Vítor Constâncio: Financial regulatory reform and the economy
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the
20th Annual Hyman P Minsky Conference, organised by the Levy Economics Institute,
New York, 15 April 2011.
* * *
It is indeed a pleasure for me to participate in this 20th Conference to honour Hyman Minsky
and I want to thank President Papadimitriou for inviting me.
I. Lessons from the crisis and the regulatory response
Four years after the eruption of the financial turmoil, which quickly turned into a full-blown
financial crisis after the collapse of Lehman Brothers in 2008, the international banking and
regulatory landscape is now being changed in ways that significantly impact the future of the
financial sector and the economy. The speed of the propagation of the crisis from one
country to another as well as from one sector to another posed exceptional challenges for
banks, regulators and supervisors alike.
1. Key lessons drawn from the crisis
The crisis had many causes, often intertwined and mutually reinforcing. A key area where
several shortcomings were detected, and therefore where decisive actions had to be taken,
concerns the regulatory framework, both from a micro- as well as macro-prudential
perspectives. Considering the set of causes that contributed to the crisis, the reform of
financial regulation has addressed the following points:
First, excessive asset growth in the financial sector during periods of boom has to be
contained, thus reducing the risks of asset price bubbles as well. In this context, it has to be
acknowledged that overly accommodative monetary policy may have contributed to inflating
the stock market and, subsequently, the housing markets. Therefore, a cautious monetary
policy of "leaning against the wind" could help to address this problem. This policy should be
based on the re-definition of price stability objectives to capture longer time horizons as well
as on a more systematic incorporation of financial and monetary developments in the
assessment of risks to price stability. However, it should under no circumstances imply any
mechanical reaction of central banks to asset price movements. The main response must
come from a reduction of the pro-cyclicality of the financial system by means of
macroprudential policy measures. As we have seen in the recent crisis, pro-cyclicality can be
exacerbated by certain features of the regulatory capital framework as well as by accounting
rules. Consequently, the implementation of effective macroprudential policies, like
countercyclical capital buffers as well as the revision of accounting standards, are of paramount
importance. Furthermore, the introduction of a non-risk based leverage ratio will also
contribute to putting an ultimate brake on the system.
Second, the financial crisis clearly showed the lack of loss absorption capacity of many
regulatory capital elements, namely of the so-called hybrids. In some important institutions
common equity was as low as 2% of total risk weighted assets in the run-up to the crisis.
There was a clear need to implement new standards demanding more and better quality
capital to strengthen the loss absorbing capacity of the financial system. The Basel
Committee on Banking Supervision (BCBS) has already agreed on a new global capital
standard, endorsed also by G20 Leaders in November 2010, the potential implications of
which I'll discuss in more detail later.
Third, the financial system was too vulnerable to market and funding liquidity shocks. The
introduction of regulation on liquidity ratios, imposing more robust buffers in the short term
and less structural dependence on unstable wholesale funding, is an important step towards
enhancing the resilience of the system.
Fourth, the elimination or significant mitigation of the "too big to fail" problem represents a
major challenge for regulators. A number of initiatives are currently being discussed at the
international level under the aegis of the Financial Stability Board (FSB).
Fifth, the prevention of systemic risk coming from the "shadow banking sector" remains one
of the most important issues of the current regulatory agenda. This can be achieved both
directly by enlarging the perimeter of regulated institutions as well as reinforcing accounting
rules on consolidation and indirectly by regulating the flows of credit or liquidity backstops
coming from the regulated sector.
Sixth, tightening the regulation of over-the-counter derivatives through the use of central
counterparties (CCP's) and trade repositories as well as by moving trade of standardized
instruments (e.g. CDS's) to organized exchanges are key elements of enhancing
transparency and mitigating counterparty credit risk in these markets.
Seventh, correction of the prevailing adverse incentives created by an excessively short-term
perspective of risk measurement and performance assessment. The introduction of new
governance principles regarding risk management and compensation guidelines should help
to align incentives with long-term sustainability.
Finally, improving the oversight of Credit Rating Agencies (CRA's) and reducing the reliance
on external ratings for official regulatory purposes. CRAs have contributed to the
procyclicality of the financial sector and played a very negative role in the sub-prime crisis by
failing to properly assess the risk characteristics of complex financial products.
