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TRANSCRIPT
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Recovering from theGlobal Financial Crisis
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Recovering from theGlobal Financial Crisis
Achieving Financial Stabilityin Times of Uncertainty
Marianne Ojo
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Recovering from the Global Financial Crisis: Achieving Financial Stability
in Times of Uncertainty
Copyright Business Expert Press, LLC, 2013.
All rights reserved. No part of this publication may be reproduced,
stored in a retrieval system, or transmitted in any form or by any
meanselectronic, mechanical, photocopy, recording, or any other
except for brief quotations, not to exceed 400 words, without the
prior permission of the publisher.
First published in 2013 by
Business Expert Press, LLC222 East 46th Street, New York, NY 10017
www.businessexpertpress.com
ISBN-13: 978-1-60649-700-5 (paperback)
ISBN-13: 978-1-60649-701-2 (e-book)
Business Expert Press Finance and Financial Management collection
Collection ISSN: Forthcoming (print)
Collection ISSN: Forthcoming (electronic)
Cover and interior design by Exeter Premedia Services Private Ltd.,
Chennai, India
First edition: 2013
10 9 8 7 6 5 4 3 2 1
Printed in the United States of America.
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AbstractWhy are some global financial crises more difficult to recover from and
overcome than others? What steps are necessary in ensuring that finan-
cial stability and recovery are facilitated?
What kind of environment has the previous financial environment
evolved to and what kind of financial products have contributed to
greater vulnerability in the triggering of systemic risks? These are among
some of the questions which this book attempts to address. In
highlighting the role and importance of various actors in post-crisesreforms as well as the huge impact of certain factors and products that
are contributing in exacerbating the magnitude and speed of transmis-
sion of financial contagion, the book provides an insight into why
global financial crises have become more complicated to address than
was previously the case.
Whilst considering and highlighting why matters related to procycli-
cality and capital measures should not constitute the sole focus of atten-
tion of the G20s initiatives, the book is aimed at identifying otherimportant issues such as liquidity risks and requirements which have
constituted, to a large extent, the focus of international standard setters
and regulators. It also aims to direct regulators, central bank officials
and supervisors, academicians, business and legal professionals, and
other relevant interested parties in the field toward current and previ-
ously ignored issues such as the cartelization of capital markets. The
need and concern for increased regulation of bond, equity markets, as
well as other complexfi
nancial instruments which can be traded inOver-the-Counter (OTC) derivative markets is evidenced by Basel IIIs
focuswhich is addressed in the book. Cartelization and organized
activities, relating to rate rigging in global capital marketsas evidenced
recently by sophisticated Euro Interbank Offered Rate (EURIBOR) and
London Interbank Offered Rate (LIBOR) rigging practices and occur-
rences, are also covered.
The aims and objectives of the book would not be complete by
merely identifying and highlighting the general root causes of global
financial crises and the current issues. Hence each chapter will also
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recommend (as well as bring to the fore) measures that should be (and
have been) put forward in order to address the issues and factors that
contribute to the magnitude and severity of global financial crises.
Keywords
financial stability, procyclicality, supervisors, systemic risks, counterparty
risks, shadow banking, Basel III, capital, liquidity standards, over-the-
counter derivatives, central banks
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Contents
List of Abbreviations.............................................................................. xi
Introduction ........................................................................................ xiii
Chapter 1 Great Expectations, Predictable Outcomes, and the G20s
Response to the Recent Global Financial Crisis: When
Matters Relating to Liquidity Risks Become Equally as
Important as Measures Addressing Procyclicality...............1
Chapter 2 Redefining a Role for Central Banks: The Increased
Importance of Central Banks Roles in the
Management of Liquidity Risks and Macroprudential
Supervision in the Aftermath of the Financial Crisis ...... 9
Chapter 3 Central Banks and Different Policies Implemented in
Response to the Recent Financial Crisis ..........................21Chapter 4 The Role of Monetary Policy in Matters Relating to
Financial Stability: Monetary Policy Responses
Adopted During the Most Recent Financial Crisis ..........41
Chapter 5 Fair Value Accounting and Procyclicality: Mitigating
Regulatory and Accounting Policy Differences
Through Regulatory Structure Reforms and Enforced
Self-Regulation ................................................................49
Chapter 6 Capital, Liquidity Standards, and Macroprudential
Policy Tools in Financial Supervision: Addressing
Sovereign Debt Problems ................................................59
Chapter 7 LIBOR, EURIBOR, and the Regulation of Capital
Markets: The Impact of Euro Currency Markets on
Monetary Setting Policies ................................................73
