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«Financial Regulation After the Crisis: How Did We Get Here, and How Do We Get Out? By Gerard Caprio, Jr. SPECIAL PAPER 226 LSE FINANCIAL MARKETS ...»

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ISSN 1359-9151-226

Financial Regulation After the Crisis:

How Did We Get Here, and How Do We Get Out?

By

Gerard Caprio, Jr.

SPECIAL PAPER 226

LSE FINANCIAL MARKETS GROUP SPECIAL PAPER SERIES

November 2013

Gerard Caprio, Jr. is William Brough Professor of Economics at Williams College and Chair of the

Center for Development Economics at Williams. Previously he was the Director for Policy in the

World Bank’s Financial Sector Vice Presidency and head of the financial sector research group. His research included establishing the first databases on banking crises around the world and on bank regulation and supervision, and he worked on financial system reform and development issues around

the world. Jerry has authored numerous articles, and his latest book is The Guardians of Finance:

Making Regulators Work for Us, with Jim Barth and Ross Levine (MIT Press, 2012), with whom he also wrote Rethinking Bank Regulation: Till Angels Govern (Cambridge University Press, 2006). He is a co-editor of the Journal of Financial Stability and served as Editor-In-Chief of a 3-volume handbook series on financial globalization for Elsevier (2012). Earlier positions include: Vice President and Head of Global Economics at JP Morgan, and economist positions at the Federal Reserve Board and the IMF. He has taught at Trinity College Dublin, where he was a Fulbright Scholar, and at George Washington University.

Financial Regulation After the Crisis: How Did We Get Here, and How Do We Get Out?

Gerard Caprio, Jr.

November 2013 William Brough Professor of Economics and Chair, Center for Development Economics at Williams College. Paper prepared for the 2013 Asia Economic Policy Conference at the Federal Reserve Bank of San Francisco. James Barth, Charles Calomiris, Stijn Claessens, James Hanson, Takeo Hoshi, Ross Levine, Ashoka Mody, and participants at the conference provided helpful comments.

The conference organizers and Kevin O’Rourke posed questions that inspired the focus of the paper. The author would like to thank Brian McNamara for excellent research assistance. As usual, responsibility for what lies herein rests with the author.

2 Abstract Following the crisis of 2007, regulatory authorities either are or should be engaging in a fundamental reconsideration of how they approach financial regulation and supervision. This paper briefly summarizes the present international consensus on regulation as embodied in the Basel framework, looks at how we came to be in such a situation, and proposesa re-start of the process that has been organized by the Basel Committee on Bank Supervision. It reviews the flaws of that framework and concludes that its weaknesses are fundamental, in its neglect of the endogeneity of risk to the regulatory structure, and of the dynamic nature of finance, and thus of its regulation as well. Neither a static rulebook, nor an ever increasingly complex one, will ever provide financial safety and soundness. Specific recommendations are made, starting with an abandonment of risk weights and the adoption of a simple leverage rule, supplemented by CoCos, and some simple rules. More radically, a different approach is urged, one that focuses on the oversight and accountability of regulators and greater transparency, both of banks and of the regulatory process.

I come to bury Caesar, not to praise him. The evil that men do lives after them; the good is oft interred with their bones; so let it be with Caesar.

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In the wake of one of the worst financial crises in history, governments in the United States and Europe are moving in fits and starts to adjust financial regulation, albeit in increments far smaller than virtually anyone with advance knowledge of the dimensions of the crisis might have imagined. Just as barn doors tend to be shut after a horse has escaped, banking crises routinely are followed by new and ‘tougher’ regulation. Regulatory change, tougher enforcement of existing rules, or both have been the norm following most modern crises, notably in the Great Depression, the U.S. Savings and Loans (S&L) crisis, and many emerging markets since the 1980s. Yet crises have showed no signs of abating or diminishing in severity, and their fiscal cost has exploded.