2. The regulatory reforms in the US and the EU
Most of the aspects of a new regulatory environment are being widely adopted around the
world. The substantive work has been done by the BCBS and the FSB under guidelines
approved by the G20. The core areas of reforms on both sides of the Atlantic address the
key lessons I just mentioned. In this context, the regulatory and supervisory objectives in the
US and the EU share a common agenda.
From a regulatory perspective, the main initiative in the US has been the Dodd-Frank Act
(DFA). With the DFA the US has created a yardstick for the regulatory response to the crisis.
The DFA is an elaborate framework and a fundamental and ambitious reform.
In Europe the European Commission has already adopted several new pieces of legislation
and many more are in preparation until the end of this year. Besides dealing with the Basel III
decisions, the whole set addresses other subjects, from OTC derivatives, consumer
protection, deposit guarantee schemes and Resolution Funds to Credit Rating Agencies,
securitization, short selling or securities market integrity.
These are just a few examples of the very comprehensive overhaul of the financial market
regulation underway in the EU. These examples illustrate, first, that authorities on both sides
of the Atlantic are determined to draw lessons from the crisis. Second, they point to the
importance of intensifying regulatory cooperation across countries. International coordination
on financial reform is essential to prevent regulatory arbitrage, avoid loopholes, and ensure a
level playing field.
Some differences are likely to remain in aspects not harmonized at world level. For example,
,
regarding CRAs the EU's regulation has introduced strict authorisation requirements and
supervision for CRAs. However, the regulation might not be enough to overcome all the risks
related to the use of external ratings. Therefore, issues such as the over-reliance on ratings
and the lack of competition in the sector are currently further explored. The DFA includes an
obligation to remove references to (private sector) external credit ratings. As the CRAs
continue to accentuate their pro-cyclical behaviour, we closely follow in Europe the efforts of
US regulators to apply this particular aspect of the DFA.
Both in the US and the EU reforms require hedge funds (above a certain threshold) to
register with an authority and report information regularly. In the US the DFA has also
introduced limits on investment in hedge funds for financial institutions as well other aspects
associated with the so-called Volcker Rule. In the EU, a Volcker-Rule-type of regulation is
not envisaged as experience with the universal bank model, which is predominant in the EU,
is generally seen as a success.
II. Implications of the regulatory reform for the economy
Given the comprehensive nature of the regulatory reform, impacting a wide range of
institutions, markets and business activities, it is understandable that the reaction of the
industry was critical towards the policy measures. While generally supporting the underlying
objectives of the regulatory reform by recognizing the responsibilities of the financial services
industry in the crisis and acknowledging the serious weaknesses in business practices
across a range of financial institutions (IIF, 2008), resistance remains substantial with regard
to certain elements of the reform package. In particular, criticism was raised against the new
capital requirements (increased minimum capital ratios, introduction of capital conservation
and counter-cyclical buffers as well as a capital surcharge for Systemically Important
Financial Institutions - SIFIs), arguing that this will increase costs for banks, reduce
profitability, lead to credit supply restrictions, shrink the banking sector and, ultimately, hurt
the economy (IIF, 2010).
Theory and historic experience however demonstrate that those claims are partly based on
misconceptions that are important to dispel. A series of recent studies (Admati et al., 2011;
Miles et al., 2011; Angelini et al, BIS, 2010; Kashyap et al., 2010) explain clearly the theory
behind the fact that changes in capital ratios had historically no such effects or, at least, not
in a magnitude claimed by the industry. As Admati et al. (2011) conclude, "... requiring that
banking institutions are funded with significantly more equity entails large social benefits and
minimal, if any, social costs".
Furthermore, there does not appear to be a clear empirical relationship between the size
of the financial sector and sustainable growth, thus it is not at all evident that a more
moderate expansion of the financial system will have adverse impact on the economy as a
whole. Let me elaborate on these issues in more detail.
1. Historically based arguments
The interdependencies between finance and economic growth are multifaceted. They should
- and will - remain high in the research agenda for the economics profession for a long
period.
The insights of Schumpeter pioneered the understanding of the role of a well developed
financial system for fostering technological innovations and ultimately economic growth.1 The
approach was taken in recent times by the endogenous growth literature, in particular
through theoretical contributions by Aghion and Howitt (2005 and 2009) and empirical work
by Rajan and Zingales (1998 and 2003). Nonetheless, the knowledge gap remains very wide
and the recent crisis has underlined the importance - in social welfare terms - of filling this
gap sooner rather than later and drawing from it more powerful policy designs.
