Four pillars of post-GFC regulation

I don't like using acronyms like GFC, the Global Financial Crisis, but it makes sense having just found a really interesting paper by Andy Haldane, who will speak at the Financial Services Club next April.  Andy is the  Executive Director for Financial Stability at the Bank of England, and the paper is co-written with Sujit Kapadia of the Bank and Prasanna Gai of Auckland University.

It was released on Monday and models the systemic risks that led to the crisis and the complexity of the relationships between the world’s banks that caused it.

What it specifically shows is that the banking system can end up with too much concentration in just a few institutions through its complexity and this has a range of implications.

The bit that interested me the most is the implications on regulatory policy as this implies a new approach to regulation through the Prudential Regulation Authority (PRA) which will succeed the Financial Services Authority (FSA) next year.

The paper argues for four major changes in approach:

• Keeping more liquid assets in reserve, with increasing levels of reserves based upon a bank’s market share;
• More taxes and levies on banks to ensure that the system can survive future shocks;
• More data transparency to illuminate counterparty risks in real-time; and
• Centralisation of clearing and netting to give clear bilateral exposure views.

First, the paper recommends much tougher micro prudential liquidity regulation.

This will mean that banks will need to keep a larger stock of high-quality liquid assets.  Liquid assets are “those which can either be sold without any price discount or used as collateral to obtain repo financing without any haircut”.

In other words it means more cash and equity in reserve and higher Tier 1 Capital ratios.

The paper argues that “an increase in liquid asset holdings makes the system directly less susceptible to systemic liquidity crises”, and that may be true, but the knock-on effect is that it also means much less credit in the system, less leverage, less securitisation and less fluid economies therefore.

A tough act to call.

Another area of policy would be to introduce macro-prudential policies and systemic surcharges.

Macro-prudential policies will be delivered through the introduction of the Financial System Oversight Committee in the US, the European Systemic Risk Board in the EU and the Financial Policy Committee in the UK.

These committees will manage bank levies and taxes for, “within the international regulatory community, the G20 and Financial Stability Board (FSB) are drawing up a blueprint for dealing with so-called systemically important financial institutions (SIFIs). Among the options on the table are additional, graduated capital charges and regulatory limitations on the extent of exposures between these SIFIs (a large exposures regime).”

These committees will also target to avoid too much concentration in singular institutions by ordering banks with larger market shares of interbank activities and SIFIs to hold greater capital in reserve and liquid asset levels than others.

Third, the paper argues for policies that create much greater transparency in the system.

This means that the committees worldwide will begin “collecting systematically much greater amounts of data on evolving financial network structure, potentially in close to real time. For example, the introduction of the Office of Financial Research (OFR) under the Dodd-Frank Act will nudge the United States in this direction.

“This data revolution potentially brings at least two benefits.

“First, it ought to provide the authorities with data to calibrate and parameterise the sort of network framework developed here. An empirical mapping of the true network structure should allow for better identification of potential financial tipping points and cliff edges across the financial system. It could thus provide a sounder, quantitative basis for judging remedial policy actions to avoid these cliff edges.

“Second, more publicly available data on network structures may affect the behaviour of financial institutions in the network. Armed with greater information on counterparty risk, banks may feel less need to hoard liquidity following a disturbance.”

Finally, the paper proposes that the right approach to netting and clearing is to support the regulations “from the G20 and FSB to centrally clear a much larger proportion of, in particular, over-the-counter products through central counterparties (CCPs). Our model speaks to the rationale for such action given that CCPs may affect both complexity and concentration.”

This is because CCPs simplify the network inter-relationships between banks and highlights their bilateral exposures. “Higher-order, unobservable counterparty credit risk is replaced by first-order, observable counterparty risk.”

Many of these ideas have already been floating around but I find it untenable to imagine banks offering all their data in real-time so that their counterparties can see their positions being achieved easily.

And it may well be that post-trade reporting gives no signs of pre-trade strategies, but I don’t think so.  After all, MiFID tired to introduce transparency in post-trade reporting and only London’s markets really achieved this in any sensible order through Markit BOAT.

Therefore, I can see the policy position presented here makes sense, but will the practical position?

I’ll wait and see.

Meantime, if you want to read the whole 34 page paper  download it here.