–  –  –

of the crisis that began (to be evident) in 2007 fall far short of what is needed to reduce the likelihood and severity of future crises,1 and policy recommendations – somewhat to much more (and differently defined) capital, higher liquidity requirements, conditional convertible debt (or CoCos), narrow banking, criminal prosecutions, or all of the above – have yet to enjoy a consensus. Any solution that is effective will reduce the availability of credit from what it was in the extreme years during the run-up to the crisis, but notwithstanding the unwillingness of politicians to make that point, better-allocated credit would be a boon to societies. Just as the tech bubble saw investments financed that should not have been (e.g.,

–  –  –

so-called ‘dark fiber,’ or fiber optic cables that still have not been utilized), the credit bubble in the 2000s featured unproductive investments in housing and a variety of consumer goods that left societies with high unemployment, a debt overhang and little else, save some empty houses, the memories of the borrowers and the enlarged wealth of many in the financial sector. Nonetheless, bankers are protesting that the response in the pipeline will produce financial disintermediation, denying credit to many and thus reducing growth.





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in terms of financial regulation and makes some suggestions about how countries might escape the current situation of a massively complex regulatory apparatus that is not producing banking sector that is both safe and yet still contributes to prosperity. Section II begins that task, focusing on how the current approach to regulation came to be the new norm. Section III reviews some lessons from the recent crisis, with the focus on the issues in which the author’s views differ from the majority position in the literature. Section IV then looks at Basel as a regulatory model and concludes that its fundamental shortcomings played a role in recent crises and that the approach to regulation requires ‘rebooting.’ Some possible ways ahead on the regulatory front are offered in Section V. Changing bank regulation and supervision is an arduous task, and as suggested by Calomiris and Haber in a forthcoming book, politics, not policy advisors, dominate the decision-making process. Erstwhile reformers therefore should know that their task will at least seem, and perhaps be, Sisyphean.

–  –  –

supervision is choking on it own complexity, as it continues to tackle three jobs: keeping the 2 The word ‘formerly’ is used because as will become clear the much vaunted regulatory ‘best practices’ that were the model for the rest of the world, and the supposed state of the art on bank supervision were part of the problem in causing the crisis.

3 banking system safe, leveling the playing field for banks, and being responsible for risk management at the individual bank level. Just as Soviet planners found that they had to intervene at an ever more granular level to avoid market participants adjusting in undesirable ways, the Basel Committee has responded to the failure of each of its Accords with an ever more complicated version. But beyond complexity, the Basel Committee has neglected the endogeneity of risk: its attempts to level the competitive field for banks have increased the covariance of banks’ exposures, which should be anathema to bank regulators but instead has received little attention. Furthermore, there is no reason to think that harmonized policies will work the same in different institutional environments, which might be one reason why cross-country empirical studies cannot find any consistent effect of tighter capital regulation or increased supervisory powers (Barth, Caprio, and Levine, hereafter BCL, 2006). The upshot of these points – increasing complexity, endogeneity, and the differences in countries’ institutional environments – means that the Basel Committee is playing at a game – literally, in that they are locked in a strategic battle with market participants – that they cannot win and should not be attempting to play. Temporary ‘wins’ will not only be short-lived, they will necessarily entail a ‘loss’ someplace else. Implications for what a new Basel Committee might do are discussed, beginning with an abandonment of the risk weighting of capital (and liquidity) requirements and the adoption of a meaningful leverage, or unweighted capital, rule. Additional specific measures are suggested as well for consideration by a proposed newly reconstituted committee with new membership.