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Chapter 8 Financial Stability, New Macroprudential Arrangements,
and Shadow Banking: Regulatory Arbitrage and
Stringent Basel III Regulations ........................................81
Chapter 9 Volcker/Vickers Hybrid? The Liikanen Report
and Justifications for Ring Fencing and Separate
Legal Entities...............................................................101
Chapter 10 Conclusions and Implications of Regulatory
Reforms and Policy Measures......................................109
Notes .................................................................................................113
References........................................................................................... 143
Index .................................................................................................157
x CONTENTS
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List of Abbreviations
ABCP Asset-Backed Commercial Paper
BBA British Bankers Association
BIS Bank for International Settlements
BCBS Basel Committee on Banking Supervision
CCP Central Counter Party
CCR Credit Counterparty RiskCDO Collateralized Debt Obligations
CDS Credit Default Swap
CEBS Committee of European Banking Supervisors
EBA European Banking Authority
ECB European Central Bank
EFSF European Financial Stability Facility
EIOPA European Insurance and Occupational Pensions Authority
ESA European Supervisory AuthoritiesESFS European System of Financial Supervisors
ESMA European Securities and Markets Authority
ESR European Securities Regulators
ESRB European Systemic Risk Board
EU European Union
EURIBOR Euro Interbank Offered Rate
FASB Financial Accounting Standards Board
FEE Federation des Experts Comptables Europeens
FSA Financial Services Authority
FSB Financial Stability Board
FSF Financial Stability Forum
HRE Hypo Real Estate
IASB International Accounting Standards Board
IRB Internal Ratings Based
LCR Liquidity Coverage Ratio
LIBOR London Interbank Offered Rate
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LTRO Longer Term Refinancing Operation
NSFR Net Stable Funding Ratio
OTC Over-the-Counter
SRR Special Resolution Regime
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Introduction
Experience has shown that political institutions often do not
maintain stable prices. They have several powerful incentives to
expand the money supply beyond the rate of real growth in the
economy. In non-democratic societies, the control of the money
supply is an important instrument of economic policy that can
address various political needs, most notoriously the financing ofgovernment needs. It is against this background that indepen-
dent central banks find their contemporary justification: central
bank independence is conceived as a means to achieve the goal
of price stability. Central bank independence has been the pre-
ferred institutional arrangement to promote monetary stability
since the end of the 1980s and beginning of the 1990s. A num-
ber of factors have contributed to this development.1
Rosa Maria Lastra, Legal Foundations of InternationalFinancial Stability, 2006
How Independent Are Highly IndependentCentral Banks?
Theories that appear to suggest that absolute independence exists (i.e.,
the theory that recognizes no limits on central bank independence, so
long as the bank itself is reliably pre-committed to achieving price sta-
bility2
), indeed, cannot be sustainable.A sufficient and appropriate degree of central bank independence is
definitely necessary for the goal of achieving price stability. However,
despite the levels of independence claimed to be enjoyed by several cen-
tral banks, recent events indicate shifts in focus of monetary policy
objectives by various central banks, notably, that of the Fed Reserve.
The impact of political and government influences on central banks
monetary policies has been evidenced from the recent financial crisis
and in several jurisdictions. Many central banks have adjusted monetarypolicies having been influenced by political pressures that have built up
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as a result of recent financial and sovereign debt crises. However, such
lack of absolute independence (from political spheres) could prove
symbiotic, in the sense that, despite the need for a certain degree of
independence from political interference, certain events which are
capable of devastating consequences, namely, a drastic disruption of the
systems financial stability, need to be responded to as quickly and
promptly as possible. Is it possible for a central bank with absolute
independence to operate effectively, particularly, given the close links
between many central banks and their Treasury in several countries?
It may be inferred that central banks crucial roles in establishing a
macroprudential framework provide the key to bridging the gap
between macroeconomic policy and the regulation of individual finan-
cial institutions. This however, on its own, is insufficientclose collab-
oration and effective information sharing between central banks and
regulatory authorities is paramount.
Consequences of lack of close collaboration, coordination, and
timely exchange of information between tripartite authorities, such as
the relationship which exists between the United Kingdoms Financial
Services Authority (FSA), the Bank of England, and the Treasury, werewitnessed during the Northern Rock Crisis. The Bank of England could
not effectively perform its traditional role as lender of last resort for a
limited time without such a role being made public.
