Regulatory response to the financial market crisis and the evolving ecosystem

Introduction

The financial crisis of 2008 not only exposed the vulnerabilities of individual financial institutions but of the entire system as a whole. Several experts blamed legislations like the Gramm-Rudman Act which allowed banks to trade derivatives that they sold to the investors and the Commodity Futures Modernisation Act which exempted credit default swaps and other derivatives from regulation for the irresponsible trading and investing.

Since then the entire financial system not only in the USA, but world over has undergone changes in terms of regulatory initiatives to make them more accountable and shock resistant. Identification, reduction and management of systemic risk have been on the agenda of regulatory boards all over the world. US Federal Reserve has identified Systemically Important Financial Institutions (SIFIs) whose collapse would pose a serious risk to the stability of the entire financial system in the US and proposed to come up with measures to increase their stability and hence the regulation on them. Legislations like the Dodd-Frank Act and the Basel III norms also propose to increase the regulation on the banks and other financial institutions. In India the need for increased regulation for banking institutions in

terms of maintaining a high cash reserve and adequate liquidity was recognised even before the crisis.

But in the midst of this increased regulation there also has been an argument that increased regulatory actions have decreased the liquidity in the market and caused a herding in the business model of the banks and also effected the risk taking activities to transition to the ‘shadow banking’ sector all of which increase systemic risk and leave parts of the market underserved.

Parameters to assess the effect of regulations in the post crisis financial system

To explore this argument we need to analyse the pre-crisis and post-crisis situation on various factors like the extent of regulation, the systemic risk, the solvency status and liquidity of the financial institutions.

Scope of Regulation: In US before the crisis a significant portion of the activities of the so called Bulge bracket Investment Banks and Bank Holding Companies (BHCs) took place outside the purview of regulation and supervision of the Federal Reserve. The inclusion of these institutions in the list of those that are under the strict scanner of the Federal Reserve has resulted in their activities to be subject to greater regulations in terms of maintaining greater capital to cover risk, adequate liquidity as well as lending and trading more responsibly. Regulations like the, Volcker Rule which restricts banks and BHCs from proprietary trading, investing in hedge fund or private equity funds and also place a ceiling on the liabilities the largest banks can hold, are to this effect. The non-bank SIFIs like GE capital, MetLife, CLS Bank International etc. are also subject to greater oversight of the Federal Reserve. These changes have ensured that a larger proportion of the financial institutions now have the oversight of regulatory authorities to check their practices.

In Emerging Market Economies (EMEs) it was seen that some Foreign Bank branches transferred capital and liquidity to parent companies in stress, which called for regulations to gradually move toward subsidiary model for foreign banks rather than just ‘branches’ and also regulation of their banking practices.

Solvency: during the financial crisis the solvency of major financial institutions became stressed which also increased the burden on the Federal Reserve for capital influx and bailouts to prevent complete collapse of financial machinery. In the post-crisis era, with the introduction of Basel II norms and other regulations which call for greater capital reserve(tier I) against risks( i.e. higher leverage ratio) and also focus on the quality of assets invested in, the solvency position of banks and other financial institutions have significantly improved both in developed economies and EMEs.

In the US the capital reserve against risk has increased significantly, the increase in capital has been driven by retained earnings, according to SNL Financial between 2010 and 2013 75% of the profits generated by the banks in US were retained and added to capital buffers, not only that the overall assets of the banks also climbed with a trend toward de-risking of assets with increase in cash reserve and US Treasuries.

According to Bank For International Settlements 82nd Annual Report between 2008 and 2011 large European, US and Japanese banks raised their common equity to capital assets ratio by 20%, 33% and 15% respectively. Among the EMEs Indian and Chinese banks expanded their balance sheets by roughly 75% during the same period, their capital was primarily composed of equity capital. For EMEs the trend was increasing since 2004.

According to a report by SNL Financial for Global Systemically Important Banks because of the policy of the Federal Reserve to have greater regulation for larger banks, their share of safest assets increased from 12% in 2004 to 29% in 2014 and the proportion of super safe holdings of non-GSIBs doubled to 9% during the same period.

