 75 75 (-6.5 to -74.3) (-35.2 to -78.6) which relies on some notion of market
Corporate & Commercial RE 100 100 (-21.9 to-41.4) (-29.7 to -52.5) efficiency. Rational markets punish poor
AAA to AA- 20 risk managers.
A+ to A- 50
BBB+ to BB- (& unrated) 100
Below BB- 150
Sources: BIS (1988) and BIS (final version June 2006); FDIC (2005); authors’ commentary.
1. Problems with Pillar 1
a) Portfolio invariance
No concentration
penalty in Pillar 1
The risk weighting formulas in the Basel capital regulations are based on a
specific mathematical model, developed by the Basel Committee, which is subject
to the restriction that it be ‘portfolio invariant’; that is, the capital required to back
loans should depend only on the risk of that loan, not on the portfolio to which it is
added (Gordy, 2003). This is convenient for additivity and application across
countries. But it has an important disadvantage: it does not reflect the importance
of diversification as an influence on portfolio risk. Thus the minimum capital
requirements associated with any type of loan due to credit risk simply rise linearly
with the holding of that asset type, regardless of the size of the exposure (that is,
appropriate diversification is simply assumed). This means that it does not penalise
portfolio concentration (as might occur for example under a quadratic rule applied
to deviations from a diversified benchmark; see below). Concentration issues are
left to supervisors in Pillar 2.
b) Single global risk factor
No country-specific
risk
For the mathematical model underlying the Basel approach (I or II), each
exposure’s contribution to value-at-risk (VaR) is portfolio invariant only if: (a)
dependence across exposures is driven by a single systemic risk factor – a global
risk factor, since it is supposed to apply to global banks operating across countries;
and (b) each exposure is small (Gordy, 2003). What we know of the sub-prime
crisis is that it originated in the US housing market (regional sector risk in this
framework) and exposures were quite large.
Of the two conditions for invariance, by far the most important is the
requirement of a single risk factor that applies to all participants. Almost
prophetically, Gordy (2003) says:
A single factor model cannot capture any clustering of firm defaults due to
common sensitivity to these smaller scale components of the global business
cycle. Holding fixed the state of the global economy, local events in, for
example, France are permitted to contribute nothing to the default rate of
French obligors. If there are indeed pockets of risk, then calibrating a single
factor model to a broadly diversified international credit index may
significantly understate the capital needed to support a regional or
specialized lender.2
c) Different treatment of financial ‘promises’: complete markets in credit
undermine capital weighting approaches
CDS destroys notions
of ex ante risks in the
specific financial
institutions
The Basel risk-weighting approach in fact encourages portfolio
concentrations in low-weighted assets like government bonds, mortgages and
lending between banks – there is always an incentive to economise on capital and
expand business into lower-weighted areas. Unfortunately, this approach evolved
at the same time as did the market for credit default swaps (CDS). Prior to the
CDS contract it was not possible to go short in credit, unlike in other markets. The
credit markets were “incomplete”. The CDS contract created the potential for
complete markets in credit. The banks were able to transform the buckets of risk
themselves with derivatives, thus undermining the fundamental idea of capital
weights, without having to trade as much on the underlying securities on primary
markets (favouring assets with low-risk weights).
This issue is about promises in the financial system. If regulations treat
promises differently in different sectors, then with complete markets in credit, the
promises will be transformed into those with the lowest capital charges.
d) Bank capital market activities
Contagion and
counterparty risk as
hallmarks
In many ways the main hallmarks of the global financial crisis were the
contagion and counterparty risks. Both of these arose from banks involving
themselves in capital market activities for which they did not carry sufficient
capital. Securitisation and its warehousing on and off-balance sheet proved to be a
major problem. In the US, Variable Interest Entities (VIEs) to which banks are
linked had to be consolidated onto balance sheets if banks became insolvent or if
liquidity of funding became problematic. This was completely missed in the
capital regulations. Similarly, counterparty risk became a major issue with the
failures of Lehman Brothers and AIG. In the latter case, the banks exposed relied
on public compensation to ensure that the crisis did not make them insolvent.
e) Pro-cyclicality
The capital
regulations are procyclical…
The Basel system is known to be pro-cyclical. There are many reasons for
this. The most basic reason is that judgments tend to underestimate risks in good
times and overestimate them in bad times. More specific factors include:
• Leverage ratios depend on current market values (and are therefore high
in good times and low in bad times). If asset values do not accurately
reflect future cash flows, pro-cyclicality results;
• Banks’ risk measurements tend to be point-in-time and not holistic
measures over the whole cycle;
• Counterparty credit policies are easy in good times and tough in bad; and
• Profit recognition and compensation schemes encourage short-term risk
taking, but are not adjusted for risk over the business cycle.
Capital regulation under previous Basel regimes did nothing to counter this
pro-cyclicality. Banks can control their RWA via regulatory arbitrage and by
varying bank capital more directly via dividend and share buyback policies (high
dividends and buybacks in the good times and vice versa).
…particularly when
banks estimate PD,
LGD and EAD
The IRB approach of the revised framework actually institutionalises this procyclicality
by making banks themselves responsible for estimating Probability of
Default (PD), Loss Given Default (LGD) and Exposure at Default (EAD), which
are all a function of the cycle, and are led by the stock market, asset values and
other financial variables. Private bankers cannot predict future asset prices and
future volatility events. The simplified system changed nothing relative to Basel I,
and the external ratings based approach still used credit ratings, which are
notoriously pro-cyclical.
f) Subjective inputs
Risk inputs are subjective. Some prices are of the over-the-counter variety
and are not observable, nor do they have appropriate histories for modelling
purposes. Banks can manipulate inputs to reduce capital required. For these sorts
of reasons, the Basel Committee envisaged that Pillar 2 would deal with risks not
appropriately covered in Pillar 1.3
g) Unclear and inconsistent definitions
The main problems here have been the definition of capital.
• Regulatory adjustments for goodwill are not mandated to apply to
common equity, but are applied to Tier 1 and/or a combination of Tier 1
and Tier 2.
• The regulatory adjustments are not applied uniformly across jurisdictions
opening the way for further regulatory arbitrage.
• Banks do not provide clear and consistent data about their capital.
This means that in a crisis the ability of banks to absorb losses is
compromised and different between countries – exactly as seen in the crisis.
2. Problems with Pillars 2 and 3
Supervisors can’t be
forward looking
Pillar 2 relates to the supervisory review process. With stress testing and
guidance from supervisors, banks can be made to hold capital for risks not
appropriately captured under Pillar 1. Building buffers in this way requires
supervisors to be forward looking, that is, to keep up with changes in market
structure, practices and complexity. This is inherently difficult. Supervisors may
be even less likely to be able to predict future asset prices and volatility than
private bankers. Furthermore, supervisors have smaller staff (per regulated entity)
and are mostly less well paid. If supervisory practices lag the policy makers will be
ineffective in countering defects in Pillar 1. 4 Pillar 2 is not likely to be effective in
a forward-looking way.
In this respect it is worth noting (see below) that the UK Financial Services
Authority (FSA), which is one of the best staffed and most sophisticated of
supervisors, signed off on Northern Rock to be one of the first banks to go to the
Basel II IRB approach, understanding fully that this would reduce their capital
significantly, immediately prior to the sub-prime crisis. More recently, the Lehman
use of repo 105 to disguise leverage in its accounts was not hidden from
supervisors – it appears they did not fully appreciate what they were looking at
(Sorkin, 2010).
Markets just aren’t
efficient
Pillar 3 relies on disclosure and market discipline that will punish banks with
poor risk management practices. Underlying this is an efficient markets notion that
markets will act in a fully rational way. At the level of markets, the bubble at the
root of the sub-prime crisis, and crises before it, suggest the systematic absence of
informational efficiency. The whole pro-cyclicality debate concerning the Basel
system is premised on the idea that asset prices do not reflect future cash flows
accurately.
C. ‘Basel III’ proposals for reform
Trading book market
risk changes
Basel II, to all intents and purposes, never came properly into effect. In July
2009 the Basel Committee already adopted changes that would boost capital held
for market risk in the trading book portfolio (see MR in equation 1 above) – in
essence applying a multiplier of 3 to VaR specific risk and to stressed VaR risk in
the calculation (BCBS, 2009a). The quantitative impact study has shown, oddly,
that the average capital requirement for banks in the study would rise by 11.5%,
but the median would only rise by 3.2% (BCBS, 2009b). More capital of course is
to be welcomed. The consultative document issued by the Basel Committee in
December 2009 aims to fix some of the problems noted above. This paper focuses
on these new proposals on capital.
1. To raise the quality, consistency and transparency of the capital base
Common equity is
good
Tier 1 capital will consist of going concern capital in the form of common
equity (common shares plus retained earnings) and some equity-like debt
instruments which are both subordinated and where dividend payments are
discretionary. Criteria for Tier 2 capital will also be tightened (subordinate to
depositors, five-year minimum maturity and no incentives to redeem). After a
quantitative impact study, it is proposed to fix minima for common equity as a
percentage of RWA, and similarly for Tier 1 capital and total capital. It is
proposed to abolish Tier 3 capital.
Remove… As far as improving the definition of capital is concerned, the report stresses
that equity is the best form of capital, as it can be used to write off losses. Not
included in (to be deducted from) common equity are:
…goodwill… • Goodwill. This can’t be used to write off losses.
…minority interest… • Minority interest. That if a company takes over another with a majority
interest and consolidates it into the balance sheet, the net income of the
3rd party minorities can’t be retained by the parent as common equity.
…deferred tax
assets…
• Deferred tax assets (net of liabilities). These should be deducted if they
depend on the future realization of profit (not including tax pre-payments
and the like that do not depend on future profitability).
…and investments in
other financial
institutions
• Bank investments in its own shares.
• Bank investments in other banks, financial institutions and insurance
companies – all cross-share holdings and investments in sister
companies, all holdings if a bank’s position in another institution is 10%
or more, and an aggregation adjustment of all holdings that amount to
more than 10% of common equity. The aim here is to avoid double
counting of equity.
• Provisioning shortfalls (see below).
• Other deductions. Such as projected cash flow hedging not recognised on
the balance sheet that distorts common equity; defined benefit pension
holdings of bank equity; some regulatory adjustments that are currently
deducted 50% from Tier 1 and 50% from Tier 2 not addressed elsewhere.
2. Enhancing risk coverage
One major problem in the crisis was the failure of the Basel approach to
capture on and off balance sheet risks (related Special Purpose Vehicles (SPVs)
for example). Going forward, it is proposed that banks:
Use “stressed” inputs • Must determine their capital requirement for counterparty credit risk
using stressed inputs, helping to remove pro-cyclicality that might arise
with using current volatility-based risk inputs.
• Must include capital charges (credit valuation adjustments) associated
with the deterioration in the creditworthiness of a counterparty (as
opposed to its outright default).
Wrong-way risk • Implement a Pillar 1 capital charge for wrong-way risk (transactions with
counterparties, especially financial guarantors, whose PD is positively
correlated with the amount of exposure). This will be done by adjusting
the multiplier applied to the exposure amount identified as wrong way
risk.
Correlation
multiplier
• Apply a multiplier of 1.25 to the asset value correlation (AVC) of
exposures to regulated financial firms with assets of at least $25bn,
(since AVC’s were 25% higher during the crisis for financial versus nonfinancial
firms). This would have the effect of raising risk weights for
such exposures.
Margining periods • Will be required to apply tougher (longer) margining periods as a basis
for determining regulatory capital when they have large and illiquid
derivative exposures to a counterparty.
Centralised exchange
incentives
• Will qualify for a zero risk weight for counterparty risk exposure if they
deal with centralised exchanges (that meet certain criteria): hence
creating an incentive to use centralised exchanges (since higher charges
will apply for bilateral OTC derivatives).
The Committee is also trying to improve the usefulness of external ratings in
the above recommendation, and so proposes to require banks to assess these
ratings with their own internal processes.
As with most other aspects of the report, the quantitative impact study will
help to calibrate the reforms on coverage.
3. Leverage ratio
‘Backstop’ leverage
ratio
The introduction of a leverage ratio is intended to help to avoid the build-up
in excess leverage that can lead to a deleveraging ‘credit crunch’ in a crisis
situation. The Committee refers to this as a ‘backstop’ measure for the risk-based
approach. It is proposing a simple leverage ratio based on Tier 1 capital, with a
100% treatment to all exposures net of provisions, including cash and cash-like
instruments. Certain off-balance sheet exposures will be included with a 100%
credit conversion factor, and written credit protection will be included at its
notional value. It is proposed that there be no netting of collateral held and no
netting off-balance sheet derivative exposures (more akin to IFRS treatment than
to GAAP).
4. Pro-cyclicality
The Basel Committee places considerable emphasis on the role of procyclical
factors in the crisis resulting from mark-to-market accounting and held to
maturity loans; margining practices; and the build-up of leverage and its reversal
amongst all financial market participants. The following ideas are proposed to deal
with this:
• To dampen the cyclicality of the minimum capital requirement the
Committee is looking to focus on longer-term calibration of the
probability of default in the modelling of risk; the use of Pillar 2
supervisory override is also being recommended when necessary.
Forward-looking
provisioning
• The Committee will promote forward-looking provisioning by strongly
supporting the IASB principles to base it on the ‘expected’ (rather than
the current ‘incurred’) losses of banks’ existing portfolios. It also
proposes to deduct from bank capital any shortfall in these provisions
(i.e. to expected losses) to provide an incentive against underprovisioning.
Buffers are very
important
• Very importantly, the Committee is proposing that banks hold buffers of
capital above the regulatory minimum – large enough that they remain
above the minimum in periods of significant sector-wide downturns.
Furthermore, when the buffers are run down banks would be required to
build them again by reducing discretionary dividend distributions,
buybacks and staff bonus payments.
• The Committee is proposing that the buffer system might be used in a
macro prudential framework to help restrain credit growth when it is
perceived as excessive – the buffer would rise and fall in a
countercyclical manner.
D. A critical assessment of the capital proposals
There are some very
good proposals such
as …
The proposals for capital reform – a new Basel III – do not address the
fundamental problems with the risk-weighting approach, but do make some
improvements with respect to some aspects of the capital management process
under the Basel II regime. In particular:
…a leverage ratio… Criticism 1.4 on bank capital market activities: This is dealt with by
enhancing coverage of counterparty exposure in the Enhancing risk coverage
section and by better inclusion of off-balance sheet exposure in the Leverage ratio
proposal. However, the introduction of a leverage ratio is likely to be the single
most important reform – a theme which is developed more fully below.
… dealing with
procyclicality…
Criticism 1.5 on pro-cyclicality issues: The proposals summarised in 2.4 on Procyclicality
deserve credit for trying to deal with this difficult area.
• Basing PD on longer-run data to determine inputs for minimum capital is
better than the alternative. This pre-supposes that the risk
weighting/modelling framework of the Basel system is the best approach,
which remains an open question in light of experience (see below).
• Forward-looking provisioning based on expected losses is a useful
approach based on accounting principles and gives firms ample scope to
manage their businesses in a sensible way. The notion of using better
times to build a buffer via restraint on dividends, share buybacks and the
like is particularly welcome. This aims to ensure that in bad times
regulatory minima for capital are not breached.
• The macro prudential recommendation on credit growth is an admirable
objective but likely to perform poorly in practice. The reason for this is
leads and lags in modelling credit, and the problem of structural change
caused by financial innovation – often in response to the very sort of
regulatory changes proposed by the Basel Committee. Credit lags the
cycle, and the identification of a ‘bubble’, leading to provisioning to
offset it, could easily occur at a time when the economy is beginning to
turn down – exacerbating the cycle. Similarly, just as securitization
dampened balance sheet credit growth in the past – leading to a false
signal that there was no leverage problem – so too might future
developments in the shadow banking system lead to similar distortions
that would be difficult for supervisors and other policy makers to
identify.
…and moving OTC
derivatives on
exchanges
Criticism 1.6 on subjective inputs: all of the measures designed to get more
OTC derivatives onto exchanges to create more reliable traded price data and
improvements in modelling are welcome. There will always be significant
subjective inputs however, and the OTC market is likely to remain large in the
future. This is because the firm-specific requirements of non-financial and
financial firms for tailor-made derivatives suitable to their needs but not to others
are not conducive to trading on exchanges.
Criticism 1.7 on Unclear and inconsistent definitions: the proposals
summarised in 2.1 to ‘raise the quality consistency and transparency of the capital
base’ are all to be welcomed. This recommendation does not appear to be new
since one can find the recommendation to deduct goodwill from Tier 1 capital in
both Basel I and Basel II documentation. Reinforcing this point in Basel III is
important however, as goodwill can’t be included in capital available to absorb
losses – mixing intangibles and actual capital is not admissible in any of the capital
regimes. Exclusion of minorities5 and deferred tax assets6 is also sensible.
However, some of the most fundamental problems with Basel I and Basel II
have not been dealt with. The following issues are discussed in turn:
• The model framework.
• Regulatory and tax arbitrage.
• The need for more capital.