The need for the establishment of bridge banks and special
resolution regimes (SRRs) has also been acknowledged in various
jurisdictions. Hence, whilst a certain degree of independence from polit-
ical interference is necessary, as well as an affirmation of the
commitment to monetary policy objectives, absolute independencecould also result in a process whereby the necessary coordination
required between regulatory and government authorities exacerbate pro-
blems which they (the authorities) were designed to solve.
Here, Rosa M. Lastras observation does appear to be manifesting
itself ever increasingly:
Perhaps in the twenty-first century we shall witness the emer-
gence of a rebalanced framework of macroeconomic policy (withfiscal policy regaining part of its earlier role) that may lead to a
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realignment of the goals to be pursued by the monetary authori-
ties, which in turn will lead to a new wave of legal reforms.
Other consequences of the recent financial crisis include increased
implementation of fiscal policy measuresin respect of taxing and
spending activities [which are distinguished from proposals relating to
quantitative easing measures (an inflationary policy measure)in
respect of the need to address the Eurozone sovereign debt crises].
As regards the implementation of fiscal policy measures, caution is
to be had to the implementation offiscal measures which are such that
whilst they generate corrective effects, they do not impede the prospects
of growth and development of the economy.
Even though the Fed Reserve is not involved in determining fiscal
policy measures (the Congress and the Administration being responsible
for this), fiscal policy measures impact the Feds monetary policy deci-
sions. The indirect effect of fiscal policy on the conduct of monetary
policy through its influence on the aggregate economy and the eco-
nomic outlook and the impact of federal tax and spending programs on
the Fed Reserves key macroeconomic objectivesmaximum employ-ment and price stability and in making appropriate adjustments to its
monetary policy toolsis notable in several situations and instances.
Hence, how independent is the Fed really from government andfis-
cal policy influences? Could it not be said that the government really
has a dual role in fiscal and monetary policy setting? As indicated ini-
tially, an appropriately and sufficiently independent central bank has a
crucial role in ensuring price stability objectives.
The following remark highlights the level of impact as well as theinfluence of political pressures on the Feds monetary policy objectives:
for several decades, a generally healthy monetary policy balance
produced good results. The Feds focus has shifted dramatically to
the short-run objective of lowering unemployment and recently
the willingness to (temporarily?) set aside its inflation target.3
In view of such political interference, would it be wise to thrustmore powers into the hands of the Fed Reserve, namely, through a
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widening of its scope of powers since the executive (Government), as
well as Congress, have a degree of influence over the decision-making
capacities of the Fed Reserve. Further, and addressing the issue indepen-
dently of political influences on the Fed Reserve, would it really be in
the interest of accountability to delegate more powers to an already rela-
tively powerful Fed Reserve?
Recent changes in the delegation of supervisory responsibilities in
the United Kingdom, namely the transfer of bank supervision from
the FSA back to the Bank of England, and the resulting increased
scope of the Bank of Englands powers, would appear to suggest that
in certain cases, regulatory bodies as well as central banks should
assume greater functions in certain capacities. Accordingly, jurisdiction
specific cases have to be viewed individually and based on prevailing
circumstances.
Hence, ensuring that absolute independence is achieved, in respect
of central bankfinancial independence, constitutes a difficult task. Is it
possible for a central bank to operate effectivelygiven the presence of
absolute independence? Close collaboration and exchange of informa-
tion between the tripartite authorities in the United Kingdom (the FSA,the Treasury, and the Bank of England), as highlighted by the Northern
Rock Crisis, if effective as it should have been, could have helped, not
only in identifying the problems which existed at Northern Rock, but
more importantly, facilitated timely intervention which would have
averted the scale of the crisis.
Crisis faced by IKB, Landesbanken, and Hypo Real Estates not only
revealed an absence of an SRR for banks, but also raised the issue of
optimal measures which could be implemented to control (in part) pri-vately owned but publicly sponsored or (in part) publicly owned finan-
cial enterprises.4
Jurisdictional Approaches to Central Bank
Independence and Monetary Policy
Mervyn Kings reference5 to central bank independence in the United
Kingdom highlights the importance being accredited to the ever increas-ing and significant role of monetary policy. He adds: How much
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discretion to give to the Monetary Policy Committee and how much
should remain with the Chancellor is an interesting question that was
raised, but not fully resolved, in 1997, referring to the date when the
bank gained operational independence.6
However, despite the growing importance of and emphasis on
central bank independence as highlighted previously, lack of absolute
independence (from political spheres) could prove symbiotic in the
sense that, despite the need for a certain degree of independence from
political interference, certain events which are capable of devastating
consequences, namely, a drastic disruption of the systems financial sta-
bility, need to be responded to as quickly and promptly as possible.