Most tellingly, as has long been known, thanks to the seminal work of Ed Kane (1981) and Buser, Chen and Kane (1981), finance is dynamic, responding to and innovating around regulation. Indeed, this point was clear at the dawn of modern banking, when

–  –  –

penalty (eternal damnation). The Basel answer to this problem of evasion has been everincreasing complexity and ever-growing numbers of supervisors. But if finance is dynamic, then so too must be its regulation. The failure of regulators to use the powers that they had during the crisis alone calls for greater accountability. But the dynamic nature of finance, by suggesting either that legislators must constantly reconsider financial legislation (a scary thought), or that more discretion for regulators is warranted, also demands more accountability, as power without accountability is unsustainable in a democracy. Creative ways of disclosing more information should be considered, and one proposal related to compensation and risk management, is offered. No doubt there will be disagreements with many of the proposals, but the key points are that the current framework, like that of Soviet attempts to replace market forces with diktats, is doomed, and that a different approach focused on simple rules (that would actually be enforced), disclosure of information, and monitoring and accountability of regulators is long past due.

It is useful to delimit this paper. Humans’ tendency to engage in searches for explanations – even of random events – tends to be equaled by their belief in single causes, or ‘silver bullets.’ Yet, in the experience of this author, most complex phenomena have diverse causes, the crisis of 2007 being a clear example. A global savings glut, integrated international capital markets with macroeconomic policies that fueled large capital flows, easy monetary policy, resulting in lowered interest rates and credit spreads, easy loan standards, a boom in toxic financial innovations, greedy bankers, and an unsustainable explosion of credit, have all been cited in explanations of the crisis, and no doubt these factors played a role. And a favorite explanation is the “perfect storm” story, namely the coincidence of all or many of these factors at once, which, it is said, could not have been

–  –  –

together of such a complicated set of factors was said to have made it impossible to anticipate or predict the crisis.3 The present paper will not revisit that discussion, but rather focuses on the inefficacy of the current approach to regulation. As much as international capital flows and macro policies may have played a role, the author wishes good fortune to those who would reform the international financial system or find a way to guarantee better macro policy. Also, there is no intention here to let bankers and others in the financial sector off the hook for responsibility, and one can only applaud the efforts, unsuccessful in the U.S. thus far, to encourage prosecutions, subjects on which this paper will not dwell.

Also an important clarification on terminology that is not inconsequential. The term ‘regulation’ as a shorthand for regulation and supervision, and ‘regulators’ is employed for regulators and supervisors. This will no doubt bother some readers. However, regulatory agencies shift back and forth their personnel working on regulations and those working on supervision, so it seems fair that authors have a similar flexibility. More importantly, what most care about is an effective regulatory framework, which results from a combination of the regulations themselves and how they are enforced. Rules without enforcement are tantamount to no rules at all. In the instance in which the act or process of ‘supervision’ (or ‘supervisors’) is the focus, that term will be used.

3 See the Letter to Her Majesty The Queen (http://www.ft.com/intl/cms/3e3b6ca8-7a08de-b86f-00144feabdc0.pdf), by Timothy Besley et al, July 2009. Interestingly, the perfect storm explanation was first seen in a number of letters that hedge fund managers send to their clients in the fall of 2007 explaining the unusual losses incurred. Some went so far as to state or imply that even if the history of the universe were re-run a number of times, events seen that summer still would not have been anticipated. An alternative explanation – that their models were wrong, in part by ignoring the increase correlation of risk – was not voiced until much later.

6 II. Where We Are, and How We Got Here Before getting to the story of how we arrived at the current approach to bank regulation, a few facts about the shape of the banking system around the world are warranted. The financial world in North Atlantic countries now, compared with that a decade ago, in many respects is markedly different as a result of the crisis and policy efforts to deal with it.

Around the world, we still see, as of 2011, tremendous differences in banking (and more generally, financial sector) development, shown in Figure 1 by the ratio of credit to the private sector relative to GDP. These differences reflect dramatic differences in the institutional setting, using this term in the sense of institutional economics and referring to the rules, laws, customs and other country characteristics that affect behavior. This figure then is a handy beginning, because a reminder of the substantial difference in countries’ institutions and stages of financial development raises cautions for any attempt to impose the same regulatory systems in every country.



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