Essay: Financial Crisis (Page 2 of 2)

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In the US, the Dodd Frank Act requirements have made the financial system safer and more resilient (Dodd–Frank Wall Street Reform and Consumer Protection Act, 2010). First, big U.S. banks are in better shape now than they were at the time of the financial crisis, in large measure because regulators have forced them to hold bigger capital cushions, which means they can absorb bigger losses without endangering each other and the whole financial system (Dodd–Frank Wall Street Reform and Consumer Protection Act). Had today’s capital framework been in place in 2007, the largest, most complex financial institutions would have been required to hold roughly twice as much common equity as they actually did. With greater common equity, fewer banks would have needed government rescue. Now, periodic stress tests, supervised by regulators, have forced bank managers to prepare for worst-case scenarios. The fraction of loans that aren’t being paid is half what it was at its peak in 2010.

According to the International Monetary Fund: “Compared to the pre-crisis period, [U.S.] banks have strengthened their capital positions, including relative to their international peers, hold more liquid assets and are less levered.” (International Monetary Fund, 2015)

However, I believe that there is still a need for a tighter framework for the rest of the world, and there are still regulatory gaps to be filled in the US financial system. Firstly, supervision has to be more more effective. With the introduction of new regulations, it is difficult to overstate the importance of robust and efficient supervision. The supervision of complex firms needs to be more in depth than in the past and better accustomed to their risk profiles and business models. Supervisors in many countries need more resources, better training and the means to be truly effective. They should be in a position to be able to challenge banks’ management on the basis of sophisticated risk and market understanding.

Another important measure of the new regulatory regime will be to enhance transparency. In the immediate aftermath of the crisis, as a lack of transparency was widely identified both as a cause and of a catalyst during the crisis, progress had been made to address this deficiency (Ackermann, 2010). First, this means that in the securitization markets especially, efforts have to be taken to give investors better disclosure on the underlyings so that they can perform their own due diligence rather than simply rely on the judgement of rating agencies. Second, in the derivatives markets, trade repositories must be established. These will significantly enhance supervisors’ knowledge about exposures in these markets and about the distribution of risks in the financial system, making the market more transparent. Thirdly, stress tests have to be increasingly us
ed. There is no doubt that the appropriateness of the scenarios simulated in the stress tests can be argued, but there is no denying, however, that it gives investors and counterparties an unprecedented level of detail on banks’ sovereign exposures, which in turn can contribute to a normalisation of the financing situation of banks.

Another important task in the new regulatory framework is to extend oversight to the shadow banking system. It has been widely documented that the rapid expansion of the shadow banking system was the underlying cause for the huge increase in the financial system’s leverage before the outbreak of the crisis (Ackermann, 2010). This means that the task of monitoring and, if need be, addressing similar developments in the future has not become any less important, and may be even more important now as the regulated part of the financial system is subject to stricter requirements. In the US, the introduced Financial Stability Oversight Council (FSOC) is tasked with identifying all financial companies that are relevant for financial stability, whether regulated or not, and will have powers to impose obligations on them (Dodd-Frank Wall Street Reform and Consumer Protection Act). However, most systemic risk supervisors in other countries unfortunately have no such powers.

Currently, even with Dodd Frank, the regulatory landscape still remains fragmented, resulting in gaps, overlaps and the potential for delayed responses to emerging risks, and should be simplified over time,” the IMF advises (International Monetary Fund, 2015). For example, the FSOC is flawed as it is composed of several independent regulators, some of which have mandates to focus on specific institutions or markets, not on stability of the overall financial system. Even after the FSOC reaches consensus on a policy, which can take a long time, it has limited power to force a federal regulatory agency to act. These gaps in regulatory oversight may leave the financial system vulnerable in the future as important financial institutions or activities remain largely unregulated even after Dodd Frank. Also, in the implementation of financial regulation, it is also important to note that there is always a trade off (Gourio, Kashyap and Sim, 2017). For example, if regulation is too light, it is highly likely that a financial catastrophe will occur. If the regulation is too tough however, the economy will be starved of credit and experiences slow economic growth.