Turning to the facts and figures of all this, let me first stress the important caveat of
measurement issues when speaking about the link between finance and growth. Even the
size of the financial sector in a given country is not easy to characterise, let alone to
measure. While many indicators can be invoked, none is immune from criticism.2 Also the
perimeter of the financial sector is typically not easy to pin down. It shifts over time, pushed
by financial innovations, and institutional3 and structural specificities at country level make
international comparisons a daunting task. The periphery of the financial sector is particularly
opaque and hard to apprehend. Comprised of OTC products, complex derivatives and
investment vehicles, its lack of transparency is commensurate to the systemic risks it has
posed to the rest of the economy, as we painfully witnessed in 2008 and 2009 after the
Lehman demise.
Let me now take you through a shortened and unavoidably oversimplified account of what
we know about growth-finance interactions.4 I will focus in particular on three results, broadly
defined.
Firstly, looking at the available empirical evidence on the relation between the financial
sector and potential growth, most studies do not point to the role of size of the financial
sector per se, but rather to the degree of development of the financial sector as the key
variable (see in particular Levine, 2005)
Secondly, when focusing on the nexus between the size of the financial sector and
sustainable growth, over the recent past, there is no clear empirical relationship. Recent
research at the ECB and elsewhere shows that the continuing increase of the financial
sector size does not always contribute to higher economic growth, in particular since
the late 90's. In fact, some empirical evidence suggests that, above a certain threshold, the
effects of finance on growth potential weaken with the degree of economic development as
the effect of finance on growth is not necessarily monotonic. There are several potential
reasons for that. The provision of financial services may reach a threshold beyond which
there are diminishing returns to scale. The expansion of the financial sector is associated
with a reallocation of productive talent away from real economic activities, which may
ultimately depress economic growth through lower industrial innovation. Besides, if banks in
particular become too large and powerful, they may extract excessive rents from the
corporate sector, impose their taste for prudence on their corporate clients, or become
captured by the interests of large inefficient incumbents, disrupting the natural process of
Schumpeterian creative destruction. Indeed, over the last years, bank equity appears to have
registered a higher average return than non-bank equity.
Third, financial development may exacerbate the trade-off between growth and stability, and
so the findings of the traditional finance-and-growth literature may have been driven by
studying short periods of relative calm during the Great Moderation. Preliminary evidence
suggests that periods of very fast expansions of credit (or other forms of financial
intermediation) tend to be disorderly and often indicative of the emergence of financial
inefficiencies that are not conducive to sustainable growth, breeding the sources of financial
crises associated with severe economic downturns.
To conclude this brief overview, I would underline that larger financial sectors have generally
been associated with a higher degree of economic diversification, resulting in a lower overall
volatility of GDP growth for the same level of long-term output growth. (Manganelli and
Popov, 2010). However, the decade of the run-up to the crisis saw the effect of larger
financial sectors on higher economic growth partly disappear. This phenomenon is
connected to the complex non-linearities involved in the finance-and-growth-nexus, causing
the effect of finance on growth to peter out over the development cycle, as well as to the
trade-off between growth and tail risk exacerbated by the expansion of the financial sector.
Indeed, the main finding of research paper by Popov (ECB, 2011) is that financial
globalization increases simultaneously the mean and the left skewness of output growth.
This implies that while raising long-term growth, financial globalization has also exacerbated
the risk of large, abrupt, and rare macroeconomic contractions. This is consistent with the
view that in financially liberalized economies, systemic risk taking raises the probability of a
collapse in financial intermediation. The paper also finds that the welfare effects of
liberalization vary with the degree of economic and financial development, therefore financial
globalization is not a one-size-fits-all development.
There is also some evidence suggesting that higher growth of the financial sector may come
at the expense of higher volatility in general (Levchenko et al., 2009), both for developed and
developing economies (Popov, ECB 2011). These research papers emphasize the
characteristics of the financial sector as key determinants of macroeconomic performance in
all its facets, notably as regards long-term potential, cyclical fluctuations and likelihood and
severity of crisis episodes (see also Kaminsky and Reinhart, 1999).