1. The model framework problems are not addressed
Addressing penalties
for concentration
• The weighting system continues to suffer from the assumption of
portfolio invariance, or linear weighting that facilitates additivity in the
model (criticism 1.1). Hence it does little in Pillar 1 to penalise
concentration in portfolios, except insofar as model multipliers depend
on exposure size in the treatment of counterparty risk. It may be possible
to deal with concentration in Pillar 1, and this should be explored: for
example, a quadratic penalty applied to deviations from a diversified
benchmark portfolio is a feasible way to deal with the issue – the
minimum leverage ratio would apply if a firm was on benchmark, but it
would have to add increasingly more capital the more it deviated from
benchmarks.
This would certainly help to remove the direct incentives for regulatory
arbitrage caused by the Basel weights (see the next section).
A one-size-fits-all
approach
The single global risk factor – one-size-fits-all – also still underpins the
modelling process (criticism 1.2). There are different forms of risk:
• Credit risk arising from the global business cycle risk factor is suitable
for treatment in the Basel analytical approach.
• Security’s pricing/market portfolio risk in global capital markets is dealt
with in a complex credit risk equivalent way and also is a one-size-fitsall
(global business cycle risk factor) approach.
However, idiosyncratic credit risk associated with individual borrowers in
different businesses and regions is not well catered for in the analytical framework
– leaving Basel III with the same problem as Basel II: undue reliance on
cumbersome supervisory override that has not worked well in the past.
2. The problem of regulatory and tax arbitrage in ‘complete’ markets and the shifting of financial
“promises”
Can we specify exante
risk buckets with
complete markets for
credit?
“Complete markets” in credit, particularly the possibility to go short credit,
make it impossible to expect that specified ex-ante risk buckets will remain stable
as a basis for holding capital. Differential capital weights and tax status and tax
rates faced by investors cannot be arbitraged away by leveraged trading. They are
policy parameters that provide incentives to minimise regulatory and tax costs.
There is a massive incentive in financial markets to use “complete market”
techniques to reconfigure credits as capital market instruments to avoid capital
charges and reduce tax burdens for clients, thereby maximising returns for
themselves and their customers. This will continue despite the proposed reforms.
a) Simple example on capital arbitrage and promise shifting
Shifting promises… • Bank A lends $1000 to a BBB rated company, 100% risk weighted, by
buying a bond and would have to hold $80 capital. Bank A holds a
promise by the company to pay a coupon and redeem at maturity.
• Bank A buys a CDS from Bank B on the bond, shorting the bond,
thereby passing the promise to redeem from the company to Bank B.
Because B is a bank, which carries a 20% capital weight, Bank A
reduces its required capital to 20% of $80, or $16.
• You would think that Bank B would have to carry the promise and 100%
weight the exposure, but instead, it underwrites the risk with a
reinsurance company outside of the banking system; the promise to
redeem is now outside the banks and the BIS capital rules don’t follow it
there. Bank B’s capital required for counterparty risk is only 8% of an
amount determined as follows: the CDS spread price of say $50
(500bps), plus a regulatory surcharge coefficient of 1.5% of the face
value of the bond (i.e. $15), all multiplied by the 50% weighting for offbalance
sheet commitments. That is, $2.60 (i.e. 0.08*$65*0.5).
• So jointly the banks have managed to reduce their capital required from
$80 to $18.60 – a 70.6% fall. In effect, in this example, the CDS
contracts make it possible to reduce risky debt to some combination of
the lower bank risk weight and a small weight that applies to moving the
risk outside of the bank sector – so there is little point in defining an exante
risk bucket of company bond as 100% risk weighted in the first
place.
…expanding
leverage
The simple transaction described above allows the banks to raise the leverage
ratio from 12.5 to 53.8. The Basel risk weighting approach has allowed banks to
expand their leverage almost without limit for all practical purposes. There are
proposals try to deal with some aspects of the problem in relation to CDS contracts
by adjusting multipliers on exposures and on correlations between firms (see C.2).
Treating promises the
same way, wherever
they might sit
The financial system is a system of promises. A basic problem with the Basel
system is that it cannot deliver a regulatory ideal of treating the same promises in
the financial system in the same way wherever they are passed in the regulatory
and tax arbitrage process. The same promises should be treated in the same way,
regardless of where they sit in the financial system. In the above example this is
problematic as shown in Table 2. Without further regulatory intervention the banks
manage to reduce the overall capital in the banking system to $18.6, instead of $80
by passing the promise to a sector that lies beyond the banking regulator. The
model multipliers can be adjusted somewhat so that counterparty risk is penalised
by more, but a one-size-fits-all model adjustment will take no account of the actual
situation of the re-insurer in another jurisdiction and which possibly holds
insufficient capital. Bank A and B are not treated equally and the re-insurer is out
of the picture.
Table 2. Promises treated differently
Bank A Bank A Bank B
Promise Regulatory adjustment
Transformations Bond 100% Cap Weight 20% Cap Weight 50% Off B/sheet Wt.
Face Value 8% Required K 8% Required K 1.5% surcharge coef & 8% Req K.
Bank A
Face value BBB bond 1000 80
Buy CDS on BBB bond
from bank B 16
Bank B
Underwrites to 2.6
Re-insurqnce $50 prem.
Total Banking Capital 80 16 2.6
Reinsurer ? ? ?
Source: Authors’ calculations.
b) Bank, insurance companies and shadow banks
The issue of not treating promises equally is rife in the regulatory framework.
Banks are regulated by bank regulators. Banks deal with insurance companies in
various jurisdictions which are not regulated in the same way so financial promises
can be shifted there. Some hedge funds issue securities in their own name and take
deposits of investors and invest with leverage on behalf of investors – they act like
capital-market-oriented banks. They are lightly regulated, but market discipline in
the absence of implicit public guarantees gives rise to a higher cost of capital that
corresponds to the risks being taken helping to keep the leverage ratio down to the
4-5 range. Banks, on the other hand, are highly regulated, and until now, this has
acted as some sort of guarantee that has allowed leverage of some bank institutions
in the 30-75 range: even if the guarantee is not a formal one, the fact of being
regulated acts as a ‘stamp of approval’, helping to reduce funding costs. It is from
the regulated sector that the crisis arose. Going forward, if regulations on banks are
stepped up, there will be a corresponding shift in the amount and nature of
business conducted in the shadow banking system. Where regulatory lines should
be drawn is a very difficult subject on which to obtain a consensus – but one
guiding principle is that similar promises should be treated in similar ways,
wherever the promise sits.
c) Simple example on tax arbitrage7
Counterparty risk arising from the use of OTC derivatives was one of the key
hallmarks of the crisis. Regulatory arbitrage and shifting promises was an
important contributor to the explosion in CDS use. Tax arbitrage too allows
promises to be transformed with strong implications for bank on- and off-balance
sheet activity.
Consider two bonds, H at a 10% coupon and L at an 8% coupon. One investor
is tax exempt while the other investor is subject to a 50% tax rate on bond H and a
25% tax rate on bond L. The non-taxable investor can buy bond H with the
proceeds of shorting bond L and capture 2% of the face value traded, per year,
with no initial investment. The taxable investor can buy bond L with the proceeds
of shorting bond H and capture a 1% spread after-tax with no investment. Both
traders gain as long as the taxable investor can utilise the tax deductions. Neither
partner needs to know that the other even exists. Price disparities signal the
opportunity. The combined profits realised by both trading partners, after-tax,
come at the expense of a reduced government tax liability. These sorts of
transaction using CDS complete market techniques give strong incentives to banks
with investment banking arms to create structured notes that are very interesting to
investors – giving rise to returns and risk profiles that they might not otherwise be
able to achieve. Banks arbitrage tax parameters that are never closed by their
actions, allowing additional (theoretically, unlimited) business and revenues – but
at the same time risking a build-up of counterparty risk and leverage. Without a
properly binding constraint on the ability of banks to expand leverage through
capital arbitrage, the incentive to build attractive businesses on the basis of these
incentives – continually expanding counterparty risks – may once again become
excessive.
d) Summary
Shifting promises
and perverse
outcomes
The ability of banks to transform risk with complete markets in credit allows
them to shift promises around according to their different regulatory and tax
treatment, and basically avoid the proper intent of the Basel risk-weighting
approach, thereby expanding leverage in a relatively unchecked manner. This
played a huge role in the recent crisis, as is illustrated in Figure 1. Basel risk
weighting was associated with a perverse outcome in the crisis – the better the Tier
1 capital adequacy of banks of the jurisdictions shown in the left panel prior to the
crisis, the greater were the cumulative losses of those banks during the crisis – in
large part due to excess leverage. As the right panel shows, the raw leverage ratio
has a negative relationship with losses in the crisis. Possible reasons for this are:
• Capital arbitrage under the Basel weighting of assets precisely permits
higher leverage (economising on capital while expanding the balance
sheet as shown in the above example), which is more risky.
• A low amount of capital versus the un-weighted balance sheet is
Risks Ahead for the Financial

Industry in a Changing
Interest Rate Environment
OECD Journal: Financial Market Trends
Volume 2010 – Issue 1
© OECD 2010
Pre-publication version
Risks Ahead for the Financial
Industry in a Changing
Interest Rate Environment
Gert Wehinger*
The current interest rate environment has been conducive to financial
institutions assuming exposure to interest rate risks. As interest rates are
expected to rise globally, albeit slowly, and current steep yield curves may
soon flatten, such risks may materialise in the near future. At the same
time, weaknesses in the banking sector still exist, especially for some
segments of the European banking sector. While the effects of changes in
interest rates and their structure on financial institutions differ, recent
changes in asset and funding structures of banks make them generally
more vulnerable to a changing interest rate environment. Currency risk
exposure has also grown, and regional concentration may pose specific
risks. An unravelling of carry trades will have a negative effect on some
institutions. Proper risk management can help during an adjustment
process, and regulatory reforms underway will better support risk
management functions in financial institutions that are, in any case,
already adjusting to the new environment.
JEL Classification: G01, G12, G15, G21, G32
Keywords: financial crisis, interest rate risks, sovereign risks, bond
markets, banks
* Gert Wehinger is an economist in the Financial Affairs Division of the OECD Directorate for Financial and
Enterprise Affairs. This article is based on a background note prepared for the OECD Financial Roundtable held
on 15 April 2010 with participants from the private financial sector and members of the OECD Committee on
Financial Markets. The present version takes into account the discussions and comments made at that meeting
and selected developments that have taken place since. The author is grateful for additional comments from
Adrian Blundell-Wignall and André Laboul, as well as editorial assistance from Laura McMahon and Jane
Voros. The author is solely responsible for any remaining errors. This work is published on the responsibility of
the Secretary-General of the OECD. The opinions expressed and arguments employed herein do not necessarily
reflect the official views of the Organisation or the governments of its member countries.
RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT
A. Current financial market outlook and risks
1. Selected recent developments
Financial markets
are searching for
direction, concerned
about sovereign risk
and the strength of
the recovery
Financial markets are searching for direction. While the global recovery is
ongoing, it is uneven across countries and regions, and investors still worry
about sovereign risk and the potential fallout from fiscal austerity programmes
and the gradual withdrawal of exceptional central bank support. Some
emerging markets are showing signs of overvaluation, especially in Asia, which
has received substantial capital inflows (Figure 1). Current weaknesses still
warrant fiscal and monetary policy support in most OECD economies, but
upward pressures on interest rates are increasing as public and corporate
financing needs are high, while central banks have started to withdraw from the
extraordinary policy measures they had taken in response to the financial and
economic crisis. Significant market pressures have accelerated fiscal
consolidation programmes in Europe. In emerging economies, most of which
have been less afflicted by the crisis than OECD countries, markets have picked
up more vigorously thanks to a relatively stronger recovery, and policy has
started to tighten.
Figure 1. Returns across a broad spectrum of asset classes
Selected investment alternatives, percentage changes over period, annualised, in US dollar terms
‐64.1%
‐49.0%
‐55.5%
‐53.7%
‐46.5%
‐40.5%
‐44.9%
‐50.4%
‐38.7%
‐38.6%
‐38.5%
‐43.3%
‐33.8%
‐28.7%
‐48.8%
‐28.2%
‐1.7%
‐6.7%
‐10.2%
‐10.9%
‐11.1%
30.0%
10.6%
21.2%
‐47.5%
‐42.8%
‐19.1%
12.3%
14.0%
12.7%
0.2%
49.9%
48.9%
45.5%
40.0%
33.7%
25.6%
19.5%
18.4%
16.2%
14.8%
13.5%
12.4%
11.9%
8.7%
6.7%
2.7%
29.2%
25.1%
24.8%
24.3%
21.9%
5.4%
1.2%
‐0.5%
49.7%
28.8%
19.5%
5.9%
1.3%
‐8.0%
‐13.6%
‐80% ‐60% ‐40% ‐20% 0% 20% 40% 60%
EQUITIES:
INDIA‐DS Market
LATIN AMERICA‐DS Market
EMERGING MARKETS‐DS Market
ASIA EX JAPAN‐DS Market
CHINA‐DS MARKET $
NASDAQ COMPOSITE
WORLD‐DS Market
FTSE 100
DJ US TOTAL STOCK MARKET
US‐DS Market
S&P 500 COMPOSITE
DAX 30 PERFORMANCE
DOW JONES INDUSTRIALS
NIKKEI 225 STOCK AVERAGE
EMU‐DS Market
TOPIX
BONDS:
JPM EMBI GLOBAL MIDDLE EAST
JPM EMBI GLOBAL ASIA
JPM EMBI GLOBAL AFRICA
JPM EMBI GLOBAL COMPOSITE
JPM EMBI GLOBAL LATIN AMERICA
JP BENCHMARK 10 YEAR DS GOVT. INDEX
EMU BENCHMARK 10 YR. DS GOVT. INDEX
US BENCHMARK 10 YEAR DS GOVT. INDEX
OTHER:
Economist Commodity Inds/All ($)
S&P GSCI Commodity Spot
DJ CS HEDGE HEDGE FUND $
Carry trade Index ‐ USD ‐ AUD (a)
Carry trade Index ‐ USD ‐ NZ$ (a)
Carry trade Index ‐ Yen ‐ AUD (a)
Carry trade Index ‐ Yen ‐ USD (a)
2008 (1‐Jan‐08 to 1‐Jan‐09)
From 1‐Jan‐09 to 29‐Jul‐10
(annualised)
Notes: a) The carry trade return index is calculated based on the assumption of one-month investments in the respective
currencies, borrowing in yen, applying one-month eurodollar interest rates and central exchange rates, without taking into account
bid/ask spreads and transaction costs.
Sources: Thomson Reuters Datastream and OECD.
Most bond spreads
have narrowed,
reflecting relief
after the recent
turmoil, but specific
risks are still
apparent…
Bond markets are showing signs of relief after the recent sovereign
turmoil. Corporate and emerging market bond spreads have narrowed again
after some widening in the wake of the recent turmoil and are back in the range
of their longer-term averages (Figure 2). Some euro area government bond
yields are still unusually high, and spreads over German bunds have widened.
However, some recent sovereign bond issues by countries with large deficits,
including Greece, received an encouraging market reception. Weaknesses in the
banking sector are reflected in interbank market rates that are still relatively
elevated.
Figure 2. Have risk spreads narrowed too much?
High-yield and emerging market bond spreads
0
200
400
600
800
1000
1200
1400
Basis points
Investment grade ‐ US (Barclays)
Investment grade ‐ Europe (JPM)
High yield ‐ US (BOFAML)
High yield ‐ Europe (JPM)
EMBI global (JPM)
Jul/Aug'07:
severe subprime
effects on
money
markets
Mar‐08:
Bear Sterns
collapse
Sep 08: GSE
takeover,
Lehman
collapse April/May 10:
EU sovereign
debt crisis
Note: Daily data until 29 July 2010.
Source: Thomson Reuters Datastream.
Ample liquidity may
distort risk pricing
With still ample global liquidity, narrow spreads are also a reflection of
investors’ search for yield in the current low-interest-rate environment. While
the very low pre-crisis spreads have not been attained when measured against
the current background, risk spreads may have been lowered to unhealthy
levels, pricing risks again too low. Ample liquidity is also evident in other
market segments, in particular in certain commodities.
Carry trades are
starting to unwind
As interest rates and exchange rates are adjusting and global rebalancing is
expected to lead to further realignments, carry trades are likely to unwind. Thus
far these trades have been profitable in exploiting low US interest rates and
some fixed exchange rates in Asia. Should such adjustments happen abruptly,
the unwinding could be disorderly, jeopardising market stability.
Figure 3. Interest rates are expected to rise
Interest rates as implied by futures markets
0.42
0.41
0.44
0.45
0.46
0.47
0.55
0.67
0.83
1.03
1.22
1.43
3.27 3.37 3.49 3.61
4.08
2.86 2.91 2.95 2.94
3.25
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Per cent, percentage points (ppt)
United States
Short term (1‐month) Short term (3‐month) Long term (10‐year) Spread 10y ‐ 3m (ppt)
0.92
0.97
1.00
1.00
1.06
1.08
1.16
1.26
1.36
1.52
1.63
1.77
2.50 2.65 2.65
1.53 1.59 1.49
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Euro area
Short term (3‐month) Long term (10‐year) Spread 10y ‐ 3m (ppt)
0.77 0.77 0.76 0.85 0.99 1.16 1.35
1.58
1.79
2.02
4.44 4.53
4.24
3.67 3.68
3.25
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
United Kingdom
Notes and Sources: see next page.