Further, subjecting actions and decisions of the central bank to other
authorities could actually incorporate greater accountability and trans-
parency into the supervisory and regulatory framework.
In relation to legislative reforms that result in a reduction in central
bank autonomy, it has been noted by several commentators generally,
that a reduction in central bank autonomy by subjecting its actions and
decisions to legislative procedures and approvals could result in more
serious problems which would aggravate the stability of the economyandfinancial system.
However, it needs to be added that the issue does not necessarily
relate to a subjection of actions and decisions for approvals, but how
well the authorities involved are able to communicate and coordinate
information between them effectively.
Central Bank Independence: Its Relevance in Developed
and Less Developed Economies and Political Systems
Even though a sufficient and appropriate degree of central bank inde-
pendence is widely acknowledged to be necessary for the goal of achiev-
ing price stability, it has also been concluded by Hayo and Hefeker that
central bank independence is neither necessary nor sufficient for mone-
tary stability.7 Maliszweski8 further, concludes:
statistical signifi
cance of central bank independence at the highlevel of liberalisation, as well as the timing of stabilisation
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attempts and reforms of central bank laws, suggest that the inde-
pendence is a powerful device for protecting price stability, but
not for stabilising the price level.
Central bank independenceimpact and significance on the econ-
omy, financial system, and the goal of achieving price stabilityrequires
a consideration of historical, legal, jurisdictional, political, and other
economic factors. As regards jurisdictional factors and with respect to
less developed countries (and not so well developed economies), the
need for central bank independence (and in particular operational and
financial independence from political institutions), it appears, assumes
greater importance.
According to the Memorandum Submitted to the National Assembly
in Respect of the Proposed Amendments to the Central Bank of Nigeria
(CBN) Act, 2007:9
Financial independence for a central bank has four ingredients
namely:
The right to determine its own budget;
The application of central bank-specific accounting rules;
Clear provisions on the distribution of profits; and
Clearly definedfinancial liability for supervisory authorities.
Further the Memorandum states that these are particularly relevant
especially in not-well-developed political systems where central banks
are most vulnerable to outside influence.10
Whilst a reduction in central bank autonomy is occurring in juris-
dictions such as Nigeria, in India, calls have been made for legislative
reforms aimed at preventing the continual undermining and reduction
of the institutional autonomy of the Reserve Bank of India. The fol-
lowing are highlighted as issues in need of urgent redress:11
The over dependency of the government on the Reserve Bank
of India in generating much needed economic growth throughrate cuts;
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The conferment by the Reserve Bank of India Act 1934, of a
temporary status on the Reserve Bank of India, which is considered
to be an issue which requires urgent and immediate redress;
The central banks role as an investment bank for government-
issued debt.
The aforementioned clearly indicates tensions between government
and central bank relations. Consequently, this has also had repercus-
sions for the implementation of fiscal and monetary policy measures.
Whilst political pressures definitely have consequences for price and
monetary stability, a decision or response on whether a reduction or
increase in central bank autonomy is required, will ultimately hinge on
jurisdictional specific factors which include legal, historical, economic,
and political factors.
In an empirical analysis, performed by Moser,12 a distinction is
made between three groups of countries: those with strong checks and
balances in their legislation, those with weak checks and balances, and
those with no check and balances.
Moserfinds that:13
1. Countries with strong checks and balances have more independent
central banks compared to those with weak or no checks and balances.
2. The countries in the last group have the most dependent central
banks.
Such results confirm the importance and need by less developed
countries, for a greater level of central bank independence (both opera-tional and financial), autonomy and independence from political insti-
tutions, as well as greater measures to ensure that accountability, trans-
parency and enhanced disclosures are facilitated.
Fiscal and Monetary Policy Objectives: The Essence
of Narrowing the Scope of Inflation Targeting
The distinction betweenfi
scal and monetary policy objectives as well asthe focus offiscal policy objectives on growth and employment, and the
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focus of monetary policy objectives on price stability, is certainly not
a contentious matter. Lastra makes reference to the dual nature of mon-
etary stabilityin addition to the internal dimension, there is also an
external dimension, which refers to the value of the currency. The sta-
bility of exchange rates (the exchange rate being the price of a currency
in another currency) and the issue of which is the best exchange rate
arrangement for a given country.
Under the Keynesian policy modalities of the 1950s and 1960s
fiscal policy had primacy and demand management policies (goals of
growth and employment) were prevalent.
