The great regulatory reform in global banking has altered the backdrop for macro trading. First, greater complexity and policymaker discretion means that investment managers must pay more attention to regulatory policies, not unlike the way they follow monetary policies. Second, changes in capital standards interfere with the effects of monetary conditions and probably held back their full impact on credit conditions in past years. Third, elevated capital ratios and loss-absorption capacity will plausibly contain classical banking crises in the future and, by themselves, reduce the depth of recessions. Fourth, regulatory tightening seems to have reduced market liquidity and may increase the depth of market price downturns.

Haldane, Andrew (2017), “Rethinking Financial Stability”, Speech at Peterson Institute for International Economics, 12 October 2017

The post ties in with SRSV’s lecture on systemic risks arising from the regulated banking system.
The below are excerpts from the speech. Emphasis and cursive text have been added.

Bank regulatory reform: the basics

“Over the course of the better part of a decade, a deep and wide-ranging international regulatory reform effort has been underway, as great as any since the Great Depression.”

Microprudential Reform

“Under the umbrella of Basel III, international reform of microprudential regulation has focused on four key areas: capital, leverage, liquidity and resolution.

  • Reform of risk-based capital standards has focused on increasing the quantity and quality of capital held by banks against their asset exposures. Minimum regulatory requirements for banks’ “core” (common equity) capital have been raised from 2% under Basel II to 4.5% under Basel III, even for the smallest banks. And allowable deductions to core capital have been reduced. On quality of capital, the types of financial instrument eligible as loss-absorbing capital (including for Tier 1) have been tightened considerably… These reforms to capital standards have…been implemented in full by nearly all countries internationally…It has been estimated that Basel III raised risk-based capital standards for globally systemic banks by a factor of around ten
  • One of the new elements of the Basel III package was to supplement risk-weighted capital standards with a risk-unweighted leverage ratio…It is in principle simpler, more transparent and less subject to risk-weight arbitrage… The Basel III leverage ratio, set at a minimum level of 3% Tier 1, is due to be implemented internationally by 2018
  • A second new element of the Basel III package was to augment solvency with liquidity-based standards… Under Basel III, these take the form of a liquidity coverage ratio (LCR), designed to ensure banks have sufficient high-quality liquid assets to meet their 30-day liquidity needs; and a net stable funding ratio (NSFR), designed to ensure banks’ funding profiles are sustainable. The LCR has been implemented in full in most countries; the NFSR is due for implementation by 2018…
  • The Financial Stability Board has agreed standards for such Total Loss-Absorbing Capacity (TLAC) for global systemically-important banks (G-SIBs)…to ensure banks have sufficient loss-absorbing liabilities which can be ‘bailed-in’ in the event of failure…These standards are to be phased-in over coming years, to reach a minimum level of 16% from 2019, and 18% from 2022, of the resolution group’s risk-weighted assets, as well as 6% and 6.75% on a leverage exposure basis, respectively…
  • A crucial missing ingredient from the financial regulatory architecture was found to be the ability to wind up financial institutions in an orderly fashion… A number of measures have been taken or are in progress to fill this gap, including the introduction of more effective national resolution regimes for financial firms and greater cross-border co-operation and co-ordination when dealing with international banks in situations of stress.”

Macroprudential Reform

“Macroprudential measures…focus on safeguarding the stability of the financial system as a whole. The most significant of these reforms have focused on three areas: macroprudential capital buffers; stress-testing; and shadow banks.

  • As part of Basel III, a new time-varying component of banks’ capital was added – the counter-cyclical capital buffer (CCyB). This recognises that risks to the financial system vary over the credit cycle, typically being highest at its peak and lowest at its trough. The CCyB aims to counteract somewhat that time-varying risk profile, with additional capital required during the upswing which can be released during the downswing…The framework has been implemented in most jurisdictions…
  • Basel III recognises the need for…systemically-important firms to carry a structurally higher capital requirement, currently of up to 3.5%, to help mitigate the additional risk they bring to the system… because of their size, complexity or interconnectedness…These capital add-ons apply to the 30 designated global systemically-important banks (G-SIBs) and the roughly 160 domestic systemically-important banks (D-SIBs), to be phased-in between 2016 and 2019…
  • Stress tests were used by regulators before the crisis to assess whether banks had sufficient capital to withstand an adverse tail event. But these tests tended to be neither comprehensive nor transparent. In 2009, the US authorities undertook a comprehensive stress test of the major US banks and published the results. For banks failing the test, regulatory restrictions on their behaviour were imposed. For some people, this marked the turning point for the US financial system. A comprehensive annual stress-testing exercise is now undertaken in the US. More recently, the US has been joined by the UK and the EU, among others
  • Since the crisis, reform efforts… of the so-called ‘shadow’ banking system…have focused on two areas. First, specific reforms have been enacted to sectors which, during the crisis, were found to contain fault-lines – for example, Money Market Mutual Funds. Second, a framework has been put in place by the FSB to define and measure shadow banking entities, to publish data on them to enhance market discipline.”