This may call for strengthening our efforts to understand the macro-finance nexus, extract
lessons from the crisis and foster the synergies across the various analyses and
perspectives (monetary policy, stability, etc.) in which central banks analyse the financial
system.
Let me now turn to another important point: historical evidence seems to indicate that there is
also no relationship between simple book capital ratio (or leverage as its inverse) and
economic growth. Miles et al. (2011, page 6) point out that in the UK in 1880-1960 the
leverage ratio was about half the level of recent decades. Similarly, Kashyap et al. (2010,
page 19) demonstrate that the book equity to book assets ratio for US commercial banks has
declined substantially over time: while the ratio exceeded 50% in the 1840s, it fell steadily to
reach 15% in 1930s and 6% in the 1940s. Later, with the introduction of the Basel I regime in
the early 90's, capital ratios started to improve again in the US, however, this development
was accompanied by increasing off-balance sheet activities, potentially reflecting regulatory
arbitrage as well as the mis-measurement of risks. The evidence of both countries indicates
clearly that very different levels of capital coincided with similar rates of economic growth,
showing no specific historical relation between the two.
Turning to the relationship between simple book capital ratio (or leverage as its inverse) and
spreads or rates of business loans, both Miles et al. (2011) and Kashyap at al. (2010) find no
evidence of any clear link between these ratios and bank lending rates, for the UK since
1890 and for the US since 1920, respectively. Overall, the main findings of these studies cast
doubts on the reliability and accuracy of some of the estimates on the excessive
macroeconomic and social costs of strengthened capital requirements. Nevertheless,
historical examination can only provide an impressionist type of evidence. We need, of
course, more precise analytical and econometric analysis.
2. Analytical and empirical evidence
Against this background, it is of particular importance that policy makers have an appropriate
and balanced view of the potential impacts of the reform package. In this context, it is
necessary to make a clear distinction between long term and short term impacts.
First of all let me underline that when the authorities calibrated the new requirements they
took into account the estimated potential costs and benefits of the reform. These estimates
were made at the initiative of the FSB and the BCBS. The Macroeconomic Assessment
Group (so called MAG) was established to assess the impacts during the transition towards
the new regulatory regime, while the Long-term Economic Impact Group (or so called LEI)
assessed the long-term (steady state) net benefits from the implementation of Basel III. The
ECB and several Eurosystem national central banks contributed actively to the preparation of
these studies.
Let me first start with the estimated long-term impact of the enhanced capital and liquidity
regulation. As we have recently experienced, financial crises can impose enormous costs on
tax payers and society at large. In order to avoid such losses, Basel III reforms aim at
improving banks' capital base and thus banking sector's resilience that can help to foster
financial stability as well as to mitigate systemic risks in the global financial system. Thus, the
long-term economic benefits, while difficult to quantify precisely, can be very substantial.
The main economic benefit of the reform stems from the reduced frequency of future crises.
The prevention and mitigation of downside tail risks for the economy implies a sizeable
reduction in the expected output losses associated with systemic events and as such,
contributes to more sustainable economic growth over the long term. To be more precise, the
study of the Long-term Economic Impact Group has estimated that banking crises occur on
average every 20 to 25 years. This estimate means that there is a 4.6 per cent annual
probability of a crisis. The study shows that a 4 percentage points increase in the capital ratio
lowers this annual probability to less than 1 per cent. Another conclusion is that a one
percentage point reduction in the annual probability of banking crises produces an expected
net saving of 0.6 percent in terms of unrealised output loss.
The LEI study also provided a thorough examination of the potential long-term economic
costs. It was found that a 1 percentage point increase in the capital ratio translates into a
[median] loss of output of 0.09 percent. The additional loss of meeting liquidity requirements
is of similar magnitude. A more recent BIS paper by Angelini et al (2011) also arrived at
conclusions that are fully consistent with the LEI report.
Overall, the main finding the LEI analysis is that there is considerable room to tighten capital
and liquidity requirements to achieve significant net benefits in terms of output. This finding is
even more pronounced if we take into account the fact that the LEI study is based on the
assumption of constant return on equity (ROE) thus potentially underestimating the long-term
benefits of higher capital and liquidity requirements.