Figure 3 (cont’d). Interest rates are expected to rise
Interest rates as implied by futures markets
1.10 1.18 1.28 1.31 1.46 1.61 1.79
2.01 2.21
2.45
3.27 3.39 3.49 3.58
2.09 2.08 2.03 1.97
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Canada
0.36 0.34 0.33 0.32 0.30 0.30 0.31 0.33 0.34 0.36
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Japan
Short term (3‐month)
Notes: Data as of 29 July 2010. United States: Short-term future rates are calculated from CBT 30-day Fed Funds (sett. price) and
CME 3-month eurodollar (sett. price); long-term futures are CBT 10-year US T-note yields. Euro area: Short-term future rates are
calculated from LIFFE 3-month Euribor (sett. price); long-term futures are Eurex Euro Bund yields. United Kingdom: Short-term
future rates are calculated from LIFFE 3-month STERLING (sett. price); long-term futures are LIFFE Long GILT yields. Canada:
Short-term future rates are calculated from ME Bank Accept. 90-day (sett. price); long-term futures are ME 10Y Canadian govt.
bond yields. Japan: Short-term future rates are calculated from TIFFE 3-month euroyen Tibor (sett. price).
Sources: Thomson Reuters Datastream, OECD.
2. Interest rate outlook and risk premia
Interest rates are
expected to rise
globally, although
not very steeply
In this context, interest rates are expected to rise more globally, as judged
by futures markets (Figure 3). For most major economies, the very low shortterm
rates are expected to rise only very slowly this year, with some slightly
more significant increases only as of next year. In Japan, short-term rates are
expected to fall well into next year. This sluggish development of short-term
rates mainly reflects the expectations that central banks will accommodate the
remaining weaknesses of these economies, while inflation pressures (as
measured by nominal vs. real bond yield differentials) remain subdued, despite
the recent commodity price increases (Figure 4). Such increases, reflecting
actual and further expected rising demand mainly from emerging markets,
might forebode further upward price pressures that might not be adequately
reflected in behaviour underlying the market pricing of such inflation
expectation proxies.
Figure 4. Expected inflation still low despite increases in crude oil and commodities
Inflation expectations as implied by indexed bonds vs. price changes in crude oil and commodities
-150%
-100%
-50%
0%
50%
100%
150%
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
3
3.5
Percentage points
United States breakeven inflation
Euro area breakeven inflation
%p.a. London BrentCrude Oil Index USD/BBL (r.h.s.)
Note: Daily data until 29 July 2010. Implied inflation expectations ("breakeven inflation") are differences in yields between 10-year
government benchmark bonds and inflation indexed bonds (BofA/Merrill Lynch government inflation-linked bond indices).
The relatively
slower rise in long
rates may compress
term spreads
The expectations of only a weak rise in economic activity and no
significant increase in inflation expectations may be the main drivers behind the
equally lacklustre upward trend for long-term interest futures. In the United
Kingdom, futures markets even expect long-term rates to fall by the first
quarter of next year, reflecting more serious weaknesses of the economy. The
weaker (or downward) trend of long-term, as compared to short-term, rates is
resulting in falling term spreads between ten-year and three-month futures rates
in all cases shown, except the United States.
Feedback effects
from the real
It is also important to take into consideration that changes in interest rates
will themselves generate feedback effects that work through the real economy
economy could
amplify or mitigate
interest rate
movements
and may mitigate or amplify interest rate movements. These changes are driven
primarily by spending and investment decisions by firms and households.
Important channels in this context are income and wealth effects. Regarding the
income effect, for example, household spending decisions will depend on
changes in the debt servicing burden. Likewise, investment decisions by firms
will depend on financing costs and the burden of servicing current debt, even
though firms tend to enjoy greater financing and risk hedging flexibility than
households. For the same reasons, small firms would be more affected than
large firms. Regarding the wealth effect, spending and investment decisions
may be sensitive to changes in net wealth incurred by changes in interest rates.
Both effects would then feed back into the financial sector in terms of credit
demand, default rates and the like, with perhaps significant second- and thirdround
repercussions on interest rates and risk spreads (e.g. credit restrictions
leading to further default rates and lower spending).
3. Sovereign risk and some implications
Sovereign risk
premia and inflation
may not be
adequately reflected
in futures prices
Looking at current developments and the risks ahead, the projections, as
implied by futures markets and presented here, are highly uncertain. For one,
these futures refer to supposedly “riskless” government paper, and it is only
recently that the risk concept for government securities is being questioned (and
may lead to a major overhaul of models and concepts in finance). The Greek
crisis has shown that being part of a monetary union does not prevent
speculative attacks on a member of the union, and widening deficits in many
other OECD economies have put sovereign risks on top of risk watchers’ lists.
Sovereign credit default swap (CDS) spreads have been reflecting such trends
more strongly (Figure 5) – making some sovereigns look riskier than the
banking sectors in major economies. However, the EU-IMF rescue package for
Greece,1 ECB interventions in the euro area secondary markets for public and
private debt securities, as well as the enhanced efforts for fiscal consolidation
made by many European governments, have calmed the markets, and risk
spreads have declined from their recent peaks.
Sovereign defaults
may become a
possibility
Even some large economies, whose market size and currency standing
gives them easy access to market financing, are on rating agency watch for
downgrades if their budget plans are considered to be unsustainable. For such
economies, the problem may be that their relatively good liquidity position is
hiding problems of a worsening, unsustainable solvency position. In the
absence of immediate market pressure, necessary adjustment may be further
delayed. While sovereign default is unlikely for large economies, a “quasi”
default via high inflation may be an option, even though not an immediate one
given the slack in most economies since the 2008 crisis. For smaller members
of the euro area (as for any fixed exchange rate regime economy) this option is
not available at a national level. As inflation cannot deviate too much from
euro-wide inflation, a real devaluation, i.e. deflation, would be warranted. But
this could trigger a detrimental debt-deflation spiral, in which the real value of
debt increases, with negative feedback from deflation and recession.
Figure 5. Selected credit default swap (CDS) spreads
0 100 200 300 400 500 600 700 800 900 1000
Greece
Hungary
Portugal
Ireland
Spain
Italy
Belgium
Slovenia
Austria
France
United Kingdom
Netherlands
Germany
United States
Norway
Sectors (memo):
US Insurance
EU Banks
UK Banks
EU Insurance
US Banks
UK Insurance
Basis points
28/07/2008
28/07/2009
29/07/2010
Notes: Senior five-year credit default swap premiums (mid) for sovereign bonds, senior five-year credit default swap premium index
(mid) for banking sector.
Steep yield curves
due to low policy
rates may soon
flatten…
Thus far, long-term benchmark rates for major economies have remained
rather low, and steepening yield curves in most economies were thus the result
of short-term policy rates being lowered to unprecedented levels (Figure 6). If
insights can be gained from experience, the relationship between policy rates
and the steepness of the yield curve in the United States was especially strong
in the 1980s (Figure 7). While term spreads are still at historically high levels,
they have recently come down and are expected to decline further as monetary
policy tightens.
Figure 6. Long-term rates are still low
(A) Ten-year government benchmark bond yields and US-euro yield spread
‐150
‐100
‐50
0
50
100
150
200
250
300
1
1.5
2
2.5
3
3.5
4
4.5
5
5.5
01/01/2004
01/03/2004
01/05/2004
01/07/2004
01/09/2004
01/11/2004
01/01/2005
01/03/2005
01/05/2005
01/07/2005
01/09/2005
01/11/2005
01/01/2006
01/03/2006
01/05/2006
01/07/2006
01/09/2006
01/11/2006
01/01/2007
01/03/2007
01/05/2007
01/07/2007
01/09/2007
01/11/2007
01/01/2008
01/03/2008
01/05/2008
01/07/2008
01/09/2008
01/11/2008
01/01/2009
01/03/2009
01/05/2009
01/07/2009
01/09/2009
01/11/2009
01/01/2010
01/03/2010
01/05/2010
01/07/2010
Per cent
United States
Euro Area
Japan
Spread US‐EMU
(r.h.s., b.p.)
(B) Term spreads between ten-year and two-year government bond yields
‐50
0
50
100
150
200
250
300
350
01/01/2004
01/03/2004
01/05/2004
01/07/2004
01/09/2004
01/11/2004
01/01/2005
01/03/2005
01/05/2005
01/07/2005
01/09/2005
01/11/2005
01/01/2006
01/03/2006
01/05/2006
01/07/2006
01/09/2006
01/11/2006
01/01/2007
01/03/2007
01/05/2007
01/07/2007
01/09/2007
01/11/2007
01/01/2008
01/03/2008
01/05/2008
01/07/2008
01/09/2008
01/11/2008
01/01/2009
01/03/2009
01/05/2009
01/07/2009
01/09/2009
01/11/2009
01/01/2010
01/03/2010
01/05/2010
01/07/2010
Basis points
United States
Euro Area
Japan
Figure 7. US monetary policy impact on yield curves
Term spread of ten-year minus two-year benchmark yield vs. Fed funds target rate
0
2
4
6
8
10
12
14
16
18
‐200 20
‐150
‐100
‐50
0
50
100
150
200
250
300
Jan‐1980
Oct‐1980
Jul‐1981
Apr‐1982
Jan‐1983
Oct‐1983
Jul‐1984
Apr‐1985
Jan‐1986
Oct‐1986
Jul‐1987
Apr‐1988
Jan‐1989
Oct‐1989
Jul‐1990
Apr‐1991
Jan‐1992
Oct‐1992
Jul‐1993
Apr‐1994
Jan‐1995
Oct‐1995
Jul‐1996
Apr‐1997
Jan‐1998
Oct‐1998
Jul‐1999
Apr‐2000
Jan‐2001
Oct‐2001
Jul‐2002
Apr‐2003
Jan‐2004
Oct‐2004
Jul‐2005
Apr‐2006
Jan‐2007
Oct‐2007
Jul‐2008
Apr‐2009
Jan‐2010
Basis points
memo: US recessions (NBER) United States
Euro Area Japan
US Fed funds target rate (r.h.s., inverted)
…but fiscal
pressures and
corporate financing
needs may lift rates
at the long end
But further fiscal pressures will keep government financing needs at high
levels and add to inflation risks further down the line. Paired with competition
for financing from the corporate sector, in particular from financial institutions
that have to roll over massive amounts of debt in the near future, this should
raise rates at the long end, likely more than futures markets currently expect.
Should monetary policy react to such pressures, raising rates more than markets
currently predict, this could counterbalance the rise at the long end and flatten
yield curves even more. All this will also depend on the impact of inflation and
inflation expectations on the short and the long end of the curve, and how much
monetary policy will “lean against the wind”.
B. Financial sector soundness, risk exposures and risk management
1. Current weaknesses
Weaknesses in the
banking sector are
still pertinent...
The banking sector is still fragile. While banks are preparing for tighter
capital and liquidity requirements that are likely to be required when Basel III
concludes at the end of 2010 (although phase-in periods will apply), many
weaknesses remain. Exposure to commercial real estate risks (small banks in
the US and some regional banks in Europe) and sovereign risks (in Europe) are
of major concern, and so is funding. While major US banks have been enjoying
solid profits and deleveraging for some time, the process of deleveraging is
lagging in Europe. However, profit reports of major European banks for the
first half of 2010 have been rather positive, mostly due to falling loan losses.
The results of Europe’s stress-testing of 91 banks announced on 23 July, found
that (only) seven banks need more capital. This has boosted confidence and
calmed the markets.
...especially for
some segments of
the European
banking sector
Despite the relatively comforting results of the European banking sector
stress tests, the aggregate results illustrate, according to the Committee of
European Banking Supervisors (CEBS), “the continued reliance on government
support for currently 38 institutions participating in the exercise. Consequently,
it seems too early to speak about a generic ‘forced’ withdrawal. Any
considerations of possible exit strategies should rather take into account
detailed case-by-case analysis in order to ensure banks’ long-term viability
after an exit from government support has taken place.” 2 Moreover, observers
have commented on the weaknesses in the German Sparkassen sector, which
was not part of these stress tests.
Table 1. Banks’ market value losses and gains
Change in market value of largest G20 banks, in USD billiona)
2010b) 2009 2008 2007 2006 2005
memo:MV
(latest)e)
memo:
recoveryf)
United States 72.8 220.1 - 338.0 - 295.2 175.0 - 19.9 811.5 86.7
United Kingdom 41.4 179.3 - 256.7 - 72.8 109.0 - 19.1 421.8 86.0
Italy - 28.5 40.0 - 177.8 73.2 61.4 47.1 142.3 6.5
France - 27.5 107.4 - 157.6 - 31.6 108.6 13.4 184.3 50.7
China - 6.5 136.4 - 124.3 60.1 82.3 - 347.3 104.5
Australia - 6.7 139.7 - 110.9 43.7 38.9 18.2 258.1 119.9
Japan 27.0 - 40.5 - 107.6 - 111.8 - 48.6 204.0 283.6 - 12.5
Russian Federation 8.6 61.4 - 107.5 24.7 45.3 17.1 99.0 65.1
Canada 16.8 112.2 - 97.4 12.2 31.1 37.2 261.6 132.4
Brazil 1.7 150.8 - 88.1 60.6 37.8 29.9 299.7 173.1
Germany - 0.2 28.0 - 80.0 - 3.7 34.1 14.8 68.1 34.8
Turkey 18.7 49.9 - 67.6 39.6 - 4.0 25.7 112.6 101.5
South Korea - 0.6 38.2 - 63.8 - 0.0 11.9 39.1 71.2 59.0
India 15.9 45.5 - 59.3 56.5 16.7 11.6 113.9 103.7
South Africa 8.6 22.4 - 22.3 - 0.2 6.8 7.9 70.9 138.8
Indonesia 17.9 24.2 - 16.2 7.6 14.1 - 1.4 66.0 259.9
Mexico 4.0 7.2 - 8.9 5.6 6.6 0.8 28.4 125.9
Argentina 1.2 2.8 - 3.2 - 1.2 2.3 0.2 6.5 121.8
G20 countries' total 164.7 1 324.9 -1 887.3 - 132.6 729.2 426.5 3 646.8 78.9
memo item: Euro area
totalc) - 120.6 304.0 - 788.0 81.6 379.2 105.4 711.6 23.3
memo item: G7 totalc) 101.8 646.5 -1 215.1 - 429.6 470.5 277.5 2 184.5 61.6
memo item: Globald) 130.5 1 710.6 -2 787.4 - 49.8 1 138.8 504.2 4 888.1 66.1
Sorted by 2008 losses.
a) Based on banks contained in respective countries' Datastream bank indices.
Note that such data are not available for Saudi Arabia.
b) From 1-Jan-10 to 29-Jul-10.
c) Based on banks contained in respective countries' Datastream bank indices.
d) Based on banks in Datastream worldwide bank index.
e) Memo item: Market valuation as of 05-Apr-10.
f) Ratio of sum of change in 2009 and 2010(b) over the negative change in 2008, in per cent.
Sources: Thomson Reuters and OECD.
Favourable profit
conditions for banks
are waning and
bank share prices
have been declining
in many cases
While financial institutions have been profiting from improving and
favourable conditions over the last year, earnings reports as recently released
by some major banks for the second quarter of 2010 show that these conditions
are waning. Over the past year and well into 2010, share prices of the sector
have improved to an extent that by now most banking sectors have recuperated
most or even overcompensated previous (2008) losses in market value (based
on sectoral indices for G20 economies; Table 1). However, more recent
developments led to year-to-date (end-of-July) declines in market value in
several cases, and these declines were particularly strong for banks in France
and Italy. If measured against broad stock market developments (and looking at
a slightly different sample highlighting some more European banking sectors),
the situation for the banking sectors in several countries looks even gloomier
(Figure 8).
Figure 8. Weaknesses in the banking sector still pertinent
Year-on-year growth of selected banking sector equity indices relative to total stock market
8.7
‐2.6
‐3.3
‐7.2
‐8.7
‐9.7
‐10.8
‐12.5
‐13.2
‐13.6
‐16.6
‐21.3
‐29.5
‐32.0
‐34.0
‐100 ‐80 ‐60 ‐40 ‐20 0 20 40 60
Canada
United Kingdom
Australia
Spain
Germany
United States
Sweden
France
Japan
Italy
Switzerland
Euro Area
Netherlands
Belgium
Greece
Per cent
Year‐to‐date (as of 29‐Jul‐2010, annualised) 2009 2008
Note: Sorted by year-to-date declines.