The Development of Macroprudential Policies

Macroprudential policies are typically designed to increase the financial system’s resilience, thus reducing the systemic risks arising from financial intermediation (Bank For International Settlements, 2017). A macroprudential approach recognizes the importance of general equilibrium effects, and seeks to safeguard the financial system as a whole. In the aftermath of the crisis, there seems to be an agreement among both academics and policymakers that financial regulation needs to move in a macroprudential direction. In the simplest terms, the macroprudential approach to financial regulation can be categorized as an effort to control the social costs associated with excessive balance sheet shrinkage on the part of multiple financial institutions hit with a common shock.

It could be argued that macroprudential policies may succeed in shoring up macroeconomic stability but only at the cost of excessively curbing economic activity and long-term growth. In other words, there might be a trade off between stability and sustainable prosperity. The more stable economies could better sustain and foster economic growth. This perspective is especially relevant from a policy viewpoint consistent with the greater appreciation of externalities and market failures (International Monetary Fund, 2013). This paper however, does not quantify the trade off between stability and sustainable prosperity. This then makes it difficult to determine how much stability economies have to achieve before they should start experimenting with macroeconomic policies.

There are actually many dimensions to having a macroprudential approach, varying from better identifying risks, to building more robust institutional infrastructures, to adopting new, system-oriented policies aimed at reducing excessive procyclicality and risks, and designing the institutional framework for operating them. The starting point and most complex issue, is to better understand the dimensions of systemic risks and have associated warning signals. Macroprudential supervision will fill an important gap in the supervisory architecture of the financial system. A regular analysis of the resilience of the financial system as a whole, of interconnectedness and issues of procyclicality is a long overdue and valuable component of financial supervision (Ackermann, 2010). While the institutional framework for the new systemic risk supervisors is now in place due to regulatory reforms, the operational framework is not. The new bodies will quickly need to achieve credibility in the markets by virtue of the quality of their analyses and recommendations.

Despite much discussion and some tentative steps forward, as of yet, approaches remain largely microprudential. For the most part, Basel III, developed after the financial crisis, is microprudentially oriented (Basel Committee on Banking Supervision, 2010). It appropriately targets the quantity and quality of bank capital as these institutions’ lack of good capital made them vulnerable during the crisis. However, more capital only helps cushion an individual institution’s losses. This means that the systemic nature of multiple and simultaneous bank distress is only partially addressed. As for liquidity risk, the determinants of the Net Stable Funding Ratio, one of the two liquidity risk components of Basel III are not yet finalized and various parts look watered down. The Liquidity Coverage Ratio and the Net Stable Funding Ratio also do not firmly counter banks’ potential to generate systemic liquidity risk ex ante, although with high enough ratios the chance of a systemic liquidity event is lessened. Even though there have been progress made through the Basel Committee, research has led me to believe that it is too backwards-looking to be fully effective. For example, it assumes that the securities which have been risky in the past are the same as the securities which will be risky in the future and does not account for future advancements and developments in the financial market.

An attempt to uncover the effects of capital requirements was done (Clerc et al., 2014). They developed a model to analyze how capital requirements affects the steady state and the transmission of various types of shocks in an economy. There were three main results that stood out in their model. To start with, they found that there is an ideal level of capital requirements. Higher capital requirements reduce bank leverage and hence their risk of defaulting. Lower leverage means that banks, to a larger extent must be financed by equity, so banks’ funding costs increase with capital requirements. The banks will then likely pass on the higher funding costs to borrowers by extending less credit to a higher interest rate. This shows that there is an optimal level of capital requirements because too high levels imply that credit will be too restricted. The model, however, does not comment on what this optimal level of capital requirements is, or what it would be characterized by. Second, they found that the higher degree of leverage there is in banks, the more responsive the economy is to shocks. This implies that limited liability and deposit insurance constitute a potentially powerful channel of financial amplification. The third finding was that countercyclical adjustments of capital requirements may improve the benefits of high capital requirements. Following a shock and the release of the accumulated capital, the buffer is meant to sustain credit sup
ply and keep rates down even though defaults by borrowers are increasing. However, in any case, if the buffer is too low, banks may still see a rise in funding costs, which will offset the intended impact of the adjustment of the countercyclical capital requirement. The most important thing to note is also that for regulatory capital requirements to matter, the level of capital in booms must be higher than the levels imposed by the market in recessions (Gourio, Kashyap and Sim, 2017). This is because of the often considerable uncertainty that prevails in periods of financial turmoil, resulting in the market demanding very high capital ratios in banks before their solvency is questioned.