Similar conclusions are provided by Miles et al. (2011) who estimated the costs and benefits
of higher bank capital. By using data on the UK banks they show that even proportionally
large increases in bank capital are likely to result in only a small long run impact on the
borrowing costs faced by bank customers. They estimate the average cost of capital for
banks to increase by a relatively minor 10-40 basis points when the bank capital doubles.
Importantly, this analysis takes into account the impact of heightened capital ratios on banks'
stability and therefore the lower return of equity demanded by investors.
The analysis by Kashyap et al (2010) also finds that long-run steady-state impact on loan
rates is likely to be modest, falling in the range of 25-45 basis points for a ten percentage
point increase in the capital requirement. Given the relatively mild impact of changes in
capital ratios on the borrowing costs that banks' customers have to face, the implications for
economic growth may also remain modest.
Overall, the referred studies found that the potential negative impact of the new framework
on long-term output was considerably lower than the benefits related to lower frequency of
systemic events. This conclusion is even reinforced when considering additional benefits
beyond the reduced frequency of crises. In particular, the new prudential rules will also
improve the level playing field for the international banking sector as it harmonises the
different national practices. Improving level playing field is expected to help financial
institutions to save costs and to encourage cross-border activities. This will in turn result in a
more efficient financial sector and will also bring benefits to non-financial corporations and
households through higher competition and increasing availability of financial services.
Let me now say a few words about the theoretical rationale behind these results. A key
conceptual issue that warrants further investigation is the impact of strengthened capital
ratios on the expected return on equity. As I already mentioned, enhanced stability of
financial institutions should, in principle, be reflected in lower risk premiums and thus lower
funding costs for banks. The theoretical underpinning behind this idea is the Modliglani-Miller
(M-M) theorem which states that if certain assumptions hold (symmetric information and
rational behaviour of market participants, complete, frictionless markets etc) the funding
structure of a firm is irrelevant for its business decisions. In an M-M world, the primary
differences between the costs of debt and equity can stem only from their different tax
treatment. Both the paper of Miles et al (2011) and Kashyap et al (2010) are based on the
- at least partial - validity of the M-M theorem. The relevant point is that more capital
reduces the volatility of return on equity and increases the safety of debt thereby reducing
the required returns by the market on both equity and debt. This means that the equity risk
for a bank should decline linearly with leverage. Indeed, Miles et al (2011) show empirically
for the UK that for a leverage of 30 the bank equity risk premium is 6.5% and for a leverage
of 15 is just 3.1%. They estimated also the relationship between leverage and equity beta by
using different analytical approaches and found that changes in leverage have a significant
impact on banks' riskiness. The results of their analysis suggest that, depending on model
specifications, the M-M effect is about 45-75% of what it would be if the M-M theorem held
precisely. However, as the authors pointed out, their analysis was based on the assumption
of no change in the required rate of return on debt, which means that with the more likely
assumption of a reduction of that required return the M-M effects would be even higher.
In this framework, it's clear that a substantial increase in the simple book capital ratio (or
leverage as its inverse) should lead to a decrease in the required return on equity. This
seems to be one of the reasons why many in the sector oppose the new capital
requirements. Therefore, it has to be emphasised in this context that a simple ROE ratio, if
not adjusted to leverage (and risk), can provide totally misleading signals for investors. In
fact, part of the high ROE ratios reported by banks before the crisis was due to high leverage
and high risk. A recent ECB study on EU banking structures (ECB, 2010) highlighted that the
inappropriate assessment of the risk characteristics, and thus the un-sustainability, of the
observed ROE ratios led to huge losses in the recent crisis. Averaging the ratios over time to
include the crisis years shows that the effective ROE of banks and other financial institutions
was much lower than previously thought. The industry has to accept therefore that the
regulatory reform leads to an apparent lower ROE which nevertheless is shown to be
misleading when proper consideration for leverage and risk is factored in. In this regard, the
ECB report pointed out that "desirable features for banks' performance measures should
encompass more aspects of the performance than just profitability embedded in a pure
market-oriented indicator such as ROE" and that "risk-adjusted types of returns indicators
may benefit from higher disclosure and better explanation to the markets, or at least to the
supervisors".