Many smaller US
banks are affected,
and important risks
remain to the US
financial system
overall
In the United States, defaults among smaller banks reached record levels
in 2009, affecting 140 banks; this is almost triple the total of 53 failed banks in
the period 2000-2008 as a whole (26 failed banks in 2008 already having been
the record of that period). Government support (liability guarantees and capital)
will still be needed, as vulnerabilities remain high and low capital levels may
be squeezed by further losses, stemming from commercial property and
consumer loans, for example, as well as by feedback effects from lower
economic activity. The fragility of the current situation has also been noticed by
the IMF in its recent Financial System Stability Assessment of the United
States, which found that bank balance sheets “remain fragile and capital buffers
may still be inadequate in the face of further increases in nonperforming
loans.”3
2. Interest rate risk, exchange rate risk and sovereign exposures
Interest rate risks
are related to
repricing risk, yield
curve risk, basis risk
and optionality
In addition to the current weakness and vulnerability of the financial sector
rooted in the crisis, a changing interest rate environment and exchange rate
adjustment are posing specific, additional risks further down the line. The key
elements of interest rate risk for banks include repricing risk, yield curve risk,
basis risk and optionality.4 Repricing risks arise from timing differences in the
maturity for fixed-rate and repricing for floating-rate bank assets, liabilities and
off-balance-sheet positions. Yield curve risks cover adverse effects on a bank's
income or underlying economic value stemming from unanticipated shifts of
the yield curve. Basis risks are rooted in an imperfect correlation in the
adjustment of the rates earned and paid on different instruments with otherwise
similar repricing characteristics. Optionality has become an increasingly
important source of interest rate risk, arising from the options embedded in
many bank assets, liabilities and off-balance-sheet portfolios.
The current interest
rate environment
has been conducive
to assuming interest
rate risk exposure
The currently low short-term (policy) rates and steep yield curves (see
above), paired with relatively stable or fixed exchange rates (especially in
Asia), have been providing incentives to profit from positive carry in fixed
income and foreign exchange markets. This will typically add to investors’
holdings of long-term assets and tilt funding profiles towards shorter maturities,
thus potentially adding to maturity mismatches.
Effects of changes
in the interest rate
structure on
financial
institutions differ
The effects of changes in the interest structure differ across financial
institutions. In general, banks and other institutions that engage in positive
maturity transformation (borrowing short and lending long), and thus profit
from the steepness of the yield curve, will suffer from any flattening of the
curve, irrespective of whether this has been brought about by higher short-term
rates or by lower long-term rates. More broadly, “asset sensitive” institutions,
i.e. those whose assets are expected to re-price faster than their liabilities,
would be positively affected by a rise in interest rates because their net interest
margins increase. Conversely, “liability sensitive” institutions will profit from a
fall in interest rates.5
Banks’ recent
changes in asset and
funding structures
make them more
vulnerable to a
changing interest
rate environment
Generally, the impact of interest rate changes will depend on the maturity
and re-pricing structure of institutions’ balance and off-balance-sheet items,
and are complex to analyse. Also, complexity of this structure has increased as
financial institutions have been assuming more complex exposures to interest
rate risk through structured products, with an embedded interest rate risk that
has not always been fully understood. More recently, during the crisis, many
banks have significantly increased their holdings of excess reserves and other
short-term liquid assets, suggesting their ability to benefit from increases in
short-term rates. At the same time, increased reliance on wholesale funding
(instead of deposits with low and relatively stable interest rates) has rendered
banks more sensitive to interest rate changes.
Proper risk
management can
help during an
adjustment process
Adjustments to changes in the interest rate structure will depend not only
on the risk exposure of financial institutions (which is hard to monitor based on
public disclosures), but also on the way in which risk embedded in these
exposures is managed. Adjustment processes can be abrupt, as feedback effects
may be at work that amplify the speed and extent of rebalancing. Work by the
Basle Committee6 has looked at these issues well before this financial crisis and
has proposed principles to be used in evaluating a bank’s interest rate risk
management and interest rate risk exposure, and in developing a (supervisory)
response to that risk. At the core of these principles is the involvement of the
board and senior management in the oversight of interest rate risk, and the
responsibility of senior management in ensuring that the structure of the bank's
business and the level of interest rate risk it assumes are effectively managed,
evaluated and controlled. In order to perform these tasks, banks must have
adequate information systems in place, and reports, independent reviews and
evaluations should result in revisions where necessary, and be made available
to the relevant supervisory authorities. Banks must also hold capital
commensurate with the level of interest rate risk they undertake, and should
release information on the level of interest rate risk and policies for its
management.
Currency risk
exposure has grown,
and regional
concentration may
pose specific risks
The profitably of carry trades as well as the increased globalisation of the
financial industry has substantially increased banks’ foreign currency exposure
(Figure 9). Profit opportunities arising from, among other factors, relatively
stronger growth in certain regions as well as specific country contexts and
relations (e.g. between Spain and Latin America) have favoured foreign
exchange exposure of major OECD banks to emerging European and other
developing regions (Figure 10). If such exposure becomes too concentrated, i.e.
if not diversified over a wider range of countries and regions, this could pose
risks. For example, observers have warned of the exposure of some European
banks to Eastern Europe, where some economies are weakened and many
financial institutions have been hit hard by the crisis. And, more recently,
sovereign exposures to some countries on the euro area periphery have come
into the focus.
How the unravelling
of carry trades
affects a given
institution depends
on the type of
institution and the
types of trades it
does
The effects of exchange rates and unwinding of carry trades on financial
institutions is more difficult to predict. First, the foreign exchange market is
rather opaque, as participants know their positions relative to a given
counterparty, but not the aggregate position of a given counterparty. Second,
how the unravelling of carry trades affects a given institution depends to a large
extent on the type of trades that an institution engages in. For example, for
institutions that are using foreign exchange primarily to trade their proprietary
books, a rapid rise in the rate of their short currencies could have significant
negative effects. On the other hand, for clearing banks, an increase in volume
and volatility on FX markets is likely to prove highly profitable. Overall, how
currency movements affect a bank’s exposure depends primarily on the nature
of the institution and the currency of its home market.
Figure 9. Banks’ foreign currency exposure vis-à-vis non-banks has grown significantly
External positions of banks in foreign currencies vis-à-vis the non-bank sector: assets minus liabilities
‐100
400
900
1,400
1,900
2,400
Dec‐95
Mar‐96
Jun‐96
Sep‐96
Dec‐96
Mar‐97
Jun‐97
Sep‐97
Dec‐97
Mar‐98
Jun‐98
Sep‐98
Dec‐98
Mar‐99
Jun‐99
Sep‐99
Dec‐99
Mar‐00
Jun‐00
Sep‐00
Dec‐00
Mar‐01
Jun‐01
Sep‐01
Dec‐01
Mar‐02
Jun‐02
Sep‐02
Dec‐02
Mar‐03
Jun‐03
Sep‐03
Dec‐03
Mar‐04
Jun‐04
Sep‐04
Dec‐04
Mar‐05
Jun‐05
Sep‐05
Dec‐05
Mar‐06
Jun‐06
Sep‐06
Dec‐06
Mar‐07
Jun‐07
Sep‐07
Dec‐07
Mar‐08
Jun‐08
Sep‐08
Dec‐08
Mar‐09
Jun‐09
Sep‐09
Dec‐09
Mar‐10
USD billion
Other
Swiss franc
Pound sterling
Yen
Euro
U.S. dollar
Note: March 2010 data are provisional (Locational Banking Statistics, Preliminary Report 21 July 2010).
Source: BIS Quarterly Review, Banking Statistics.
Regulatory reforms
to better support risk
management are
underway , and
financial
institutions are
adjusting to the new
environment
Some support for financial institutions in their efforts to cope with all
these risks will come from regulatory reforms currently envisaged by policy
makers worldwide. Many banks are already reacting by building up capital
buffers to the proposed Basel III rules7 for which broad agreement was reached
end of July,8 and which are expected to be finalised by the end of 2010. These
rules will impose tighter regulatory requirements in terms of capital and
liquidity, including those attenuating pro-cyclicality inherent in the current
rules. In terms of corporate governance and risk management, there is some
evidence that banks have been improving their risk management and corporate
governance more generally. For example, remuneration schemes have been
reformed in line with official as well as industry proposals 9 in order to make
them more risk-compatible and to avoid excessive risk-taking. There is also
evidence that risk assessments and stress tests are becoming more
comprehensive, and risk officers are being given a more prominent role in the
corporation, and are encouraged to think about extreme risk and rely less on
theoretical models.10 Furthermore, risk control and management could be
enhanced by separating bank business, as foreseen by the recent reforms
(“Volcker rule”) in the United States11 or the firewalled Non-Operating Holding
Company Structure (NOHC) proposed by the OECD. 12 Finally, measures to
strengthen the market infrastructure (including exchange trading and disclosure
requirements) could enhance transparency, the pricing of risk, and help
financial companies to better manage risks exposures.
Figure 10. Banks’ foreign currency exposure is substantial in some countries
Consolidated foreign claims of reporting banks vis-à-vis selected countries and regions, ultimate risk basis.
Amounts outstanding as of end-March 2009, in USD billion
0 500 1,000 1,500 2,000 2,500 3,000 3,500
Other (a)
Other European banks
France
Germany
Italy
Spain
Switzerland
United Kingdom
Japan
United States
USD billion
Other developing countries
Latin America/Caribbean
Emerging Europe
Asia & Pacific
Other developed countries
United States
Western Europe
a) The rest of a total of 24 reporting countries (reporting countries are: Austria, Australia, Belgium, Canada, Chile, Chinese Taipei,
Finland, France, Germany, Greece, India, Ireland, Italy, Japan, the Netherlands, Norway, Portugal, Singapore, Spain, Sweden,
Switzerland, Turkey, the United Kingdom and the United States).
Note: Data are provisional (Consolidated Banking Statistics, Preliminary Report 21 July 2010).
Source: BIS Quarterly Review, Banking Statistics.
NOTES
1 Following the tensions on European sovereign issuers, the Ecofin Council and the EU Member States agreed on
10 May on a comprehensive package of stability measures, including a European Financial Stabilisation
Mechanism. This arrangement will provide up to EUR 500 billion of funds committed by euro area
members to members in difficulty, subject to strong conditionality. The IMF is participating in the
financing arrangements with EUR 250 billion. EUR 60 billion of the EU commitment draws on an
existing facility, and EUR 440 billion will be sourced through a special purpose vehicle (SPV).
2 CEBS et al. (2010).
3 IMF (2010).
4 For more details see BCBS (2004).
5 For this and the following paragraph, see also Kohn (2010).
6 BCBS (2004).
7 BCBS (2009a, b).
8 On 26 July 2010 the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee
on Banking Supervision, reached broad agreement on the Basel Committee's capital and liquidity reform
package; see the BIS press release at http://www.bis.org/press/p100726.htm and its annex
http://www.bis.org/press/p100726/annex.pdf.
9 For industry recommendations to reform remuneration policies, see IIF (2008).
10 It is also interesting to note that JPMorgan Chase has put aside USD 3 billion of “model-uncertainty reserves” to
cover losses related to mishaps of quantitative models (see The Economist, “Number-crunchers
crunched”, February 13, 2010).
11 The so called Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law by President
Obama on 21 July 2010 and should “promote the financial stability of the United States by improving
accountability and transparency in the financial system, to end ‘too big to fail’, to protect the American
taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other
purposes.”
12See OECD (2009), and Blundell-Wignall et al. (2009).
REFERENCES
Basel Committee on Banking Supervision (BCBS) (2004), Principles for the Management and Supervision of
Interest
Rate Risk, July.
Basel Committee on Banking Supervision (BCBS) (2009a), Strengthening the Resilience of the Banking Sector,
consultative document, December, available at www.bis.org/publ/bcbs164.htm.
Basel Committee on Banking Supervision (BCBS) (2009b), International framework for liquidity risk measurement,
standards and monitoring, consultative document, December, available at www.bis.org/publ/bcbs165.htm.
Blundell-Wignall, Adrian, Gert Wehinger and Patrick Slovik (2009), “The Elephant in the Room: The Need to Deal
with What Banks Do”, OECD Journal: Financial Market Trends, vol. 2009/2.
Committee of European Banking Supervisors (CEBS), European Central Bank (ECB) and European Commission
(2010), Questions & Answers: 2010 EU-wide stress testing exercise, available at
http://www.ecb.int/pub/pdf/other/euwidestresstestingexercise-qaen.pdf.
Donald L. Kohn (2010), Focusing on Bank Interest Rate Risk Exposure, Remarks at the Federal Deposit Insurance
Corporation’s Symposium on Interest Rate Risk Management, Arlington, Virginia, January 29.
Institute of International Finance (IIF), Final Report of the IIF Committee on Market Best Practices: Principles of
Conduct and Best Practice Recommendations – Financial Services Industry Response to the Market
Turmoil of 2007-2008, July 2008, available at www.iif.com/regulatory.
International Monetary Fund (IMF) (2010), “United States: Publication of Financial Sector Assessment Program
Documentation – Financial System Stability Assessment”, IMF Country Report No. 10/247; available at
http://www.imf.org/external/pubs/ft/scr/2010/cr10247.pdf.
OECD (2009), The Financial Crisis: Reform and Exit Strategies, September 2009, OECD, Paris, available at
www.oecd.org/dataoecd/55/47/43091457.pdf.
Regulatory Issues Related To Financial

Innovation
I. Introduction
Financial
innovations are
neither inherently
good nor
inherently bad
This note outlines components of a balanced regulatory approach to
financial innovation, defined as one that gives proper weight to each of the three
common core policy objectives featured in most regulatory frameworks:
mitigating systemic risk, ensuring proper market conduct, and ensuring adequate
protection for retail borrowers and investors and other end-users of financial
services. It starts from a premise that financial innovations are a natural outcome
of a competitive economy. They are neither inherently good nor inherently bad.
Innovations have the potential to provide for a more efficient allocation of
resources and thereby a higher level of capital productivity and economic
growth. Many financial innovations have this effect and for that reason
policymakers may wish to adopt a positive attitude towards innovative activities;
that is, to start from a presumption of benefit until detriment is proven as
opposed to the reverse construction.
Many innovations
prove to be
beneficial, on net,
but some others
result in adverse
outcomes
But there is a need for caution. Innovations can affect financial
intermediation and the effective working of the financial intermediation process
is inherently a matter of public interest.1 Moreover, while many innovations,
perhaps even most, prove to be beneficial, on net, others can result in adverse
outcomes, some of which may be quite severe. Examples of the latter include
products that are misrepresented or simply inappropriate for end-users and result
in delinquencies, bankruptcies or other problems among them, or products that
are inadequately managed with respect to the various credit or market risks they
entail and result in broader negative consequences for the financial system or the
economy at large.
The potential for
possibly severe
adverse outcomes
sounds a note of
caution regarding
innovative
activities…
Most regulatory frameworks have a mandate to protect consumers and the
private and social costs of major financial instability are sufficiently high that
policymakers have a clear role as well in preserving financial stability in order to
minimise the risks and costs of widespread financial distress. Under the
circumstances, the tendency should naturally be to err on the side of caution.
Doing so may require placing greater weight on up-front avoidance of systemic
problems as opposed to ex post resolution of crises. And at the end of the day,
the commercial success of financial intermediaries themselves rests squarely on
the effectiveness with which their activities contribute to the macro goals of
mobilising and allocating savings, which is arguably the core function of the
financial system.
…and may argue
against adopting a
completely handsoff
approach
These caveats argue against a completely hands-off approach to innovative
activities in finance. The benefits to the system are not from innovation per se
but, rather, from sustainable innovations, those that do not result in undesirable
distributional outcomes or other negative externalities. Failure to make this
distinction can lead to the unhealthy premise that all innovations are necessary
for the growth and development of financial systems over time, which past and
recent experience suggests is not true.
That said, it is no
easy task to move
from expressions
of concern about
The real question is, thus, what should be the appropriate policy response to
financial innovations. The view expressed in this note is that authorities should
seek ways to preserve the benefits of innovative activities, while ensuring that
new products and services that prove harmful are appropriately contained.
REGULATORY ISSUES RELATED TO FINANCIAL INNOVATION
OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009 3
potential harm
from innovations
to a concrete
financial
innovation policy
Admittedly, this task is not an easy one to achieve. For one, distinguishing
“beneficial” from “harmful” innovations at an early stage is by no means a
straightforward exercise for policymakers; indeed, some observers, prudential
supervisors among them, question even the feasibility of doing so. Second, were
potentially harmful innovations to be identified, different categories of
authorities (i.e. micro-prudential, macro-prudential, consumer protection, tax)
would likely have different views as to the appropriate degree of containment.
For example, products that facilitate tax avoidance may raise no safety and
soundness concerns. And, as with any regulatory policy, an attempt to subject
innovative activities to stricter regulatory oversight would no doubt suffer from
two sets of errors – false positives and false negatives.
At a minimum,
authorities must
ensure that the
infrastructure
needed to support
innovative
activities in
finance is in place
and functioning
properly
To minimise the chances that such mistakes occur the note argues that
relatively greater weight should be given to ensuring that the infrastructure
needed to support innovative activities is in place and functioning properly.
Measures addressed to physical, legal, and human components are cited. Other
elements depend on the specificities of particular types of innovations. That is,
rather than seeking to impose controls on innovative products per se, authorities
should seek to ensure that all participants, ranging from service providers to endusers,
have the necessary capacities to engage in said activities. Of course, where
shortcomings are identified, authorities must be willing to act accordingly.