Regarding macroprudential policies that can possibly be implemented, a broad distinction can be made between those that aim to reduce risks arising from procyclicality and those arising from interconnections. One way to categorize the different policy tools is to note that systemic risk and hence macroprudential policy, can be divided into two categories (Elliott, Feldberg and Lehnert, 2013). Firstly, structural risks are threats to the economy that are always present. Examples would be the “too big to fail” problem which may induce moral hazard and the implicit promise within money market mutual funds to repay investors at par on demand, which may make them prone to runs if uncertainty arises. Secondly, cyclical risks are threats that include asset price bubbles and rapid credit and leverage growth leaving the economy vulnerable to shocks.

Since the crisis, only a few macroprudential tools have been adopted and mostly only for banks. Notably, Basel III contains the countercyclical capital buffer to account for the procyclicality of credit extension and the systemically important capital surcharge that tries to address the overweight importance of too big to fail institutions (Basel Committee on Banking Supervision, 2010). However, the calibration and effectiveness of these surcharges, and macroprudential policies tools more generally, is yet to be fully determined, with the calibration mostly based on rough estimates so far. While countercyclical buffers have been used, notably in Spain, where the evidence suggests some effectiveness (Jiménez et al., 2012), they did not stop a banking crisis from occurring.

Many other tools, ranging from adjustments in loan-to-value ratios that act to limit real estate lending during booms to avoid busts to levies or taxes which reduce the incentives for wholesale funding or to offset the too big to fail subsidy, have been mentioned as potential macroprudential tools. Some of these have been studied for the effectiveness of various macroprudential tools in a cross-country context (International Monetary Fund, 2011), the use of macroprudential policies for mitigating real estate booms and busts (Crowe et al., 2013), and for cross-country work on how macroprudential policies affect banks’ riskiness (Claessens, Ghosh and Mihet, 2013). Results have shown that the tools are being developed in the correct direction as they attempt to put in place incentives that will lower systemic risks. Nonetheless, there is still much to be determined before their effective use can be assured, including their calibration to country characteristics and circumstances. This study has very valid methods of procuring data with a detailed analysis that is supported by the use of statistical tests. However, there are still limitations to studies of this magnitude. Since the data was collected via an extensive self-report survey, its reliability is dependent on the participants’ honesty, understanding, and ability to be introspective.The study by the International Monetary Fund provides a comprehensive empirical study and uses data that is supported by statistical testing. However, there are still limitations to this study. First, of the 49 countries tested, almost two-thirds were developed countries which are normally linked with higher financial stability in comparison to developing nations, and so the results of this study may be skewed. Second, the empirical analysis here also does not address the issue of cross-border arbitrage and the side-effects of applying macroprudential instruments.

Other essential elements of a macroprudential framework include issues of the regulatory governance – to determine who is in charge, including as regards to cross-border aspects and their relationships (Nier et al., 2011) and interactions with other policies, mainly microprudential, monetary, and fiscal policies. While the greater emphasis on macroprudential policies is promising, and some emerging market countries seem to have utilized such policies effectively, it may still be too early to rely on them heavily, as their costs, including indirect adverse effects on resource allocation, are not well known. This is critical in advanced economies with more sophisticated financial systems, where arbitrage and avoidance are serious problems. For example, Spain’s use of dynamic provisioning, an accounting technique designed to build up capital buffers in good times, did not stop the banking system from requiring a bailout (Jiménez et al., 2012). At the same time, credit markets are also closely interconnected, so restricting the market for mortgages may affect business credit in unintended ways. Another barrier to total reliance on macroprudential policies is also that although bubbles look obvious with hindsight, predicting them is tricky. Expecting regulators to identify bubbles in advance and then design rules to deflate them, may be optimistic, but if countries are to avoid repeating past mistakes, macroprudential regulations may need to become a small but growing permanent part of how they manage their economies.