Should inflation targeting be accorded a more prominent role in
many jurisdictions or what factors are necessary in order for greater focus
to be accorded to monetary policy objectives? What reforms will be
required in order to achieve the objective of according greater priority to
inflation targeting? Currently in the United Kingdom, efforts are being
undertaken to recommence with bond purchasing or reduce interest rates
although it is added that more fundamental changes and reforms will berequired as opposed to a proposed fine tuning of the present scope of
inflation targeting.
Other areas worthy of consideration include:
Merits of targeting the size of the economy in cash terms instead
of inflation.
Reviewing the arrangements for setting monetary policies.
Would merely a cut in interest rates be sufficient to boost the econ-
omy, given several considerations (among which include the fact that
banks, building societies interests also need to be taken into account)?
To what extent does unemployment need to fall before a central bank
decides to raise interest rates? Why should greater preeminence be given
to monetary policy objectives than was previously the case? It has been
demonstrated in several jurisdictions that inflation rates are usually
higher than their targets and this being consistently the case given theimpact and influence of government fiscal measures on monetary policy
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objectives. However, an absolute independence of the central bank from
government (which is certainly not logical or feasible) is not advocated
for, since there should be some degree of communication between Trea-
sury and the central bank. The consequences of lack of effective com-
munication between the regulator of financial services (the FSA), the
central bank (Bank of England), and the Treasury were evident during
the Northern Rock Crisis.
Hence regulatory structural reforms are also required in addition to
the implementation of certain measures aimed at ensuring that the cen-
tral bank is not overly influenced by those authorities responsible for
determiningfiscal policy measures, or aimed at ensuring that the central
bank is well placed at the required level of communication with those
authorities responsible for settingfiscal policy measures.
Furthermore a grant of greater or reduced powers to the central
bank would also require consideration of the system of checks and bal-
ances in operation. In view of regulatory reforms, two categories merit
consideration:
1. Reviewing the structure of financial regulation (which involveswhether the structure of regulation is that of a unifiedfinancial ser-
vices regulator or functional regulator. It also involves whether
greater powers should be granted or entrusted to central banks).
There are several debates revolving around whether the Fed should
be granted more powers, given the degree of powers it already pos-
sesses. However, there are also several grounds for arguing that
supervisory powers should be transferred back from the United
Kingdoms FSA to the Bank of England.2. Reviewing the system of regulation (on site and off site system of
supervision which embraces the financial regulators use of external
auditors in exercising certain regulatory functions). The use of external
auditors should also serve as a means of incorporating increased checks
and accountability into the regulatory process. The transfer of supervi-
sory powers back to the Bank of England in July 2013 should signify
an era which introduces (or rather reintroduces) greater implementation
of external auditors
expertise in contrast to that which embraced thereduced level of use of external auditors by its predecessor, the FSA.
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Focus on low long-term interest rates appear to be a recipe for the
success attained by Canadas central bank. Should such a policy simply
be adopted by other jurisdictions or should present existing institutional
frameworks and historical considerations be taken into account before
deciding to adopt certain measures? Certainly jurisdictional specific fac-
tors, as well as legal, political, economic, and other factors which vary
over time, need to be considered, even though regulatory structural
reforms may still be required.
Sola et al.14 argue that the central bank in Brazil has been able to
gain increasing discipline over the monetary system, partly owing to:
The economic stabilization plan and, not;
As a result of prediction premised on conventional wisdom,
namely, not on the basis of the argument that price stability follows
from an autonomous central bank. Further, they argue that economic
stabilization has less to do with getting the institutions right and that
it is more consequential of a dynamic bargaining game between the fed-
eral executive, legislators and sub national governments. The substantialshift in the political game between legislators, executive, and governors
during the 1990s is also highlighted.
Rogolon adds that the positive theory reveals that the degree of
independence is negatively correlated with the mean inflation, the infla-
tion variability, and the inflationary uncertainty, but is positively corre-
lated with the credibility of monetary policy. And further, that practice
as regards the Brazilian experience involves discussions of the impor-
tance of the Central Bank of Brazils independence for the efficiency ofthe stabilization policy, focusing on the periods of high inflation (1980/
1993) and moderate inflation (1994/).15
Conclusion
It was illustrated in the previous section that whilst regulatory structural
reforms are required in certain jurisdictions before goals relating to price
stability can be achieved, certain country and jurisdictional experienceshighlight the fact that economic stabilization has less to do with getting
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the institutions right and that it is more consequential of a dynamic
bargaining game. Certain jurisdictions have been engaged in legislational
reforms not necessarily aimed at increasing central bank independence
but targeted at achieving price and economic stabilization.