The paper is organised as follows. The next major section examines
financial innovations over time in the context of their influence on the financial
intermediation process. The noted developments include the increase of capital
market activities in intermediation and the corresponding shift in the activities of
banks and other intermediaries to broader risk transformation. The difficulties
associated with this process are discussed afterwards. They include the increased
exposure of banks to market risks and a more general tendency towards periodic
bouts of marked illiquidity, insolvency, and market misconduct.
This discussion is followed by a suggestion of measures needed to make the
financial system more accommodative to innovative activities, which include
enhancements to regulation and supervision and improvements in governance
and internal controls of financial intermediaries. The following section offers
reasons why this task won’t be easily accomplished.
If a general conclusion is to be drawn from the discussion it is perhaps that
remedial measures should be designed to address specific problems. Looking at
recent history, one finds that many of the innovations in product offerings have
suffered from the same market defect – a tremendous information asymmetry
between the creators of the products and services and the end-users. For such
issues of a consumer protection nature, the regulatory approach tends naturally
to be ex ante, in the sense of being more proactive or preventative. Preventive
measures are also generally required to avoid potential systemic instability.
Otherwise, the best direction for public policy may well be ex post corrective
measures.
4 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009
II. Policy concerns arising from financial innovations
Financial innovations and the intermediation process
Innovations in
finance run the
gamut in terms of
policy issues
Innovations in finance have encompassed a vast range of products and
services, processes and functions. They run the gamut in terms of policy issues,
so it is generally not helpful to consider them en masse and attempt to treat
“financial innovation” as a singular issue. In this sense there can be no “financial
innovation policy” per se, but rather, various policies attuned to the nature and
incidence of particular innovations.
The wide range
argues for a caseby-
case treatment
of innovations
By this reasoning, an optimal approach to financial innovation would
examine innovations on a case-by-case basis in the context of a standardised
framework that considers the financial landscape in which the innovation is
introduced, the policy objectives that have been elaborated for the financial
system, and the system of institutions (policy instruments) that may be drawn
upon to meet those objectives.2
History shows that
many innovations,
perhaps most, have
been beneficial for
the economy, but
some innovations
have had
undesirable sideeffects
An impartial review of financial innovations over time would find that
many innovations have been beneficial, resulting in increased choice for
consumers and greater flexibility on the part of other economic agents. And
while no complete accounting has been done, a valid case can probably be made
that the effect of innovations for the global economy has, on net, been positive
over the longer term. That said, an impartial observer would also note that there
have been unexpected and undesirable side-effects associated with some new
products and services. The fact that episodes of financial instability have often
occurred in the wake of a change in the structural regime that reflected some
form of market innovation has not gone unnoticed by advocates of stricter
oversight of innovative activities in financial services.
In addressing these
concerns,
authorities have
sought ways to
make the system
more resilient
Numerous reforms in recent decades have been introduced in response to
episodes of instability. Unfortunately, many of the measures adopted, in effect,
looked backwards at previous problems, while the intended target had moved off
in some other direction. Crises have elements in common, but rarely the same
trigger. Obviously, what is needed is something more flexible, capable of
looking forward a bit more. That such a framework has not been implemented is
reflected in the system’s periodic lack of resiliency.
A number of trends
and developments
in the financial
services industry
have increased the
need for greater
resilience
A number of structural developments have tended to affect the degree of
resilience of the financial system, in part, by leading to increased potential for
problems in individual institutions or markets to spread. Innovations in product
design have blurred the distinctions between instruments and institutions, and
several market segments, wholesale markets in particular, have trended towards
international integration. Among other important structural changes have been
the increased importance of capital markets in credit intermediation relative to
banks and other traditional lenders, corresponding changes in the activities and
risk profiles of financial institutions, and the related growth and development of
products and markets for intermediating risks.
Some
developments can
be traced to efforts
at liberalisation,
which allowed for
increased
competition across
sectors and borders
Some of these developments can be traced to efforts at liberalisation, which
succeeded in boosting competition across sectors and borders. Many measures to
liberalise entry and ownership restrictions and to facilitate international trade in
financial services were introduced during the 1980s and 1990s. Along with
changes in regulatory objectives and other aspects of the regulatory framework
governing financial services, the reforms had the effect of enlarging the set of
tactical and strategic manoeuvres institutions could employ in response to
competitive impulses.3 All told, the choices of various segments of the financial
services industry have covered a range of options with regard to strategies,
product mix, and organisational structures.
A natural
consequence of
these developments
is a change in the
nature of the
intermediation
process…
This ongoing change in the intermediation process is part of the normal
development of financial systems over time. Banks and other loan originators
specialise in lending to borrowers for which publicly available information about
credit histories is lacking and in financing activities that contain a large measure
of subjectivity and are difficult to assess. To survive in competitive markets,
primary lenders must be able to distinguish better credit risks from poorer ones
and set their loan terms accordingly. Banks, for example, are usually (though
obviously not always) good at assessing credit quality in deciding whether or not
to extend credit,4 and in addition to higher interest charges and other fees levied
on risky borrowers, banks also use non-price terms to reduce the risk of default
and mitigate other agency costs.
These arrangements protect the bank’s interests and also help to insulate its
creditors from credit risk. In addition, regulators require depository institutions
to maintain a buffer layer of capital that is subordinate to the claims of
depositors and other providers of low cost funds and market forces compel banks
to endeavour to maintain capital cushions above the regulatory minimum.
Relatively speaking, this buffer layer of capital is expensive. 5
…which generally
entails the most
creditworthy
borrowers shifting
to capital markets,
while credits that
require more direct
monitoring are
forced to rely on
banks and other
traditional lenders
A general conclusion of the academic research in this area is that borrowers
whose credit risk is relatively easy to assess and for which indirect monitoring
mechanisms are adequate will opt for capital market financing, while borrowers
for which comparable information about credit histories is lacking will be forced
to rely on banks, other intermediaries, or non-formal sources of credit. Banks,
thus, tend to specialise in financing activities that require more direct monitoring
mechanisms. Competition from lower cost sources of credit forces banks to
operate more or less at the edge of illiquidity (as reflected in holdings of less
marketable assets), typically in transactions where arm’s length contracts are
more difficult to specify.6 Their ability to successfully provide such credit is one
of the reasons why banks are special and why they are so important to the
functioning of the financial system.
Banks typically
respond to this
‘disintermediation’
by altering their
business models
and product mix,
As competition for the “best” borrowers increases, banks respond by
altering their activities and product mix, which for many institutions entails
taking on more complicated risks. Larger banks in particular have shifted from
traditional lending against deposit liabilities to trading and market-making in
various market segments, in some cases reaching out to non-traditional
customers or to traditional customers but with innovative products. 7 Larger
often to include
entirely new
products and
trading strategies
institutions increasingly have focused on the creation of new products and
services to satisfy myriad needs of their clients, by transforming liquidity and
maturity risks and other dimensions of financial contracts, thanks to analytical
breakthroughs in modelling contingent claims and other complex instruments,
which have enabled them to adopt variable holding periods for their risk
exposures and to implement corresponding rapid changes in trading strategies.
Large complex
institutions have
shifted from credit
intermediation to
risk
intermediation…
For the largest institutions, especially globally active ones, intermediation
has expanded from more straightforward credit intermediation to risk
intermediation, in which institutions make use of advanced statistical techniques
and quantitative models as the basis for risk measurement and pricing,
sometimes as full scale substitutes for more traditional qualitative judgments.
Securities firms have also been at the centre of this intermediation landscape.
…a strategy that
relies heavily on
the use of
derivatives and
complex models of
risk
In this context, large commercial banking organisations, their securities
arms, and independent investment banks have become fairly active users of
credit derivatives and other such “hedging” instruments to off-load specific
credit risk exposures to other investors. As a consequence, both the scale and
complexity of their funding and trading interrelationships have grown, including
with counterparties that operate outside regulated segments of the financial
system.8 Major market participants now maintain a variety of such relationships
over numerous markets in different financial instruments, currencies, and time
zones.
At the same time,
banks will typically
securitise a large
portion of
traditional credits,
which may leave
them holding more
complicated risks
Thanks to advances in securitisation, banks can actually transfer off their
balance sheets much of the risk associated with many of the “plain-vanilla”
credits they do originate (e.g., residential mortgages and certain types of
consumer loans), although when market discipline functions properly, they have
to retain a portion, usually the first loss, to signal the quality of the risks to
potential buyers. But while some risks may be transferred to other investors,
banks’ balance sheets may not necessarily be any safer than in the past, as they
may well contain newer, perhaps even more complicated risks, including risks
arising from the customisation of products for specific clients.
The implications of
these developments
for the system as a
whole are
ambiguous
What these developments mean for the system as a whole is ambiguous.
Successful process innovations, such as new risk management techniques, and
product innovations (the creation and introduction of new financial instruments)
have the potential to facilitate a more efficient allocation of resources and,
thereby, a higher level of capital productivity and economic growth. For
example, new products and markets broaden the menu of financial services
available to borrowers, lenders, issuers of securities, and other market
participants. And improved risk measurement and risk management techniques
can result in a more optimal distribution of risks throughout the system.
The result could be
a more optimal
distribution of
risks throughout
the system…
Certainly, the entry and broader participation of new entities in the financial
system has allowed risks to be more widely spread throughout the economy,
which brings some advantages. For example, compared with banks, some of the
new participants have longer investment horizons and different risk management
and investment objectives, which may facilitate less cyclical provision of credit.
But the opposite may also be true and there are growing concerns that some new
activities and participants may constitute sources of instability.
… to the extent
that risks are
shifted to parties
with the
wherewithal to
bear them
Exposure to risk is inherent in economic activity. It is the coverage and
proper management of such exposures that offers benefits to individuals,
enterprises and the economy as a whole. Thus, the dispersal of risks throughout
the system has benefits only to the extent that risks are shifted to parties that
have the knowledge and wherewithal to bear them, and not just that risks exit the
banking sector.
Banks’ balance
sheets have
become more
dynamic in the
process...
For many banks, meanwhile, increased trading activity has significantly
increased their exposure to market risk, and as market risks have grown in
importance, the balance sheet has become more dynamic, in the sense that risk
exposures can change rapidly and possibly with severe adverse consequences.
...and the degree of
leverage in the
system has
increased
The risks and opportunities for failure tend to be exacerbated by the
leverage associated with many new activities and by the larger numbers of
players and greater degree of anonymity in today’s financial markets. 9 For
instance, some new products have involved substantially greater amounts of
complexity than traditional products and proved eventually to be quite
damaging.
Difficulties associated with the evolution of financial services
Usually, despite
these changes, the
system functions as
intended…
…but there are
periodic episodes
of instability…
When functioning well, the financial system helps to produce fair, stable,
and efficient market outcomes to support sustainable long-run growth of the
economy. And quite often, financial markets do function properly, which means
they achieve their core objective of ensuring that savings are allocated optimally
among competing investment opportunities. But periodically, the financial
services industry is subject to episodes of marked illiquidity, insolvency, fraud
and other misconduct to the detriment of consumers and investors and the
economy at large.
…which tend to
occur in the wake
of innovations
These outcomes are not so rare in practice. Experience shows that erosion
in market discipline tends to occur periodically, as market participants shun
prudence in pursuit of short-term profit opportunities. Problems develop during
boom periods and either manifest themselves during busts or precipitate them.
Innovations have often been implicated in these developments in the sense that
episodes of marked financial instability have often been preceded by some form
of market innovation that altered the nature of competition and gave rise to
subsequent adverse consequences.
Various reasons
account for these
outcomes,
including the
behaviour of
individuals and
institutions…
The recent near meltdown in the global financial system and the emergence
of numerous other episodes in the past couple of decades in which isolated
financial sector problems developed and reached crisis proportions provide a
compelling argument that markets left more or less to their own devices will not
always generate socially optimal outcomes. For one, individual behaviour often
runs counter to the assumptions of economic theory. And perhaps more
important, the behaviour of individual agents or institutions in the pursuit of their
own goals does not ensure collective rationality.
…and the fact that
participants do not
There is nothing necessarily insidious in this assertion. Economic agents
may be expected to act in their own best interest, which for institutions means
face market
pressure to
internalise external
costs needed to
protect the system
the pursuit of profits. Market participants may be expected to manage their
affairs to balance revenues against costs, which would entail taking on risks up
to the point where the cost of doing so makes sense from their own point of view
of their balance sheets. From each individual institution’s perspective, there may
be little, if any, economic incentive to internalise costs that may be associated
with the protection of third parties or the system as a whole.
Differences
between private
and social costs of
financial activities
are one of the
major
imperfections in
financial markets
The existence of such differences between the private and social costs of
financial activities, so-called spillover effects or negative externalities, has long
been recognised (at least in some quarters) as one of the important imperfections
in financial markets. Other potential market imperfections can include:
Market power imbalances, including the existence of market
participants who cannot be expected to make appropriate choices for
themselves and thus need protection;
The existence of indivisibilities or pervasive economies of scale;
The existence of public goods (e.g. market liquidity); and
Information asymmetries
The existence of
market failures
interferes in the
proper functioning
of markets…
When market failures exist, markets may not allocate resources efficiently
across space and time, may not effectively manage risk, and as a consequence,
may become unstable or subject to other weaknesses. Importantly, in the
presence of market failures, market discipline may not function effectively,
among other things allowing risks to the system to become mispriced.
…which may
include impeding
market discipline,
as in the recent
crisis…
The recent crisis is a case in point. It shares with a number of previous
crisis episodes a substantial build-up of leverage and accumulation of assets, in
an environment characterised by very low risk spreads and high concentrations
of risk, bred in this case by a long period of high growth, low real interest rates,
and subdued volatility, and supported by evolutions in risk management
processes and wider acceptance of instruments for credit risk transfer and
various other structured products. The crisis erupted against the backdrop of a
range of weaknesses, beginning with imbalances on the macroeconomic front
and including flawed incentives across the range of market participants in the
chain running from loan origination to distribution of securities backed by the
loans.
…in which there
were failures of
discipline across
all participants
ranging from endinvestors
to service
providers and
third-parties
In particular, there was weak management of core risks on the part of major
financial institutions, including poorly defined and weakly enforced lending
limits, poor governance and internal controls, and inadequate control of
operational risks.10 Investors for their part performed little due diligence of their
own and relied solely on credit ratings they failed to understand fully.
Furthermore, without sufficient pressure from supervisors to adequately enforce
proper underwriting and risk management criteria, excess leverage built up in
structured investment vehicles (SIVs) and conduits. And most market
participants grossly underestimated the liquidity required to support the market,
part of a more general critical lack of appreciation of underlying risks, reflecting
the use of complex products and off-balance sheet vehicles.
Insufficient
concerns about
credit risk were at
the core of the
problems,
motivated in some
cases by the desire
to accommodate
demands for risk
At the core of the problem was a mispricing of credit risk, or insufficient
regard for it. Through the use of credit default swaps (CDS) and other risk
transfer instruments and based on predictions of quantitative risk models,
originators/sponsors were inclined toward the view that their exposures were
sufficiently hedged. At the same time, the lack of any perceived concentrated
risk exposures left them with too little incentive to monitor the performance of
individual loans. Rather, underwriting criteria were relaxed, in part, to feed a
growing demand for higher yielding securities on the part of investors and
perhaps as well to facilitate tax arbitrage. 11 The underlying loans were then
bundled, via the use of leveraged funds, and repackaged into various
heterogeneous complex structures.
The tiered
structures of risks
that had been built
up to feed the
process collapsed
once the degree of
mispricing of risk
became evident
Many of these structures of tiered risks began to collapse once the
deterioration in the performance of subprime collateral began to surface and
participants began to sense that many of the basic assumptions implicit in the
underlying analysis of credit risk, such as those concerning default correlations,
were inaccurate.12 But securities structures had become so complex and
heterogeneous that it was difficult for participants to disentangle the various
layers to determine who bore what risks, at least not on the basis of standardised
approaches. In that environment, market participants lacked confidence in the
financial integrity of potential counterparties to the extent that credit extension
and financial intermediation more generally ceased to function.
Though unusually
severe, the crisis
reflects a typical
pattern
The financial crisis itself has been unusually severe by various measures.
But in other respects, the recent developments actually match the historical
pattern quite well. Indeed, looking backwards over time one finds many periods
in which rapid growth has been spurred and supported by financial innovations,
but in which the pace of growth masked key underlying risks, as innovation
outpaced the capacity of managers, boards of directors, supervisors, and the
market as a whole to adapt accordingly.
Importantly,
liberalisation and
innovation are
important for
financial
development, but
often have hidden
flaws…
One official notes in this context that financial development depends on the
liberalisation of financial markets and on innovations that improve the flow of
information. Even sophisticated market participants must have sufficient
information if they are to protect themselves from risks related to new products,
markets, or market players. Unfortunately, liberalisation measures and financial
innovations often have hidden flaws and do not solve information problems as
well as markets may have assumed. When these flaws become evident, markets
sometimes seize up, often with very negative consequences for the real
economy.13
…which can prove
problematic when
they do emerge
The flaws associated with recent innovations derived mainly from excessive
heterogeneity, complexity, and opacity, which obscured underlying risks,
allowing them to build to levels grossly disproportionate to the perceived
benefits.14 It is important to note that the individual products themselves may not
be intrinsically bad. When used appropriately, they can be useful instruments for
hedging selected risk exposures. But their higher degree of complexity increases
the chances for mistakes to be made, while the associated higher amounts of
leverage to which they give rise act to magnify any problems that do emerge.
