Assessing a decade of financial regulation Sound at last? Assessing a decade of financial regulation Xavier Vives Director Banking Initiative IESE Business School Brussels, June 20, 2019

Xavier Vives

Banking industry in the aftermath of the crisis Since the global financial crisis regulation and supervision improved: Banks are better capitalised. Authorities now pay more attention on systemic risk. On the other hand, advanced economies are also experiencing high sovereign debt to GDP ratios and very low persistent levels of interest rates. Authorities lack necessary political support to take forward the reforms and appropriate regulation. Sufficient powers to deal with major crises in doubt ‘End bailouts’ is the political reaction to the past crisis. Completion of the Banking Union in the Eurozone is still under discussion and unrealistic commitments to end bailouts undermine it. Credibility of regulators is at stake: Politics as the very source of instability.

Looking forward The next global crisis may have different origins, possibly: In entities that perform the functions of banks but are outside of the regulatory perimeter. In an emerging market where regulation could well be different from the reformed patterns of the West. Challenges Incumbent banks must adapt to digital disruption and to the increasingly competitive environment it created. Regulators must maintain a level playing field and protect financial stability while allowing the benefits of innovation to permeate the system. Shadow banking and new digital competitors are a threat to incumbent banks. Stricter regulations and higher compliance costs make entry difficult: Increasing the tendency for market concentration, potentially aggravating ‘too big to fail’ concerns.

Assessing a decade of financial regulation Sound at last? Assessing a decade of financial regulation Regulatory Reform: Basel III and Beyond Resolving TBTF An Enlarged Role for Central Banks

Assessing a decade of financial regulation Sound at last? Assessing a decade of financial regulation REGULATORY REFORM: BASEL III AND BEYOND Observation: Narrow banking is not a ‘magic bullet’ The inherent fragility of the banking core function would resurface elsewhere in the financial system.

Prudential Regulation (I) Prudential regulation should take a holistic approach setting requirements for capital, liquidity and disclosure together, taking account of their potential interactions, including the competitive conditions of the industry. Stress tests are very useful if well designed: Need to be severe, flexible and not overly transparent. Need to incorporate a systemic perspective. Main lesson from the euro area: effective stress tests can only be implemented when there is a backstop for the banking system.

Prudential Regulation (II) Capital: Requirements & levels are up, but enough? Liquidity: One requirement may be enough  LCR Non-banks: Need of a framework to monitor, assess, designate, regulate & supervise

Capital Requirements: Risk-weighted and Leverage Ratio RWA: 2009: 5.7% 2018: 13.9% Leverage ratio: 2009: 2.8% 2018: 5.8% Basel Committee Quantitative Impact Study (QIS) estimated ratio of common-equity tier 1 capital to risk-weighted assets or tier 1 capital to total assets using fully phased-in Basel III definitions. Data from 2011 to 2018 are from a consistent sample of 66 large internationally active banks with tier 1 capital in excess of €3 billion.

Comparing Basel III & Basel II Risk-weighted Capital Requirements   Basel III range 8% to 10% Basel II Baseline 4% Adjustment for hybrid capital -2% Adjustment for goodwill, intangibles, deferred tax assets, etc. -1% Adjustment for changes in risk weights -¼% Effective Basel II converted to a Basel III basis < ¾% Basel III >10 times Basel II! MREL, TLAC

Liquidity Requirements: Some Balance Sheet Arithmetic Assets Liabilities Liquid Runnable Illiquid Stable LCR: Liquid ≥ Runnable NSFR: Illiquid ≤ Stable

Non-bank Intermediation Global financial system assets by sector 2007 to 2017: Globally: Banks  (48% to 44%) Nonbanks  (31% to 36%) Financial Stability Board (2019), monitoring dataset.

Non-bank Intermediation For entities outside the perimeter of regulation, authorities require a framework to: Monitor Assess Designate Regulate Supervise