Source: Bankscope; BIS 82nd Annual Report

All these indicate that post-crisis due to increased regulation the solvency position of financial institutions strengthened and they became more stable due to an increased ratio of low risk assets and equity capital on their balance sheets, not only that the overall assets on their balance sheet also increased significantly.

Source: SNL Financial

Liquidity: liquidity was among the prime cause for the situation to go from bad to worse during the Financial Crisis; hence the second aspect of regulatory measures is to ensure adequate liquidity in financial institutions through quantitative liquidity regulations. The Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) under the Basel III norms intend to provide a strong liquidity structure to banks. LCR intends to increase the resilience of short term liquidity condition of banks by promoting holding of High Quality Liquid Assets (HQLAs) to withstand a 30 day liquidity shock. The requirements of LCR create a buffer against the liquidity risk and reduce the bank’s vulnerability to a run, also creating time for the authorities to assess the situation and react appropriately. NSFR is complementary to LCR it requires a stable funding to cover the liquidity risk of banks’ assets and liabilities for a time period of one year and hence decrease the reliance on short term funding. NSFR aims at discouraging financially unsound practices like over reliance on instruments which are highly volatile and procyclical. NSFR is the ratio of the available stable funding to the required stable funding, with the least ratio of 1, on an on-going basis. The NSFR is calibrated under the assumption that banks will be willing to rollover a significant portion of maturing loans to maintain customer relationship. LCR while is widely accepted by the industry there still are concerns regarding the NSFR. A few of the concerns raised were that secured financing transactions (SFTs) will be unduly penalised as they are mainly with non-banks. The treatment of derivatives is also unclear and also transactions with non-banking financial parties would end up attracting a 50% weighing in in the same way as unsecured lending, even if they are backed by highly rated securities. There were alsoconcerns that in the EMEs with less developed capital markets and financial intermediaries, long term funding may suffer to close the NSFR gap.

The Volcker Rule has also received criticism that it reduces liquidity especially of the corporate bonds market during periods of stress and adjustments to it are being considered. The trends of global liquidity supply however show a positive trend, an analysis of the IMF and Federal Reserve Board data by Yardeni Research, Inc. shows the same

Maintaining substantial levels of liquidity is important but at the same time emphasis needs to be given to the difference between appropriate levels of liquidity and giving the traders and investors free reign to buy and sell anything instantaneously which was the prime reason for the financial crisis.

Contagion: one of the prime reasons that distress in one sector of the financial system escalated to a crisis was that the distress quickly spread to other sectors because of them being inter-connected and inter-dependent, the institutions were exposed to common sources of risk. To minimise this risk, a federal regulation, the Volcker Rule was introduced, one of its objectives is to reduce interdependency of various financial institutions and hence reduce the risk of contagion. According to the Federal Reserve ‘Volcker Rule prohibits insured depository institutions and any company affiliated with an insured depository institution from engaging in proprietary trading and from acquiring or retaining ownership interests in, sponsoring or having certain relationships with a hedge fund or private equity fund. These prohibitions are subject to a number of statutory exemptions, restrictions, and definitions.’

The Volcker Rule has received severe criticism over the years from different quarters, in a working paper by The Board of Governors of the Federal Reserve System staff members and a Cornell University professor of finance, concluded that during times of stress the corporate

bond market becomes less liquid as an effect of the rule because it discourages market-making activities as dealers that fall under its purview are less willing to infuse liquidity during these times. This of course does not raise a question upon its ability to decrease the risk of contagion and trading in very risky instruments by strategically important financial institutions. In saying that, it is to be realised that amendments are definitely needed in the Volcker Rule and the financial regulations in general, taking in inputs from all quarters of the financial sector.