And the risks of inappropriate use are not limited to end-investors. Financial
intermediaries may also use them inappropriately, either through mistakes in risk
management or as part of deliberate risk-taking strategies. Indeed, the bubble
that preceded the crisis was fed by various participants shifting into asset classes
seemingly irrespective of the risks, in some cases to mimic product offerings that
had proved profitable for competitors.
Problems this time
with new products
included excessive
complexity and
opacity, which
allowed risks to
build to
unsustainable
levels
In the end, the complexity of product design and the sheer pace of market
innovations exceeded the capacity of the entire system to measure and limit risk
and to manage incentive problems in the securitisation process, which was
caused in large part by a general failure of many market participants, to
understand fully the instruments that were created. A wide-spread lack of
awareness about risk certainly increases the odds of participants making
incorrect choices that precipitate problems, and in an integrated network of the
sort that has come to characterise modern financial systems there is a non-trivial
chance that those problems when they do emerge can become systemic.
Properly
functioning
markets for new
products and
services take time
to develop
Looking back, it seems that new products and services can be introduced
and markets for them can develop and even flourish for some time in the absence
of formal enabling regulations, relying instead on the basic legal infrastructure or
on the regulatory framework in place for other components of the financial
system. But while new products may be introduced and gain acceptance among a
broad audience, properly functioning markets for the products need some time to
develop, which typically entails a less rapid process of learning and strategic
adjustment.
For example, the
validity of model
assumptions
becomes evident
only after some
time has passed
For example, market participants use models and various statistical
techniques to project cash flows and estimate the risk exposures related to new
financial instruments, but the true nature of these factors becomes evident only
over time, through observations of behaviour under a variety of economic
conditions, such as over the credit or business cycle. Problems with the
infrastructure needed to support an innovation may also emerge with a delay, at
which point they can threaten the health of individual institutions, markets or the
system as a whole.
Measures needed to enable the system to accommodate innovation
The current
institutional
framework cannot
manage innovative
activities in an
acceptable way
It seems, given the periodic breakdowns that have occurred, that the system
does not seem especially robust to innovative activities. Authorities must find
ways to protect the system against systemic risk, and must ensure proper market
conduct on the part of financial service providers and adequate protection for
consumers and investors, if they are to prevent problems at individual
institutions and markets from propagating and to preserve public confidence in
the integrity of the financial system.
In particular, it
does not seem to
provide for
adequate
protection of
consumers and
Financial activity depends to a considerable extent on notions of trust and
fairness. In particular, end-users of financial products and services – especially
unsophisticated consumers and investors – find it difficult to evaluate the quality
of financial products and related information. There are limits to the ability of
small retail consumers and investors to protect themselves in their dealings with
the financial services industry, so they generally need some form of assurance
avoidance of
systemic nearmeltdowns
that financial institutions and markets operate according to rules and procedures
that are transparent and fair, in the sense of being free from manipulation,
conflicts of interest, or other such shortcomings. 15
To do so effectively
would require a
case-by-case
assessment of
innovations
The difficulty is that it does not seem possible within the current regulatory
and institutional setup to accommodate innovative activities in a way that
achieves the objectives of protecting consumers and the system on an ongoing
basis, which means avoiding widespread delinquencies or periodic meltdowns.
This note argues that two sets of measures are needed to accomplish these tasks
and make the financial system more resilient. One set consists of required
improvements in the infrastructure for financial services. Other measures target
various types of innovations.
Measures needed to prepare the system for innovative activities
Step 1: Adopt an unbiased stance
Historically, periods of heightened innovation have often been followed by
a much slower pace or even a reversal or retreat to previous norms, as
subsequent failures or crises brought on, at least temporarily, strong antiinnovation
sentiment among members of the general public and policymakers
alike. But in time, tempers calm, memories fade, and the pace of innovation
picks up anew.
Despite periodic
problems,
innovations have
generally been
positive, on net, for
economic growth
and development
This response is to be expected. Innovation is best viewed as a natural
aspect of the workings of a competitive system. And despite the periodic
upheavals, it is arguably the case that the effect of financial innovations has, as
noted above, been positive, among other things by lowering the costs and
broadening the menu of financial products and services available to ultimate
savers, ultimate borrowers, and other market participants. 16 Moreover, customers
who once were forced to remain outside the formal financial system have gained
access to credit, via the availability of new lending products and distribution
channels.
Thus, authorities
should not be
predisposed
against
innovations
Advances of this type are important if economies are to replenish
themselves over time. And for that reason, authorities should refrain from
adopting a negative bias against innovative activities. Of course, an unbiased
stance does not mean that authorities/supervisors should not care at all about
innovative activities and adopt a completely hands-off approach, whereby new
financial instruments or activities are allowed to develop and spread without any
official scrutiny whatsoever. The issue is where the proper line should be drawn.
Step 2: Ensure that the necessary framework conditions for markets to function properly are in place
There are a
number of
important prerequisites
for the
At the broadest level, government intervention in the financial sector seeks
to ensure that the financial system supports the smooth functioning of the real
economy and a large component of the fundamental regulation of financial
services is generic to all parts of the economy. Basic elements include measures
financial system to
perform its
functions
to ensure that the legal system supports economic exchange by protecting
property rights (through anti-fraud provisions and contract and commercial
law17), establishing judicial and other enforcement mechanisms, and ensuring
proper market conduct.18 These measures are among the core components of a
well developed infrastructure for financial services, which also includes reliable
accounting, auditing, and tax systems, as well as more specific requirements at
the level of individual sectors (i.e. banking, insurance, securities).
But market
framing rules
alone are not
sufficient
All of these measures are necessary framework conditions for markets to
work. But these market framing rules alone are not sufficient to enable a market
to function properly. They must be backed by sound fiscal and macroeconomic
policies and appropriate monetary controls to support sustainable aggregate
economic activity and constrain major internal and external imbalances 19 and by
a broader set of market perfecting measures.
Rather, various
market-perfecting
measures are
needed, which
include various
forms of regulation
Basic anti-fraud measures typically suffice for private, bilateral contractual
agreements but more intrusive regulatory requirements are introduced as the
complexity of financial arrangements increases and as balance sheets of service
providers become more opaque. The main components of the regulatory
framework for financial services in most OECD economies generally include the
following activities: (1) licensing, registration, and prudential supervision of
some categories of financial institutions; (2) disclosure requirements for public
offerings of securities; (3) authorisation and oversight of securities markets; (4)
regulatory and supervisory procedures governing the management of financial
distress events and the restructuring or exit of insolvent financial institutions; (5)
regulation of anti-competitive market structures and takeover activity; and (6)
regulation of market conduct.
The challenge is
link the structure
to innovative
activities
The key is to link this structure to innovative activities, bearing in mind the
ability of market participants to contract around regulatory hurdles. As market
practices in financial services can evolve rapidly, overly detailed regulations
may not be effective and may become counterproductive over the longer term.
Broad regulatory principles will need to be applied in some circumstances.
Step 3: Acknowledge that there is no one policy measure that can be considered optimal in all
circumstances
A balanced
approach is
required, which
means regulation
and supervision in
combination with
competition and
market pressure
The next step in the design of a regulatory framework adapted to
innovations in financial services is to accept that the issue for policy is not a
choice between two polar cases of exclusive reliance on competition and market
pressure (i.e. market discipline) on the one hand versus complete reliance on
regulation and supervision on the other. Competition and market pressure are
necessary for the attainment of sustainable market outcomes, but alone are rarely
sufficient. But by the same token, though necessary for the attainment of stable
and efficient market outcomes, regulation and supervision alone are also not
sufficient.
Both sets of
measures have
their role to play
It is important for policymakers to appreciate the fact that both sets of
instruments have their place in the policy repertoire. In economic parlance, they
are not perfect substitutes; that is, it is not possible to make wholesale
substitutions between them and attain desired outcomes. Rather, government
policy affects market outcomes in interaction with private sector behaviour and,
as the General Guidance notes, the success of regulation as a policy instrument
depends to a significant extent on encouraging proper behaviour, which requires
aligning the incentives of participants with policy objectives.
Regulation is
important, but if
not properly
designed, could
result in
unforeseen
consequences that
precipitate wider
problems
Regulations are obviously important, but they are only one component of a
full complement of measures that underpin the proper functioning of financial
systems. It is important to recognise that regulation is not a panacea for problems
and imperfections that arise in the financial system. For one, all official
interventions in the workings of the economy have their own costs and can
create distortions of market signals or have unforeseen consequences that
precipitate wider problems down the road. The end result could well be
efficiency losses that are at least as substantial in economic terms as the market
imperfections the regulations are supposed to correct.
For example,
poorly designed
regulation can
distort market
signals and result
in net economic
costs rather than
net benefits
Usually, it is improperly conceived and poorly designed regulation that
results in net economic costs. This outcome sometimes results from direct effects
on individual market participants or segments, but more often occurs indirectly
through the distortion of market signals. And often as not, that outcome stems
from ambiguous objectives. It is important to take a step back and ask again
what is it that we are trying to achieve with financial policy. The answer should
be a precise statement of the desired outcome, such as, improving standards of
market conduct, changing the behaviour of all participants in a certain way,
improving the capacity of consumers to understand the products on offer, etc. If
the goal is not clear, it becomes difficult to design or implement efficient
corrective measures.
Step 4: Ensure that the policy instruments needed to achieve incentive-compatible objectives are in the
toolkit
(a) Clarify what is meant by maintaining systemic stability
More regulation
may or may not be
the answer to
emerging problems
When problems do occur, it may prove to be the case that the correct policy
prescription entails tighter regulatory control. But it may not and policymakers
should resist taking the false comfort that comes from the view that more
regulation is always the solution to market failures. Instead, policymakers should
seek the right balance among policy instruments. Financial policy instruments
are complementary, which means that changing one measure alone could prove
to be counterproductive. All components – market discipline and
regulation/supervision – must work in concert to achieve desired outcomes.
Policy needs to
start from a clear
set of objectives
As most people would agree that a principal goal of financial regulation is
to promote financial system stability, that’s a good place to start. In most
countries some authority, be it the central bank, another entity, or a committee
has a broad objective of maintaining the stability of the financial system, owing
to the simple fact that if the system is not safe and stable, then it is exceedingly
difficult, if not impossible, to achieve any of the other objectives. Surprisingly,
considering the importance of this goal, what exactly is meant by this
commitment has often not been clearly defined.20 This ambiguity has historically
not been constructive.
The place to begin
is with a clear idea
of what is meant by
the goal of
systemic stability
Occurrences of financial instability become systemic when an event (some
type of shock21) triggers reactions that are sufficiently large or widespread to
produce significant adverse effects for the financial system as a whole and
thereby the broader economy. Accepting this description as valid suggests that
the avoidance of systemic risk requires preventing disruptions at individual
institutions and markets from propagating and spilling over to disinterested third
parties and the broader economy. Technically speaking, failures of individual
institutions need not be causes for concern. Failures are a normal outcome of the
proper functioning of a competitive economy. The failure of individual projects
and at times of entire firms (even financial institutions) is one means by which
competitive markets weed out weaker performers. It is the ultimate market
discipline. Indeed, sustained economic growth requires that resources are
reallocated in this way, shifted from activities that are no longer profitable to
more productive uses.
This goal should
normally not be
taken to imply zero
failures
Thus, the goal of public policy towards the financial system has to be to
make the system more resilient in the wake of failures by preventing problems at
individual institutions and markets from propagating and not by reducing the
incidence of failure to zero.
(b) Properly address exit problems for large institutions
The current
approach seeks to
prevent problems
from occurring at
institutions
The current approach to protecting the financial system from the
propagation of disturbances is to try to prevent serious problems from
developing at individual institutions, under the premise that maintaining the
health of individual institutions is the best way to ensure the health of the system
or at least to preserve confidence in it.
Special care is
taken to avoid
problems at large
institutions...
Inasmuch as system-wide financial crises have often occurred in the wake
of a widespread loss of confidence that in turn was prompted by the failure of a
major financial institution, authorities in many jurisdictions have treated
prospective failures of large institutions differently from failures of small
institutions. And so, while a principle of allowing poorly managed institutions to
fail is fine in theory, in practice, when confronted with the potential failure of
large institutions, most authorities have been reluctant to take the chance that
non-intervention will work out for the economy. The so-called ‘constructive
ambiguity’ regarding intervention tends to be ambiguous only with respect to
small institutions, while very large institutions become perceived as “too big to
fail”, out of fear of the potential risk to the system and the threat to government
safety nets.
… but such an
approach can give
rise to moral
hazard
The problem with this approach is that accidents that are waiting to happen
eventually do. Thus, institutions that are considered too-big-to-fail most certainly
will; they will just cause big problems when they do, unless procedures are in
place to facilitate their winding down in an orderly fashion. Orderly, equitable,
and transparent exit procedures are the counterpart to minimal entry barriers to
achieve an efficient allocation of resources, from older, less productive entities
to newer, more innovative ones.
In fact, the
adoption of a toobig-
to-fail doctrine
may encourage
excess risk taking
that results in more
serious problems
once failures do
occur
Failures of financial institutions can generate sizeable negative spillover
effects if not properly managed, but it is abundantly clear that a too-big-to-fail
approach gives rise to considerable moral hazard. The existence of government
guarantees and other insurance mechanisms may reduce the incentives of private
financial counterparties to manage the risk exposures they assume. For example,
the moral hazard problem associated with explicit safety net guarantees such as
deposit guarantees arises from the potential for the deposit-taking institution, the
depositor, or both to be less “prudent” than might otherwise be the case, relying
instead on the existence of the state-sponsored safety net to underwrite mistakes.
Similarly, the expectation of public sector intervention to ward off
“systemic” losses in the event of financial difficulties of large institutions is a
form of implicit safety net that may encourage some participants to hold more
concentrated exposures with covered institutions than they likely would
operating under an effective potential for failure.
The threat of
failure can help to
minimise
tendencies towards
excess risk taking
The threat of failure keeps institutions ‘honest’ by inhibiting any tendency
to trend towards excessive risk. The willingness of creditors to withdraw their
funds on suspicion of improper behaviour or excessive risk taking is an
important component of market discipline. This component is not active if
prospective creditors and counterparties have sound reasons to believe that large
financial institutions will not be allowed to fail abruptly.
It must be possible
for institutions to
fail, even large
ones
The obvious policy conclusion is that if market discipline is to function
properly, participants must believe that it will be possible for institutions to fail,
regardless of their size or degree of interconnectedness, with obvious negative
consequences for creditor and investors.22 The pursuit of systemic stability
should not entail adopting a too-big-to-fail approach for large institutions.
It has been argued many times that, even with failures of large institutions,
market principles need to be applied. They include that managers of failed
institutions receive the appropriate punishment, that shareholders are forced to
bear their burden of loss, and that the financial community as a whole is
involved in efforts to resolve the problem. The rationale is that adherence to
these principles should help to lower moral hazard and instil more discipline in
the market. But, of course, under current arrangements, once an institution’s size
and complexity and its degree of interconnectedness pass certain thresholds the
likelihood of an abrupt exit is perceived by many participants to decline
considerably.
To make such a
system operational
requires a
dedicated
framework for the
orderly unwinding
of failed
institutions
The need for a dedicated framework for facilitating the orderly unwinding
of financial institutions, both for entities that take deposits and for other large
integrated intermediaries that operate in scale across numerous markets, has been
acknowledged for some time. But few such frameworks have been introduced.
Special procedures may apply for banks, but similar measures may not be
available for other forms of large, complex financial organisations. There are
discussions underway in a number of jurisdictions regarding measures to enable
the system to cope with isolated failures of large, complex institutions (e.g. a
rapid resolution plan). Ideally, these discussions should converge on an approach
that can be made operational across jurisdictions, but the difficulties in doing so
will not be easily resolved.
(c) Establish a proper macro-prudential framework
Focussing on
individual
institutions is
questionable
The second issue with current safety and soundness regulation is the
mistaken premise that a focus on the behaviour of individual institutions is
sufficient to ensure the health of the system as a whole. The current crisis has
illustrated all too well that risks to the system can hide in the interactions
between intermediaries, products, and markets, and not with particular
institutions per se.
Oversight needs to
be expanded to
address macroprudential
concerns,
including in
securities markets
It is now a given that regulation needs to be enhanced in scope to address
systemic risk. A particular concern in this context is the approach to securities
market oversight, which in many jurisdictions has had a focus almost exclusively
on protection of retail investors and largely through disclosure requirements.
This focus is mostly the outcome of specific historical, political, and economic
circumstances (especially the Great Depression). The problem with this
approach is that it ignores other risks that can negatively affect the integrity of
markets and the system as a whole.