Hence it is to be concluded that central bank independence,
though an essential contributor to price stabilitydepending on
jurisdictional considerationscannot be considered to be the sole deter-
mining factor in predicting a country or economys state of monetary
stability. Theory appears to support the widely accepted view that cen-
tral bank independence is a principal contributory factor to price and
monetary stability. However investigations and empirical evidence relat-
ing to developed, transition, and developing economies highlight
distinct trends in relationships between central bank independence,
price stability, and levels of inflation.
As concluded by Sola et al., in studying monetary authority and
central bank institutions, the analyst should identify the relevant actors,
their interests, and how economic and political conjunctures are able to
shift the relevant bargaining position of those very actors.16 Moreover,
as highlighted also by Lastra, central bank independence remains animportant tool in maintaining price stability, particularly in economies
where the control of the money supply is an important instrument of
economic policy that can address various political needs, most notori-
ously the financing of government needs.
To which it is also to be added that in studying and investigating
monetary policies and central bank independence, legal, political, histor-
ical considerations as well as various other jurisdiction specific factors
also merit special focus.
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CHAPTER 1
Great Expectations,Predictable Outcomes, andthe G20s Response to the
Recent Global FinancialCrisis: When Matters
Relating to Liquidity RisksBecome Equally as
Important as MeasuresAddressing Procyclicality
1.1 Introduction
The meeting of the Governors and Heads of Supervision on September 12,
2010, their decisions in relation to the new capital framework known as
Basel III, as well as the endorsement of the agreements reached on July 26,
2010, once again reflect the typical situation where great expectations
with rather unequivocal, and in a sense, disappointing results are deliv-
ered. The outcome of various consultations by the Basel Committee on
Banking Supervision (BCBS), consultations which culminated in the
present Basel III framework, also reflects the focus on measures aimed
at addressing problems attributed to Basel II, that is, measures aimed at
mitigating procyclicality. This is rather astonishing given one critical
lesson which has been drawn from the recent financial crisiscapital
measures on their own were, and are, insufficient in addressing and
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averting the financial crisis. Furthermore, banks which have been com-
plying with capital adequacy requirements could still face severe liquid-
ity problems.
In addition to an increase of the minimum common equity
requirement from 2 to 4.5%, the recent agreement and decisions of the
Governors and Heads of Supervision also include the stipulation that
banks hold a capital conservation buffer of 2.5%, hence consolidating
the stronger definition of capital (as agreed in the previous meeting held
by the Governors and Heads of Supervision earlier in July 2010).
This chapter considers and highlights the reasons why matters
related to procyclicality and capital measures should not be the sole
focus of attention of the initiatives of the G20. In so doing, it kicks off
with a section which introduces the topic procyclicality, a subsequent
section that aims to highlight the importance of liquidity risks, and a
third section that looks into the degree of prominence that the G201
has accorded to these respective issuesnamely, procyclicality and
liquidity risks. Having considered these aims, the chapter finalizes with
a concluding section.
1.2 Procyclicality
Procyclicality is a term used to denote the tendency for periods of finan-
cial/economic downturn or boom to be further exacerbated by certain
economic policies.
An example of a fundamental source of procyclicality, as provided
by the Committee of European Banking Supervisors (CEBS),2 is attrib-
uted toexcessive risk-taking during periods of expansion, which results
in the buildup of vulnerabilities.
Recommendations Put Forward and Highlighted as Means of
Addressing Procyclicality
The Basel Committee has proposed to build up buffers aimed at
addressing and mitigating procyclical effects through a combination of
countercyclical capital charges, forward-looking provisioning, and capital-
conservation measures.
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The promotion of financial stability through more risk-sensitive
capital requirements constitutes one of Basel IIs primary objectives.3
However, some problems identified with Basel II are attributed to pro-
cyclicality and the fact that not all material credit risks in the trading
book are adequately accounted for in the current capital require-
ments.4 The procyclical nature of Basel II has been criticized since
capital requirements for credit risk as a probability of default of an
exposure decreases in the economic upswing and increases during the
downturn,5 hence resulting in capital requirements that fluctuate over
the cycle. Other identified6 consequential effects include the fact that
fluctuations in such capital requirements may result in credit institu-
tions raising their capital during periods when it is costly7 for them to
implement such a rise, which has the potential of inducing banks to
cut back on their lending. It is concluded, risk sensitive capital
requirements should have pro cyclical effects principally on under
capitalised banks.8
Regulators will be able to manage systemic risks to the financial
system during such periods when firms that are highly leveraged
become reluctant to lend where more market participants such ascredit rating agencies are engaged in the supervisory process. The
Annex to Pro cyclicality9 not only significantly emphasizes the fact
that regulatory capital requirements do not constitute the sole deter-
minants of how much capital banks should hold, but also highlights
the role of credit rating agencies in compelling banks to increase their
capital levels even where such institution may be complying with reg-
ulatory requirements.
