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The Fundamental Principles of Financial Regulation

Geneva Reportby

Brunnermeier, Crockett, Goodhart, Persaud and Shin

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Background

• We have observed a cycle of financial leverage and then deleveraging (asset price bubble and bust)

• We argue that

– The regulatory framework of Basel II and IFRS amplified this cycle, producing ‘procyclicality on stilts’.

– This occurred because Basel regulation is too focussed on micro-prudential oversight: improving the condition of the individual bank

– It is a fallacy of composition to believe that, if each individual institution behaves ‘prudently’, the system as a whole will be safe.

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Indeed most systemic crises arise because of the responses of the banks, and other financial intermediaries, to exogenous shocks, not just from such latter shocks.

Two main such self-amplifying mechanisms are the loss spiral and the margin spiral.

Endogenous risk

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5Source: IMF GFSR

Repo Haircuts

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Our theme is that the Basel approach (Basel I and II) has focussed excessively on the risks of individual banks;

• Micro-prudential rather than macro-prudential• Valuable but insufficient.

Measures of systemic cyclical variation:-

1) Leverage (FDICIA; SNB)2) Credit expansion (Banco de Espana)3) Maturity Mismatch

We suggest all three.

Capital requirements for systemic risk

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Applying capital requirements for systemic risk

How applied :-

• Provisions (Spain)• Separately to capital (FDICIA; SNB)• Interactive with Basel II (US) (Helps to avoid ‘gaming’)

But which Basel ratio?

• Details and coefficients to be estimated.• Absolute need for precommitment/rule, and graduated ladder of responses.

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Taxonomy (a) Individually systemic (identify in advance, if possible)(b) ‘Systemic as part of a herd’(c) Non-systemic, but large(d) Tinies

Main problem is (b), largely hedge funds. Macro-prudential, but also micro-prudential?

Home/host issues: Cycles differ from country to country. Also cross-border banks are “international in life, but national in death”.

To whom should such capital requirements apply?

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Financial risk arises from a combination of asset price volatility and maturity mismatch.

Both the asset and liability structure are crucial.

Crisis arose from excessive confidence in continued ability to fund, or roll-over, in short-term wholesale financial markets.

Liquidity

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Proposed liquidity regulation• Need for liquidity regulation based on maturity mis-

match, enforced by explicit capital charges

• Proposal on ‘Mark to Funding’

• The ability to hold to maturity depends on funding structure

• Problem: incentives to finance potentially illiquid assets on the basis of short-term debt, both in good and bad times

• We need to counter-balance that

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(a) Remuneration

Supervisor should set higher capital charges for more risk-promoting remuneration schemes

(b) Loan-to-Value Ratios in Mortgages

(c) Credit Rating Agencies

(d) Year-end Spikes

Other regulatory issues

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We advocate enhancing macro-prudential regulatory requirements to support and to accompany existing Basel micro-prudential requirements.

The two involve a different ethos and professionalism:-• Macro-prudential Central Bank• Micro-prudential FSA

Cross-border, home/host issues• Cycles differ between countries• Common Principles, differing application Europe?

FSFProblems (1) Democratic legitimacy

(2) G7 representation(3) Warning procedure

The structure of regulation