A system-wide
macro-prudential
approach is needed
to account for risks
that hide in the
interface between
institutions and
markets
In the run-up to the crisis, for example, many entities or products that either
were exempt from regulation altogether or benefitted from a ‘light touch’
contributed to the mispricing of assets, excess leverage, and ultimate instability.
Even products directed at sophisticated parties must be subject to proper
oversight as regards their market impact. And where sophisticated investors are
institutional investors, there must be proper oversight to ensure that they
themselves are aware of and capable of managing the risks to which they gain
exposure, in order to ensure said risks do not harm their fiduciary mandates or
have broader market impacts (e.g. from their need to make disorderly portfolio
adjustments or to withdraw altogether as sources of liquidity).
All of these changes are needed to ensure that the institutional structure of
regulation is sound for all components of the regulatory framework. All
components of the regulatory framework must operate according to proper
mandates if the financial system is to sustainably accommodate innovations and
be resilient to failures. Properly construed and enforced regulation is part of the
core infrastructure that supports financial stability and innovation.
(d) Establish a proper framework to ensure adequate protection for consumers
And it is necessary
to maintain
adequate
protection for
retail consumers
and investors…
The potential private costs of financial instability are large (i.e. losses to
banks’ clients and shareholders), but it is the large social costs that often induce
authorities to act. They include losses on the part of small depositors and
investors, reduced (if any) access to credit on the part of small to medium-sized
enterprises especially but borrowers in general, disruptions to payment and
settlement systems, reductions in output, higher unemployment, and costs to
taxpayers. As a consequence, authorities use various preventive mechanisms to
ensure the stability of the system as a whole and to maintain the integrity of the
payments system and public confidence in the system.
…if the financial
system is to
continue to attract
capital and
function efficiently
What about protecting consumers and investors? Maintaining consumer and
investor confidence is necessary if the financial system is to attract capital and
function efficiently. Market confidence is undermined if the financial system is
not adequately protected from abuse, as trust and confidence once lost are
difficult to restore. There are no obvious instruments for doing so, which
explains why authorities have had few options to address the problems faced by
unsophisticated consumers/investors other than various forms of bonding
arrangements (i.e. guarantees), which are designed to provide partial or complete
protection against undue losses. The word ‘undue’ is extremely important. Endusers
of financial services should be protected against fraud, malpractice and
other misconduct on the part of service providers. But this objective should not
entail efforts to reverse errors of judgment that are committed knowingly.
Step 5: Ensure regulators and supervisors have the requisite skills and experience
Regulators and
supervisors will
need enhanced
capabilities to
effectively handle
the complexities of
today’s financial
markets
The core elements of high-quality regulation are not limited to the policies
alone. Supervisors need to develop skills and expertise in the appropriate use of
regulatory instruments in order to apply them in an effective manner, which may
in some cases require taking a proactive approach. Hence, the next step in the
design of a framework that is capable of effectively and efficiently responding to
innovations is to ensure that staffs of experienced, well-trained supervisors exist
in all inter-connected jurisdictions; otherwise, the weakest among them becomes
the port of entry for subsequent problems.
This includes some
mechanism to
address crossborder
issues
Moreover, there is an international character to many product
developments, which requires that the level of cross-border supervisory
communication and coordination is commensurate with the degree of
interconnectedness of markets. The recent crisis makes it clear that a better
coordination mechanism is needed for all areas of cross-jurisdictional oversight.
Supervisors must
have an in-depth
understanding of
the activities of
supervised
institutions…
The crisis also serves as a reminder of the types of conflicts of interest,
governance problems, and weaknesses in risk management that can arise in large
integrated financial institutions. When present, these conditions hamper the
functioning of market discipline. Self-discipline also becomes less effective as
problems develop within an institution, which means that increasing regulatory
intervention becomes necessary. Particular challenges brought on by recent
market innovations have included among other failings an overly rapid pace, a
lack of transparency, complexity, and a lack of understanding of core risks.
…which includes
understanding the
particulars of risk
management
models and
internal control
structures
The requirements for supervisors to effectively monitor and address these
issues are far from trivial. Supervisors need to develop as much knowledge about
an institution and its risk management models and control procedures as the
individuals who build the quantitative models and the members of the
management team who formulate the risk management strategy in which the
model plays a role. Some activities may appear to be highly profitable, but often
enough that outcome may reflect the fact that some risk is either being mispriced
or not priced. Supervisors need to be able to identify these cases. And they must
be capable of doing so relatively quickly and flexibly under potentially rapidly
changing circumstances.
Step 6: Ensure a proper balance between regulation and governance
Need for proper
governance and
internal controls at
financial
institutions
themselves
The improvement in the capabilities of supervisors must work in concert
with institutions’ own internal controls. The relationship between regulatory
policy and broader governance is critical. The success of regulation as a policy
instrument depends to a significant extent on influencing behaviour, which
means that regulatory policies must be complementary to other aspects of a
jurisdiction’s corporate governance regime. This governance structure must
function properly.
In the run-up to the crisis, the weak capacity of boards to exert proper
oversight of their institutions’ business operations and attendant risks was at the
core of the problems. Crucial information perhaps never reached the board, or
the members failed to understand the risks inherent in their institution’s change
in business model, or were powerless to do anything to stop it. None of these
possibilities is acceptable.
Authorities need to
ensure that
institutions have
the proper internal
control
mechanisms for
the types of risks
they assume
It must be acknowledged that it is not the purpose of policymakers to
substitute for boards and senior management of financial intermediaries.
Regulated institutions are still private companies and are responsible to their
shareholders. However, it is the purpose of policy to ensure that institutions
internalise all costs, including the social costs associated with their own
operations, their market conduct, and their behaviour vis-à-vis clients and
customers. Institutions should be free to pursue their chosen business strategies
(subject to shareholder and board approval), provided they take into account all
costs. To wit, some activities may need to be backed by higher levels of capital
support, more stringent disclosure obligations, etc., as needed to ensure adequate
protection for the system.
There are special
requirements in
the case of new
products and
services…
Authorities need to ensure that the governance framework for an institution
is appropriate for the institution’s risk profile and business model. For example,
the requirements for sitting on the board of a small retail institution are
obviously different from those for a globally active financial group. An
institution’s business mix and risk appetite places important demands on the
management and control structure through which it operates. Proper risk
management and control processes are especially important as regards
innovative activities.
…which may be
extremely complex
and based on
instruments that
can make the
balance sheet
vulnerable in times
of stress
Some new products seem to be complex, but actually can be decomposed
into a few simple payment streams that are themselves combinations of even
more basic components. But some other new products are extremely complex.
They may be based on entirely new processes; sometimes new organisational
structures are also involved (e.g. SIVs and conduits), all of which can result in
substantially greater levels of complexity and opacity than for similar, more
traditional products. New financial products that are tailored to specific clients
are often based on complex derivatives and place considerable reliance on
market liquidity, arrangements that can tend to make the balance sheet
vulnerable in times of stress.
Dynamic risk
exposures require
an integrated
approach to risk
management
The types of dynamic risk exposures that can arise in the development and
distribution of new products can affect both sides of an institution’s balance
sheet and cut across its constituent entities, such that aggregate risk for the entity
as a whole can exceed the sum of the risk exposures of individual units. In such
an environment, the application of standard risk management tools for the
constituent entities on a stand-alone basis likely will not suffice. Rather,
institutions must have an integrated approach to risk management at a
sufficiently high level in the organisational structure to manage the risks
associated with new product development.
Measures addressed to particular innovative activities
Even with these
measures in place,
failures of
institutions will
occur
All of the above-mentioned measures are intended to ensure that the
financial system is capable of measuring and managing risk and able to
withstand periodic dislocations, either of individual markets or of the system as a
whole, without teetering on the edge of collapse. But mistakes and accidents are
going to happen nonetheless. Risk is an inherent aspect of financial activity and
a core function of banks and other intermediaries is to price, manage and allocate
risk. There is some component of risk in the system that stems from commercial
activity and cannot be eliminated. The end result of attempting to make the
system safe by driving all risk from regulated sectors would be to push it toward
less transparent, unregulated entities or onto households, which is even less
beneficial from a social or systemic stability perspective.
The objective is not
to prevent all
failures; it is to
attempt to
moderate the
amplitude of
swings and prevent
serious problems
and harm to
consumers
The implication, of course, is that failures will occur. There is no costeffective
way to prevent all failures. What we tend to learn from crisis events is
how to avoid a repetition of the very same debacle, not how to prevent them
altogether. Financial markets have historically been subject to periodic booms
and subsequent crashes and most likely will continue to be. Thus, the objective is
not to attempt to prevent crashes, which is probably unattainable. But it should
be possible to moderate the amplitude of the swings and prevent egregious errors
and to better insulate retail end-users from the vagaries of institutions’ mistakes.
To do so requires a more focussed attention on certain types of innovative
activities.
Step 7: There should be appropriate monitoring of new products, markets, and processes
Authorities should
develop a thorough
understanding of
financial
innovations
Authorities need to develop a thorough understanding of financial
innovations to avoid the potential for a given innovation to cause widespread
harm to consumers or prove catastrophic for the system. One of the higher
principles to be observed in this context is the need for precaution. The General
Guidance highlights the need for oversight of the financial system to be riskbased,
which partly entails guarding against outcomes that occur with low
probability but at very high costs.
In short, new
products and
processes should
be analysed over
The analysis of new products and processes over time should be seen as a
critical tool to facilitate authorities’ understanding of financial innovations.
There need be no presumption that specific action is necessary, but a failure to
adapt regulation and supervision to changed market circumstances can be
time to see if
amendments to
regulations are
needed
problematic. There can be a considerable delay between the introduction of a
new product and the emergence of problems. Thus, a determination that an
existing policy approach is sufficient should be based on a sound analytical
foundation.
The process of
monitoring of new
products and
processes should
entail
consideration of a
range of issues to
ensure the system
can remain
resilient should
problems emerge
Part of the analysis
is to gain an
understanding of
the motivation
behind the
particular
innovation
All of the measures described above in Steps 1-5 have as their focus
ensuring that the system remains resilient in the wake of problems. There is a
wide range of potential issues to be considered, which may include:
What appears to be the intended target of the innovation: e.g.
individuals (retail, high-net-worth, sophisticated); institutions (a
particular category or type, cross-border, cross-sector); a particular
industry or sector; infrastructure (trading platforms, clearing and
settlement systems, procedures, or processes)?
What appears to be the core purpose of the innovation: e.g. risk
mitigation, capital relief, regulatory or tax avoidance, revenue
enhancement, hedging, arbitrage, client need?
Does the innovation result in true value added or does it represent a
transfer from one entity or sector to another?
What are the key assumptions underlying the innovation: e.g. existence
of abundant liquidity; continued low or high interest rates, inflation, or
volatility; benign macroeconomic environment?
What is the timing of the innovation (i.e. in what part of the cycle is it
being introduced; has it been tested under conditions of stress)?
How does the product itself or the process used to produce it differ
from traditional methods or products? Is the innovation revolutionary,
or is it adaptive?23
Is the innovation accompanied by a change in institutional structure or
business models? New structures can serve multiple purposes. For
example, by channelling risk positions through conduits or special
purpose vehicles created solely for the purpose of unbundling and
repackaging selected risks, banks were able to obtain favourable
treatment under applicable accounting standards; under corporate, tax,
bankruptcy, and securities laws; and under numerous banking capital
regulations.24
For banks, capital
relief has been a
common factor
motivating
innovative
activities
Among particular developments, micro-prudential supervisors will want to
be alert to innovations that seemingly are created solely to reduce capital
requirements. There are various motivations to free up capital, including passing
along the benefits to shareholders in the form of increased dividend payouts or
share repurchases, or simply re-deploying the capital to other more highly
remunerative activities. Freeing up capital allocated to the loan book first
became an issue back in the late-1980s, as banks came under regulatory scrutiny
for exposures to highly leveraged borrowers. These pressures, concomitant with
demands from shareholders for higher returns on equity, gave impetus to the
development of the secondary market for loans.
Securitisation is one technique by which institutions have traditionally
sought a more effective use of capital. Initially, securitisation was used mainly
for assets for which the costs of acquiring and distributing information to rating
agencies and investors about loans and borrowers was low, reflecting the use of
standardised loan underwriting criteria and advances in information technology,
which made it easier to estimate default probabilities and payment patterns under
a variety of economic conditions.
Securitisation has
been an oft-used
technique in this
regard, especially
for standardised
loans
Assets such as mortgages and consumer receivables were sufficiently
standardised that they could be “insured” at relatively low cost, such that most of
the assurance of payment was inherent in the underlying collateral and the ability
of mortgage insurers to successfully guarantee the ultimate payment of interest
and principal, while issuers and servicers assured the timeliness of payments.
That, at least, is how it was in the past. But financial innovations have since
facilitated the use of the techniques even for very heterogeneous assets, albeit at
a cost of considerable complexity and subsequent problems.
Step 8: Adapt the regulatory system as necessary to the market environment it is intended to regulate
Decisions about
regulatory
intervention should
be based on a
systematic analysis
of all these issues
The decision to intervene, either to modify existing rules or to introduce
new ones, should be based on a systematic analysis of these and various other
issues. Where problems or concerns are found to exist, the analysis should
identify whether its origins lie in the characteristics of particular market
participants (including consumers and investors), in the products and services
offered, or in the structure of the market.
In principle, policymakers have a range of strategies for responding to any
concerns about potential negative side effects associated with particular
innovations. Which approach is chosen depends in part on what regulation seeks
to achieve.
Measures are to be
based in part on
the incentives of
market participants
and end-users…
The measures adopted should take into account the nature of the incentives
of market participants and end-users through which they have to work. Different
thresholds may be involved for different policy objectives; that is, some
objectives may call for ex ante preventive measures while ex post corrective
measures may be better for others.
…and partly on the
underlying
objectives of policy,
which can differ
among them
Consider the recent crisis. The degree of heterogeneity and rapid pace of
introduction of new products, and the complexity of product design
overwhelmed the capacity of the system to measure and limit risk and to
maintain proper incentives in the securitisation process. The traditional antidote
for complexity is simplicity, accompanied by enhanced transparency and
disclosure. But while disclosure and transparency are important for properly
functioning markets, they are not panaceas.
Unsophisticated
customers and
investors have
difficulty
processing
End-users of financial products and services, especially unsophisticated
customers and investors, have difficulty processing financial information to
evaluate the quality and perhaps even the suitability of financial products and
services. Thus, there are limits in their ability to protect themselves in their
dealings with financial service providers. Even the best disclosures, alone, are
financial
information, thus
even the best
disclosures alone
are not adequate
protection
not adequate. And it is highly unlikely that more, read lengthier and possibly
more detailed, disclosures are going to resolve the problem. Some products are
just not suitable for unsophisticated consumers and investors. To avoid situations
in which retail investors become involved with unsuitable products institutions
should be “encouraged” to develop sufficient measures for client protection as
part of their product development activities.
Consequently,
some authorities
have taken more
direct measures to
ensure protection
against
innovations
deemed unsuitable
for a retail
clientele…
Different jurisdictions sometimes draw different conclusions of the exact
form such encouragement should take. For example, the central bank of the
United Arab Emirates (UAE) issued a recent directive to local banks requiring
them to obtain the central bank’s permission before selling structured products to
their retail customers. According to the directive, banks must first submit a
written request to the central bank containing the relevant details and the
rationale for asking for an exemption to the rule. The central bank expressed the
view that it is not desirable for banks operating in the UAE to sell structured
products to their retail customers, a category that in the central bank’s view
includes high net worth individuals.
…who may not
fully appreciate the
risks inherent in
structured products
A somewhat different approach has been adopted by the Monetary
Authority of Singapore (MAS) in response to the fallout from the presumed
‘mis-selling’ of so-called Lehman Brothers “mini-bonds” to retail investors.
Mini-bonds were not actually bonds in the traditional sense, but instead were
‘capital protected’ structured notes. One difficulty lies in the label – capital
protected, which along with ‘principal protected’, suggests for many investors a
degree of protection that is not actually provided. An investor is ensured of
getting back all of his or her invested funds at maturity only with ‘guaranteed’
products, such as ‘capital guaranteed’ products, which are backed by third-party
(or affiliated) insurance.
But other
authorities have
opted to strengthen
and enhance
disclosures and
introduce
measures to better
educate the public
The Monetary Authority of Singapore (MAS) has reviewed the regulatory
regime governing the sale and marketing of unlisted investment products
following the fallout from the presumed ‘mis-selling’ of the Lehman Minibond
Notes to retail investors. In March 2009, it proposed a series of measures to
promote more effective disclosure, strengthen fair dealing in the sale and
advisory process, educate the public and enhance MAS' powers to investigate
and take regulatory action. Some of the main proposals are as follows:
a) Issuers will be required to prepare a short, user-friendly Product
Highlights Sheet to promote more effective disclosure. In addition,
requirements for ongoing disclosure and fair and balanced
advertising will be strengthened.
b) Financial institutions will be required to undertake an enhanced
product due diligence process before selling new investment
products.
c) Representatives will be required to enhance the quality of
information obtained from their customers. They will be required to
provide customers with more details in their basis for
recommendation and set out more clearly in a formal document why
the products are suitable for them.
d) A new category of “complex investment products” will be
introduced, and subject to enhanced regulatory requirements.
