The Fundamental Principles of Financial Regulation

1
The Fundamental Principles of Financial
Regulation Geneva Report by Brunnermeier,
Crockett, Goodhart, Persaud and Shin
2
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.

3
Endogenous risk
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.
4
(No Transcript)
5
Repo Haircuts
Source IMF GFSR
6
Capital requirements for systemic risk

• 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.

7
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.

8
To whom should such capital requirements apply?
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.
9
Liquidity
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.
10
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

11
Other regulatory issues
(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
12
The structure of regulation

• 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?
• FSF
• Problems (1) Democratic legitimacy
• (2) G7 representation
• (3) Warning procedure