More complexity and policymaker discretion

One important dimension of that new architecture is the significantly larger number of regulatory rules or constraints that now operate. On top of risk-based capital standards have been added regulatory rules for liquidity, leverage and loss-absorbing capital. In other words, we have moved from a system of largely uni-polar regulation to multi-polar regulation. Some individual parts of the regulatory rulebook – such as the use of internal ratings-based risk weights – also remain complex.”

“The new regulatory architecture has also introduced measures which are likely to make for a greater degree of regulatory discretion. The authorities in the US, UK and euro area have moved to annual stress-testing exercises in which the stress scenario, modelling framework, success criteria and regulatory response are each subject to significant degrees of regulatory discretion. Regulators internationally are also now setting a counter-cyclical capital buffer requirement, which is also set in a largely discretionary fashion.”

“This new regulatory regime could reasonably be described as ‘constrained discretion’. Regulatory rules provide the constraint within which policymakers exercise discretion…In its broad contours, this new regulatory framework has some similarities with the prevailing monetary policy framework in a number of countries…Equally, as in the monetary policy sphere, there is a question about whether this new regulatory regime strikes the right balance between regulatory rules and the degree of discretion with which they are operated…This is partly because adverse crisis outcomes are highly non-linear and costly, making it more difficult to pre-commit to avoiding forbearance and bail-out.”

“By any historical metric, however, macroprudential policy remains a fledgling framework.”

The impact on lending conditions

“The costs of higher bank capital requirements arise from potentially tighter credit supply conditions. Banks may adjust to the need to fund themselves with more equity by tightening lending rates and restricting loan volumes. The Long-Term Economic Impact study assumed that each percentage point increase in the capital ratio would raise loan spreads by around 13 basis points.”

“While credit conditions have clearly improved since the crisis…the recovery in lending might have been stronger still had capital requirements risen by less…Credit growth has also tended to be statistically significantly lower among banks that have seen the largest increase in their capital ratios. On average, banks that have increased their capital ratios by an extra one percentage point have provided 4% less in cumulative credit since Basel III was introduced. This is very similar to the estimates used by the FSB’s Macroeconomic Assessment Group (2010), which reported a range of estimates from -0.7% to -3.6%.”

“[Other studies] find that shifts in required capital had large negative effects on UK banks’ lending decisions…In times of credit expansion, higher required capital has only a minimal effect on lending. But when credit growth is weak, higher required capital can result in a large reduction in lending. This echoes previous research which has found that banks reduce lending in response to negative capital shocks.”

The impact on recession risk

“Evidence from a long historical time-series and across multiple countries [suggests that]…credit booms are probably the single most important determinant both of the likelihood of crises and of economic performance in the recovery after them…Credit growth has historically been a significant predictor of crisis severity, whereas the level of indebtedness appears less important…In the post-WWII era, mortgage credit growth has been the dominant driver of financial crisis risk.”

“[The first chart below] looks at a measure of banks’ Tier 1 risk-weighted capital ratios. For both global systemically-important banks and domestic systemically-important banks in our sample, these have risen significantly over the past decade, almost doubling from around 7-8% to around 13-14%. A very similar picture emerges for leverage ratios [second chart below]. These have also roughly doubled over the past decade, from around 3% to around 6%. On these metrics, there has been a material strengthening in solvency-based standards among systemically-important banks over the past decade.”

“Historical evidence, using aggregate economy-wide covariates, has reached the perhaps surprising conclusion that bank capital ratios have virtually no predictive power for the occurrence of financial crises in major advanced economies…[However], while bank capital does not prevent a crisis from occurring, it matters for the pain suffered in its aftermath…Real GDP per head is 5 per cent higher 5 years after the onset of a crisis-related recession if bank capital is above its historical average when the crisis hits.”

“The benefits of capital in reducing the severity of crisis are also borne out by experience since the crisis. [The chart below] plots international banks’ capital ratios prior to the crisis against their subsequent lending growth. The relationship has a statistically significant upward slope. Banks that entered the crisis with higher capital have, on average, been better able to continue their lending. On average, each extra 1 percentage point of pre-crisis capital boosted banks’ cumulative lending over the subsequent decade by over 20%.”

The impact on market liquidity

“A…potential cost…[is] the potential for falls in market liquidity in core financial markets – for example, securities financing markets such as repo. This could potentially raise the cost of capital for users of these markets. Market commentary in recent years has often laid the blame at the leverage ratio. This, it is argued, has led some dealer-banks to reduce their inventory holdings and market-making capacity, thereby reducing secondary market liquidity in some markets.”

“Research at the Bank of England has sought to identify the impact of leverage ratio requirements on the functioning of UK government bond (‘gilt’) and gilt repo markets, using transaction-level data. It does find some causal impact of the leverage requirement on various metrics of liquidity, a worsening that is particularly acute at quarter-ends. Significantly, the banks most constrained by the leverage ratio reduced their activity in financial markets most.