Even though the implementation of higher levels of capital bufferscould serve as a means for the management of systemic risks, liquidity
requirements have also been acknowledged by many as having a funda-
mental role to play in mitigating contagion, thus assuming a role which
is similar to that of capital buffers. The link between countercyclical
buffers, capital, and liquidity standards is further demonstrated through
the impact generated as a result of the implementation of capital and
liquidity standards. Countercyclical buffer schemes could serve as a
means of enhancing the following effects generated by higher capitaland liquidity standards, namely,10
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making the financial system more resilient and
reducing the amplitude of the business cycles within the financial
system.
The association between systemic risks and liquidity risks and the
rather apparent lack of due recognition accorded to liquidity risks under
Basel II constituted other reasons (apart from procyclicality) for the
growing criticism of Basel II.
1.3 Liquidity RiskThe definition of liquidity, as provided by Bank for International Settle-
ments (BIS), is
the ability of a bank to fund increases in assets and meet obliga-
tions as they come due, without incurring unacceptable losses.
The fundamental role of banks in the maturity transformation of
short-term deposits into long-term loans makes banks inherently
vulnerable to liquidity risk, both of an institution-specific natureand that which affects markets as a whole.11
In their report, Addressing Pro cyclicality in the Financial System:
Measuring and Funding Liquidity Risk, The Financial Stability Forum
(FSF) noted that at the onset of the recent financial crises, the complex
response offinancial institutions to the deteriorating market conditions
was, to a large extent, attributed to liquidity shortfalls that reflected on
and off balance sheet maturity mismatches and excessive levels of lever-age.12 This has resulted in an increasingly important role for liquidity
provided by central banks in the funding of bank balance sheets.13
Furthermore, the FSF highlighted the urgency of both authorities,
namely, supervisors (in their monitoring of liquidity risks at banks) and
central banks (in their design and implementation of market operations)
collaborating in order to restore the functioning of inter bank lending
markets.14
As identifi
ed in the European Central Bank
s (ECB
s) FinancialStability Review (December 2009), the specific knowledge that banks
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possess about their borrowers make bank loans particularly illiquid.15
The connection between liquidity and systemic risks is further
highlighted in the review where it elaborates on possible consequences
resulting from a banks failure:16 the destruction of such specific
knowledge which banks have about their borrowers and the reduction
of the common pool of liquidity.17 Such reduction in the common
pool of liquidity may also trigger the failure of other banks with the
result that (a) the value of such illiquid bank assets diminishes and
(b) further problems within the banking systems are aggravated.18
Endogenous risks could also be generated depending on the type
of information which the bank possesses about their borrowers and how
the dissipation of such information to the public, if it has the potential
to trigger a bank run, can be prevented.
According Greater Attention to Liquidity Risks
In February 2008, the Basel Committee on Banking Supervision
(BCBS) published a paper titled Liquidity Risk Management and Super-
visory Challenges, which highlighted the fact that many banks hadignored the application of a number of basic principles of liquidity risk
management during periods of abundant liquidity.19
An extensive review of its 2000 Sound Practices for Managing Liquid-
ity in Banking Organisations report was also carried out by the Basel
Committee as a means of addressing matters and issues arising from the
financial markets and lessons from the financial crises.20
In order to consolidate the BCBSs Principles for Sound Liquidity Risk
Management and Supervision report of September 2008, which should leadto improved management and supervision of liquidity risks of individual
banks, supervisory bodies will be requiredto develop tools and policies to
address the procyclical behavior of liquidity at the aggregate level.21
In responding to the apparent gaps which exist with Basel II, as
revealed by the recent crises, proposals that are aimed at imposing
penalties for the occurrence of maturity mismatches22 have been put
forward.23 The degree of disparity which exists between the maturity of
assets and liabilities is crucial to determine the state of a companys
liquidity. Such penalties aimed at deterring the occurrence of maturity
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mismatches could include higher capital requirements for banks which
finance their assets with overnight borrowing from the money markets
than banks which finance similar assets with term deposits.24
The inability of bank capital to address funding and liquidity pro-
blems on its own has been acknowledged by many academics. As a
result, further proposals, in addition to the above-mentioned amend-
ment to Basel II, have been put forward. These include coupling of the
existing regulatory framework with capital insurance or liquidity insur-
ance mechanisms.