Systemic Risk: the threat that the failing of a few important financial institutions will result in the entire financial system coming to a crash is serious and needs to be dealt accordingly. To curb this the Federal Reserve along with the Financial Stability Oversight Council (FSOC) has been given the responsibility to determine Systemically Important Financial Institutions (SIFIs), in 2011 the Financial Stability Board also published a list of Global SIFIs or (G-SIFIs). The central banks around the world have taken measure to increase the regulation on and supervision of the institutions systemically important to them. In the US under the Dodd-Frank Act, systemically important institutions have been subject to strict standards of metrics. The results of such measures on several parameters like the Tier 1 Capital Ratio of the past twelve quarters (2014 Q4 -2017 Q3)

Data for all Banks in the US

Source: Federal Reserve Board

The data shows that the banks have fundamentally grown stronger and have become more stable in their growth because of the regulations in the post financial crisis era.

The argument of Shadow Banking

The Financial Stability Board (FSB) defines shadow banking as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system”. Non-bank entities that provide capital are and additional support to fund economic activity, but if these ‘shadow banks’ engage in credit intermediation activities by in any one of the four ways:

? maturity transformation: using short term funds to finance loans with longer maturity period

? liquidity transformation: using more liquid funds like cash to buy less liquid assets like loans

? leverage: borrowing money to buy fixed assets which magnifies the potential gains or losses on an investment

? credit risk transfer: transferring the risk of borrower’s default to an entity other than the issuer of loan

Since these entities operate outside the regulation of authorities and have no obligations like deposit insurance, bank capital, liquidity requirements and at the same time do not receive any provision of central bank funding, when they engage in risky activities without any safety net, crisis management becomes very difficult. There real problem is their interconnectedness with regulated banks and the opaque nature of their ownership and governance, because of which traditional banks and financial institutions get caught up in a crisis originating in the shadow bank sector.

It is understood that with increased regulation those who want to escape them have moved considerable operations to shadow banking. The Global Shadow Banking Monitoring Report 2016 estimated the total value of Other Financial Institutions (OFIs) which can very broadly be categorised as the “shadow sector” at US$ 92 trillion up from US$ 62 trillion in 2007, while the value of Narrow Measure of Shadow Banking which includes all the entities which are considered to be involved in credit intermediation where financial stability risks from the shadow banking may occur at US$ 34 trillion.

The Dodd-Frank Act brought in several regulations to tackle the problem of shadow banking, like regulation of the activities of hedge funds by making it mandatory for them to register with Securities and Exchange Commission(SEC); over the counter derivatives trading being moved to exchanges and clearing houses; regulation of all SIFIs by Federal Reserve and several such measures. The regulations of Dodd-Frank Act have not been able to successfully tackle the problem of shadow banking. Further improvements are needed in the parameters of assessment and the systemic risk involved with them.

The problem of increasing operations in the shadow banking sector cannot be denied but the FSB along with other regulatory authorities continuously improves its metrics to assess the size, nature of operations and interaction of shadow banking with mainstream institutions to tackle this problem. Further inclusion of financial institutions that might increase the systemic risk, under the purview of Federal Reserve and other regulatory authorities around the world is needed, along with that widening the scope and improving the metrics is necessary.

Conclusion: The question of Stability vs. Growth?

In the post financial crisis period near term financial stability seems strong backed by global recovery, banks have grown fundamentally strong, but medium term vulnerabilities are increasing given to intensified search for yield, which has increased the sensitivity of financial system to market and liquidity risks. On the other hand the GSIBs which are at the resilient with strong and sustainable capital and liquidity position also the de-risking of their assets. At the same time the GSIBs have also maintained their international lending and

services volume, those that were less affected by the financial crisis have actually expanded their international operations.

While addressing the question of stability versus the growth of global financial institutions it may seem that both are mutually exclusive but a closer evaluation and understanding reveals that both are complementary, sustained growth which continues to fuel the financial system can only be achieved when the financial institutions globally are fundamentally strong and stable. Spurts of unsustainable growth backed by risky practices do more harm and recovery from each crisis situation blights the growth rate for years. Hence, moving towards sustainable practice for a stronger financial system and sustained growth is of utmost importance, at the same time taking inputs from all the stakeholders and bringing in best practices collectively is also necessary.

The capital and liquidity position of GSIBs over the period of 2005-16

Increase in international lending of the GSIBs over 2006-16

Source: IMF October 2017

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