Financial institutions will only be able to sell a complex investment
product to customers when they give customers advice on whether it
is suitable for them. The prospectus, Product Highlights Sheet, and
all marketing and advertising materials of complex investment
products will carry "health warnings" that serve to alert investors that
they may not easily understand the risks and features of the product
and should seek to do so when their financial adviser provides them
advice. The "health warning" should further include that investors
should not buy the product if they are unable to fully understand the
product.
e) MAS’ powers to investigate and take regulatory action will be
strengthened.
The Singapore financial services industry has already put in place some of
the proposals put forward by the MAS. The Association of Banks in Singapore
(ABS) in July 2009 announced a series of measures that its member banks would
be adopting to further protect the interests of consumers who buy investment
products. The measures include a prohibition on bank tellers referring customers
to representatives for the purchase of investment products, as well as enhanced
due diligence for new products. Member banks of the ABS have also adopted a
seven-day cooling off period proposal for structured products with the exception
of time-sensitive treasury or investment products.
Better financial
education remains
necessary
Measures such as the ones described above should help to ensure that
consumers have the information they need to make appropriate choices. Of
course, consumers must also have the education to understand the information
that is provided, and available evidence suggests that much remains to be
achieved on the financial education front. For example, surveys in OECD and
other countries continue to show that consumers have low levels of financial
literacy and often overestimate their skills, knowledge and awareness when it
comes to credit products. The consequences of uninformed credit decisions can
be disastrous, especially if the credit in question concerns a mortgage loan,
which may be the single largest and perhaps the most important financial
commitment an individual or household makes.
Difficulties to be encountered when mapping policy instruments to financial innovations
As mentioned early on in this report, regulatory frameworks in OECD
countries generally endeavour to achieve three broad policy goals:
mitigating systemic risk,
ensuring proper market conduct, and
ensuring adequate protection for retail borrowers and investors and
other end-users of financial services.
These broad goals will typically map into a broader range of objectives at
the sector level, as different functions of the financial system give rise to
different sets of “micro” policy issues.25 Unfortunately, no systematic way has
been found to link policy objectives with policy instruments, even in static
environments, and financial innovations, which change the status quo, greatly
complicate this task. Among the challenges innovative activities can pose for
existing regulatory structures is that a given innovation can straddle multiple
policy areas.
Functional
equivalence makes
it difficult to
generalise among
innovations…
Form and substance problems help explain why financial regulation has
historically had difficulty adjusting to the innovation process. It can be
challenging in some cases to determine what regulatory entity should have
oversight over products that span institutional categories, or to decide what body
of regulation should apply.
…and are
especially
challenging for
formal rules
Jurisprudential scholars have long considered the existence of form and
substance problems, that is, situations in which financial arrangements having
the same intrinsic characteristics can be represented by myriad different formal
instruments, to impede the use of “rules” to regulate behaviour. Rules tend to
break down in the presence of such “functional equivalence”. 26
Formal definitions
apply regulatory
standards to
institutions or
products that fall
within the
prescribed
category…
To understand the difficulties, it helps to consider an example, bearing in
mind that it is but one of many that occur time and again in finance. Note, first,
that many jurisdictions use either or both of two basic classification systems for
linking financial institutions and products and services to regulatory structures:
“formal” versus “functional” definitions. A formal definition creates a regulatory
category and typically applies a regulatory standard on institutions or products
that fall within the category. Typically, the category itself will be determined
under the chartering statute for the institution involved. Rules may stipulate, for
example, that only entities formally licensed as “insurers” may engage in the
business of insurance. The advantage of formal definitions is that they are based
for the most part on unambiguous legal requirements. The problem with formal
definitions is that they are subject to a high degree of manipulation, the
incentives for which are particularly acute when the definition is used as a
prerequisite for imposing a regulatory burden.
…but functionally
equivalent
institutions or
products will be
exempt from the
rule
There are numerous examples. Take the United States as a case in point.
Back in the early 1980s, US regulations controlled the payment of interest on
various deposits at ‘depository’ institutions (i.e. banks and savings and loan
associations). But the restrictions did not apply to stand-alone securities firms, as
they were not formally licensed as depository institutions. By the same token,
securities firms, not being banks or thrifts, could not technically offer checking
accounts, but that proved not to matter. A number of securities firms took
advantage of the loophole in the formal definition to create money market
mutual funds with check-writing privileges, using contractual agreements with
partner commercial banks to gain legal access to check clearing systems. The
products were functionally equivalent to bank checking deposits, but were not
subject to the same regulatory controls on payment of interest and proved to be
extremely popular among retail investors, attracting a considerable outflow of
deposits from banks and thrifts, which lacked equivalent products to offer. 27
An alternative
approach is the
use of functional
definitions to
categorise
financial activities
An alternative approach to establishing regulatory jurisdiction that avoids
the limitations of formal definitions is to assign financial activities to regulatory
structures by means of “functional” definitions. Functional definitions establish
jurisdictional boundaries most often by identifying a set of “core” characteristics
for the activity or institution in question. For example, the insurance business can
be said to include various core activities (e.g. the issuance of contingent
promises) and only entities licensed as insurance companies and that are subject
to and comply with the regulatory provisions governing insurers can be allowed
to conduct said activities.
Functional
definitions
overcome some of
the shortcomings
of formal
definitions, but
among other
difficulties can be
over-inclusive
Functional definitions, thus, overcome the difficulties formal definitions
have with functional equivalence. On the minus side, however, they tend in
practice themselves to be indeterminate and can be over-inclusive. It can be
difficult to establish firm boundaries around activities to determine whether they
belong principally within one category of business versus another. Using the
example of insurance once again, a functional definition based primarily on the
issuance and management of contingent promises would capture a wide range of
activities that are probably not the intended targets of the regulatory provisions,
such as credit default swaps (CDS) to name one example.
Consequently,
functional
definitions are
typically bounded
by a series of
exceptions or
exclusions
As a consequence, functional definitions of financial activities are typically
bounded by a series of exceptions or exclusions, which include among other
types, numerical exclusions, sophisticated investor exemptions, and institutional
carve-outs. Binding regulatory constraints open up a range of interesting
possibilities in this context. There is considerable incentive for private parties to
avoid regulation by having their activities fall within one or another category of
legal exemptions. Hedge funds, for example, historically avoided being subject to
regulatory provisions governing private investment companies by requiring
initial investments well above the regulatory minimum, marketing themselves
only to wealthy investors, and limiting the overall number of investors. 28
There are
numerous reasons
why classification
schemes for
financial
innovations can be
difficult
In sum, classification schemes for financial innovations can be problematic
for various reasons. As illustrated by the example, lists based on traditional (i.e.
legal or regulatory) labels are problematic, as innovations are often designed with
the express intent of spanning different traditional labels or avoiding them. 29
Lists by name are equally unhelpful because names are often used to differentiate
products that are otherwise quite similar. An alternative is to use a classification
scheme based on product function, but even that is no panacea as no functional
scheme would avoid the complication that any single innovation is likely to
involve multiple functions.30 Consider, for example, a mortgage combined with a
unit-linked life insurance policy; this hybrid financial product embodies banking,
securities, and insurance components.
Most efforts to
resolve problems
of functional
equivalence rely
on subjective
assessments
Classifications based on product feature can result in a system that has too
many dimensions to be definitive, as most products will almost always embody
multiple aspects. As a consequence, most efforts to resolve issues of functional
equivalence attempt to determine the “predominant” characteristic of the
transaction in question and then classify it according to that subjective
assessment. One way to proceed with such an approach is to base the
determination on the perceived “principal motive” behind the product or service.
There are many
possible
motivations for
financial
innovations
In the review by Tufano31, the list of common motivations for financial
innovations includes the following:
−Innovation exists to complete inherently incomplete markets (i.e.
unmet needs or preferences of clients);
−Innovation exists to address inherent agency concerns and
information asymmetries;
−Innovation enables parties to minimise search, transactions, or
marketing costs;
−Innovation is a response to taxes and regulation (e.g. decoupling
economic ownership or exposure from legal ownership –
governance and tax implications);
−Innovation is a response to globalisation and increasing risks; and
−Innovation is the result of technological shocks.
But no one single
explanation will
typically apply
But there can be other motivations and in general no single explanation will
typically suffice on its own, which makes it difficult to establish conclusively
which factor is “most” important.
These difficulties
aside, the proper
choice for
policymakers is
not to walk away
and admit defeat,
as innovations
touch on issues
that are of
considerable
public interest
What should policymakers do? Walk away, throw up their hands and admit
defeat, and hope the market gets it right this time? The obvious answer is no.
Innovations can affect financial intermediation and the effective working of the
financial intermediation process is inherently a matter of public interest. 32 And at
the end of the day, the commercial success of financial intermediaries themselves
rests squarely on the effectiveness with which their activities contribute to the
macro goals of mobilising and allocating savings, which is arguably the core
function of the financial system. Authorities, thus, need to finds ways to preserve
the benefits of positive innovations, while curtailing the diffusion of harmful
ones. Admittedly, this task is not an easy one to achieve and, as with any
regulatory policy, a regulatory approach to financial innovation will no doubt
experience two sets of errors – false positives and false negatives.
Not all
innovations are
necessary for
growth and
development of the
economy
But authorities should not be swayed by worst-case scenarios of the “likely”
adverse outcomes of subjecting financial innovations to some form of regulatory
oversight. Failure to make a distinction between innovations leads to the
unhealthy premise that all innovations are necessary for the growth and
development of financial systems over time and, hence, to the conclusion that
policy should be predisposed toward accepting all innovations as is. Past and
recent experience suggests that this approach is fraught with danger.
The benefits to the
system are from
‘positive’
innovations and
not from
innovation per se
The benefits to the system are not from innovation per se but, rather, from
positive innovations, those that do not result in undesirable distributional
outcomes or other negative externalities. While numerous innovations over the
years have contributed to economic welfare, some have contributed to consumer
detriment, to institutional failures and to market or systemic crashes. Most
regulatory frameworks have a mandate to protect consumers and the private and
social costs of major financial instability are sufficiently high that the
government has a clear role as well in preserving financial stability in order to
minimise the risks and costs of widespread financial distress. Under the
circumstances, the tendency should naturally be to err on the side of caution,
which requires placing greater weight on up-front prevention of systemic
problems as opposed to ex post resolution of crises. The real question is, thus, not
whether there should be regulation in this area, but rather what form should it
take.
IV. Concluding remarks
Financial markets today are characterised by rapid innovation and an
evolving business environment, together with longer-term changes in customer
needs and profiles. The result has been a greater array of participants, products,
and distribution channels. In such an environment, regulatory measures that are
overly detailed or too restrictive may induce distortions in the allocation and
pricing of financial resources and may limit the ability of financial institutions to
respond to changes in the competitive environment, which may render them
unprofitable or unsafe. The ideal approach is to find an appropriate balance
between preserving safety and soundness of the system and allowing financial
institutions and markets to perform their intended risk management functions.
That approach entails first ensuring that the necessary market-framing and
market-perfecting rules are in place and then establishing a proper structure for
reviewing financial innovations. The first step in the process is surveillance, with
a particular focus on certain red flag developments that have been linked to
problems in the past. The next step involves careful analysis, which requires that
regulators and supervisors have the necessary experience and skills to
understand what may be complex instruments. That understanding should be
considered a pre-condition for allowing a product to continue as is, without the
need for official measures to ensure providers take on board all costs associated
with the activity, including social costs of market or system failures. Different
thresholds may be involved for different policy objectives. A given product or
activity may not raise particular concerns for some objectives, but may be a
serious issue for others. All objectives must be considered and some authority
must take a system-wide view.
Highlights of Recent Trends in Financial Markets

I. Overview
After some major
corrections in May
and June, equity
markets recovered
well and despite
heightened
uncertainty,
sentiment in
corporate bond
markets remained
positive.
After some significant corrections in the second half of
May and in early June, major equity markets have resumed
their growth, in some cases regaining levels reached before
the May-June contraction. Against a backdrop of healthy corporate
balance sheets, robust earnings growth and low
default rates, investor sentiment has remained positive, as
reflected in these equity market developments and compressed
credit spreads. However, there are signs of increasing
nevousness, which include the May/June market turbulence
and somewhat increased levels of historical and implied volatility.
The increased nervousness may reflect in part downward
revisions to economic forecasts.
In the light
of a weakening
economic outlook,
yield curves
flattened as central
banks continued to
withdraw liquidity.
While central banks have continued to withdraw liquidity,
short-term interest rates have been rising but such
increases have not been fully matched at the long end. As a
result, government benchmark bond yield curves have flattened
a bit further. In corporate bond markets, after the turbulence
earlier in the year spreads have either moved
broadly sideways or declined. Viewed over the whole
period since the last meeting, these spreads have risen
somewhat, but they remain at relatively low levels. With
some exceptions, emerging market bond spreads also
remain at relatively low levels, even if they have increased
from their historical lows.
10
© OECD 2006
Financial Market Trends, No. 91, November 2006
II. Equity markets
The equity market
downturn in May
and June wiped out
gains made over
the previous
months…
In May and early June, equity markets across the
globe experienced major corrections amid investors’
fears of increasing inflation, higher interest rates and in
some cases slowing growth prospects (Figure 1). As a
result, some major markets dropped back to levels that
they had reached in the last quarter of 2005, which for
some of them implied losses of up to around 20 per cent
from their recent peaks. Those losses were particularly
steep in markets where strong gains had been recorded
previously, like in Japan or the euro area. Cumulative
declines in the Japanese broad market index brought the
index on June 13 to its end-of-October 2005 level, a
decline of over 20 per cent from its peak on 9 May. The
euro area broad market index fell more than 17 per cent
over the same period, falling back to January 2006 levels.
For the US broad market index, the corresponding loss
was slightly less than 9 per cent, but the decline nevertheless
wiped out within a few days gains that had beenmade
since the previous November.
… and volatility
increased over fears
of weakening
economies,…
In the course of these downward adjustments, volatility
of major indices increased substantially, breaking
through long-term averages (measured from the beginning
of 1990 to date), and continued to rise even after
markets had started to regain some strength (Figure 2).
Volatilities subsequently receded only in July and
August, but have remained above their pre-correction
levels of early May, indicating some heightened uncertainty
on the part of investors about the future direction
of equity markets. The fact that for all major indices histor
ic volati l ity, a backward-looking measure, has
remained well below implied stock market volatility, a
forward-looking measure (based on option contracts),
corroborates this view.
Asset management has always been known to be close to people who belong to the finance
domain. The recent event of sub-prime crisis and its ensuing effects has resulted in people being
extremely cautious about their assets and investment of their assets. Safeguarding the assets then
became an important point of thinking.
With the world slowly recovering from the sub-prime effect, it is time for us to look into the
latest asset management trends. Economic developments in many countries have resulted in
these trends to be in place.
Here are the top 5 asset management trends for 2010
1. Weak global banking will encourage private credit – All leading banks across the globe
took a beating while the sub-prime crisis was at its peak. Experts believe that banks
would need some time to recover from the aftermath of the event. The willingness of
leading banks to lend is no longer there, but private lending institutions with rates lower
than that of banks, are already seen making a big march. Will they win?
2. Developing countries will outpace advanced countries in growth rate – IMF estimates
that in 2010, advanced countries would grow at about 1.5%, while developing countries
like India and China would grow at about 5% thereabouts. Clearly, this points to a
favorite destination for investors to invest in assets.'
3. The Damocles' Sword of inflation and deflation will continue to dictate people's
investment decisions – Economies reeling under a consistent sprout of inflation is now an
old story, which now has been replaced with deflation. The threat of sustained deflation
has gone down steadily in most economies, but investors seem to be extremely cautious
about a possible relapse of inflation. Deflation is now, a no-guarantee word, especially if
governments cannot promise the need of financial institutions to get fresh funds.
4. Dynamic Asset Allocation seems to be the way forward – Traditionally, Strategic asset
allocation has been known as the tool for asset investment, which also factors in long-
term equilibrium. All that will change now, what with Dynamic Asset Allocation being
able to exploit long term equilibrium, as well as deliver short term gains.
5. Hedge funds remain a mystery – Hedge funds have been taking an absolute battering in
the last some years. Fund managers continue to promote these funds in lure of higher
commissions, but the investors are turning out to be extremely cautious about these
funds. They have started seeking more transparency, directionality in these funds, if they
really wish to consider investing in them.
These 5 asset management trends clearly underline the way forward for asset allocation and asset
management by various financial houses. It must be said here that the investors' mindset hasn't
changed much, even after the sub-prime fallout. One thing is for sure though – Today, the
investor wants clear directions and concise information.

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Financial Market Trends: Current Issues in Financial Markets: Exit and Post-Financial Crisis Issues

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Financial Market Trends

Current Issues in Financial Markets: Exit and Post-Financial Crisis Issues

Risks Ahead for the Financial

Regulatory Issues Related To Financial

Highlights of Recent Trends in Financial Markets

Here are the top 5 asset management trends for 2010

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