1.4 Mitigating the Procyclical Effects of Basel II
Basel III and Recent Efforts to Address Procyclical
Effects of Basel II
In response to the recent financial crisis and to the realization that capi-
tal levels (which banks operated with) during the period of the crisis
were insufficient and also lacking in quality,25 the Basel Committee
responded by raising the quality of capital as well as its level.26
Further consequences of the recent Basel reforms also include:27
a tightening of the definition of common equity;
limitation of what qualifies as Tier-1 capital;
an introduction of a harmonized set of prudential filters; and
the enhancement of transparency and market discipline through
new disclosure requirements.
The introduction of Basel II resulted in changes being made to the
1988 Basel Capital Accord to provide for a choice of three broad
approaches to credit risk.28 This was introduced into Basel II in view of
the realization that the optimal balance may differ significantly across
banks.29 The increased focus on risk (and particularly credit risk)
resulted from growing realization of the importance of risk within the
financial sector. The range of approaches to credit risk, as introduced
under Basel II, and which also exists for market risk, consists of thestandardized approach (which is the simplest of the three broad
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approaches), the internal ratings based (IRB) foundation approach, and
the IRB advanced approach.30
Under the standardized approach, regulatory capital requirements
are more closely aligned and in harmony with the principal elements of
banking risk owing to the introduction of wider differentiated risk
weights and a broader recognition of techniques which are applied in
mitigating risk.31
However, problems with Basel II internal credit risk models (which
relate to the fact that such a banks internal credit risk models were
overly sensitive in their implementation32 for the calculation of regula-
tory capital, and generated procyclical effects) were realized during
the recent financial crisis, as particularly exemplified by the case of
Northern Rock.
Do the recent Basel III efforts reflect a situation where some appar-
ent lessons from the recent financial crisis have deliberately been
ignored by the G20, or is it yet another case of typical summits which
generate great expectations but fail to deliver the expected and corre-
spondingly expected results?
1.5 Conclusion
Whilst efforts taken by the Committee (Basel Committee) appear to
have focused on capitalas evidenced by its Consultative Document on
Counter Cyclical Capital Buffer Proposalmore forward-looking provi-
sions as well as provisions that are aimed at addressing losses and unfore-
seen problems attributed to maturity transformation of short-term
deposits into long term loans
would be greatly welcomed. To an extent,this move could address the problem attributed to liquidity risks.
Further, the CEBS has acknowledged that tools which could be
implemented as measures for mitigating cyclicality exist beyond those
measures proposed by the Basel Committee. As a result, it has taken up
initiatives in relation to measures such as dynamic provisioning and
supplementary measures that include leverage ratios.33
Recent efforts aimed at addressing the financial crisis also include
two new liquidity requirements, namely, the Liquidity Coverage Ratio(LCR) and the Net Stable Funding Ratio (NSFR), which serve the
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purposes of ensuring that banks have adequate funding liquidity to
survive one month of difficult funding conditions (the LCR), and to
address the mismatches between the maturity of a banks assets and that
of its liabilities (the NSFR).34 Whilst such liquidity requirements
would help to address the critical issues arising as a result of maturity
mismatches, the implementation of countercyclical capital buffers as
well as these new liquidity requirements (the LCR and the NSFR)
would be bolstered by introducing more forward-looking provisions.
Despite the above liquidity-related efforts, the results and efforts
relating to liquidity risks do not correspond to its overwhelming contri-
bution to the recent financial crisis; neither they accord justice to its sig-
nificance. The G20s response to the recent crisis could also be regarded
as a case aimed at appeasing the needs and demands of various jurisdic-
tions, in relation to those who had favored tougher rules and those who
had appealed for not too stringent rules. Whilst such a tendency to
appease the needs of different jurisdictions may serve as a formidable
weapon in achieving the goal of regulatory convergence, it may also
serve as a hindrance in the realization of the all-importance objective of
deterring regulatory arbitrage.Furthermore, given the urgency of addressing liquidity risks and
maturity mismatches, the transition periods for implementing the two
new liquidity requirements are questionable even though as with capital,
consideration is to be had to the impact of limited transition periods.
In the new economy, information, education, and motivation are
everything.
Bill Clinton
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