In some of the advanced economies, controversially, regulators are experimenting with targeted rules to try to prevent specific markets from developing bubbles. Last year the Reserve Bank of New Zealand imposed higher loan-to-value ratios on mortgage lenders (Reserve Bank of New Zealand, 2016). Concerned that property prices were rising unsustainably, this move limited the flow of credit to buyers. So far the experiment has proven a success, with growth in property prices quickly tapering off, without harming the rest of the economy. Similarly the Bank of England, worried about rapidly rising property prices, announced new restrictions on the size of mortgages relative to borrowers’ incomes (Bank of England, 2014). The overall efficiency of these tools, however, is still uncertain. It will hence remain important to not rely on macroprudential policies too much and complement them with tools such as banking system stress tests, which can also be viewed as a macroprudential tool from certain aspects.

At the same time, the introduction of macroprudential policies alone will be insufficient to limit systemic risk. These macroprudential policies need to be strictly enforced, which requires that administrators be empowered to act without interference from vested interests. And they need to be supported by sound macroeconomic policies to manage the economic cycle. Additionally, corporate governance reform is needed to limit systemic risk at the source, by requiring bank managers to act in the interests not only of bank shareholders, but also of the bank’s stakeholders at large. An important step in this direction, apart from bail in mechanisms that will improve market discipline, is that capital requirements be substantially higher in good times when excessive risk is taken (Crowe et al., 2013). The limitation to this paper however, is that they also do not comment on the optimal level of capital requirements, and so does not provide a proper guideline to determine this level. Incentives are also crucial, and corporate governance and market discipline are essential, including through capital requirements, compensation structures, and bail-in and resolution procedures. This means that a lot depends on the strength and independence of the macroprudential authority
and the risk attitude of the public at large toward boom-bust cycles. Moreover, political economy constraints will also continue to plague the resolution of too big to fail institutions during a systemic financial crisis, the creation of new, optimal regulation measures, and also enforcing the new regulations in the booms. Therefore, macroprudential policies should focus on the prevention of financial crises through higher capital requirements, to use less short term debt finance in general (including households, not only firms), and to use these measures to tame the buildup of leverage and credit booms.

Conclusion

In conclusion, research has led me to believe that it may not be possible to prevent a repeat of the 2008 financial crisis. Although there has been much development and improvement in the efforts to mitigate risks in the financial market, with every macroeconomic policy option that I explored, I have found that there is still much work to be done to develop a tighter framework to be used by policymakers to control systemic risk. Conventional economics that would suggest using monetary policy to deflate financial bubbles through higher interest rates in the case of large rises in asset prices, has been found to have limitations in the financial market. This is because it is too broad and does not work with enough specificity, resulting in manifold spillovers in the wider economy and contraction in demand. I have also concluded that regulatory reforms since the crisis have undeniably improved the regulatory framework for financial markets but that there are still regulatory gaps in the financial systems that pose great threats to the financial market, and therefore an even tighter framework is still required. However, I have also concluded that macroprudential policies, a recent ongoing development since the 2008 financial crisis, can fill important gaps in the regulatory system of the financial market, mainly in supervision, and thus further strengthening the current regulatory reforms. It is also a sharper regulatory instrument, targeting the financial and asset market specifically. When implemented carefully, it can possibly reduce or even eliminate completely the unintended consequences of conventional monetary policy. Recent developments have led to a growing consensus among policymakers and economic researchers about the need to refocus the regulatory framework towards a macroprudential perspective. However, there is still much to be explored with macroprudential instruments as its complete effects are still uncertain, and there are more developments that can be made through deeper research and experimentation. This means that although there are positive prospects with the growth and progress of this tool, policymakers will have to ensure that these macroprudential policies are complemented with other regulatory tools to further strengthen the financial market, without forgetting to focus also on mitigating the effects of a large financial crisis, should it ever occur again.

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