Let me now turn from long-term, steady state impacts towards the potential short term
consequences of the reform proposals. While the long-term net benefits of the new
regulatory framework vindicate the scope and magnitude of the regulatory measures, it
should not mask the challenges that are associated with the implementation of the reform
package. Indeed, Basel III will have some potential transitional costs that arise as banks,
on average, need to increase their capital base in order to fulfil the new requirements. While
the basic assumptions on the M-M theorem may hold in the long term, financial markets are
characterised by information asymmetries and frictions in the short run, which can be
especially prevalent in distressed periods.
Banks have several possibilities to adjust their capital ratios. For instance, they can raise
capital, increase lending spreads, reduce dividends and/or downsize (risk-weighted) assets.
In practice, it is likely that banks' adjustment is going to be achieved through a combination
of all these measures. There is empirical evidence, however, that in the short term and in
crisis periods in particular, banks react to capital (and liquidity) constraints by de-leveraging
and by tightening of credit conditions (Hempell - Kok, 2010) that can have a measurable
impact on loan supply and thus on economic activity (De Bondt et al. 2010). Whatever
methods banks choose to adjust their capital ratios, the overall effect is channelled to the
macro-economy via various transmission channels.
The Macroeconomic Assessment Group analysed transitional costs related to a
1 percentage point increase in the capital ratio implemented over eight years, assuming a
constant return on equity. The results of the study show that the transitional costs are
subdued. The cumulated reduction of GDP relative to the baseline would amount to
0.15 percentage points. Similarly, the negative [un-weighted median] impact on bank lending
to the real economy would be approximately 1.4% in cumulated terms. The lending rate
spreads are estimated to increase by 15.5 basis points. The peak impact would occur after
35 quarters from the beginning of implementation period but the negative impact recedes
when the time elapses.
The interim report of the Macroeconomic Assessment Group assessed also the implications
of new tighter liquidity requirements. A 25% increase in the holding of liquid assets was
estimated to yield a fall in lending volumes of 3.2% and a [median] increase in lending
spreads of 14 basis points after four and a half years. This would induce a [median] decline
in GDP of 0.08% relative to the baseline. However, as the new liquidity requirements are
subject to a long observation period that allows further fine-tuning of the requirements, it is
far too early to draw definitive conclusions over the macroeconomic impact.
As shown by the results of the Macroeconomic Assessment Group as well as by the referred
paper of Kashyap et al (2010), the length of the implementation period matters crucially for
determining the transition costs. Clearly, the longer the implementation period, the milder is
the negative impact on the economy. If the new framework were implemented hastily, banks
would need to undergo sizeable consolidation of their capital base and carry out a reshuffling
of their balance sheet structure over a short period of time. This could have some adverse
impacts on credit intermediation in the short term. Such transitional impact motivated the
design of long phase-in arrangements.
As the transition period is agreed to last from 2013 to 2018, the new measures will become
fully effective only on 1 January 2019. These eight years from now should provide the
banking sector ample time to adjust to the new regulatory requirements by earnings retention
and improved efficiency. Also, we can reasonably expect a gradual decline in investors' profit
expectations as they realise and price in the improved stability of individual institutions and
the financial system as a whole. Taking into account the expected improvements in
profitability of the banking sector, it is likely that banks will be able to cope with the new
requirements without major distress. Thus, the long phase-in period of the new Basel III
capital requirements prevent disruption in credit flows and bring enough clarity and scope for
banks to smoothly absorb the necessary adjustments over time. This implies in turn that the
transitional costs for real economic activity are likely to be relatively moderate and distributed
over the long implementation period.
III. The benefits of higher capital and its calibration
As I have highlighted, better capitalised banks may represent substantial benefits from a
social perspective in the long run while the transition costs depend largely on the amount of
additional capital that banks have to accumulate and the available time for banks to adjust to
the new framework. The question therefore is whether we can identify an "optimal" level of
capital that could maximise social benefits.
According to the LEI report, the long term benefits for the society are highest when the
capital ratio falls in the range of 13-15%. Taking into account the potential impact of
declining ROE expectations that may moderate the increase in funding costs of banks; the
socially optimal capital ratio can be even higher. Indeed, Miles et al (2011) arrive at a
concept of optimal capital ratio of 16 to 20% for the UK. Kashyap et al (2010) for the US
mention appropriate capital around 15%.
The total capital ratio demanded by the new Basel regulations until 2019 is 8%,