The Fundamental Principles of Financial Regulation Geneva Report by Brunnermeier, Crockett, Goodhart, Persaud and Shin

Background We have observed a cycle of financial leverage and then deleveraging (asset price bubble and bust) We argue that The regulatory framework of Basel II and IFRS amplified this cycle, producing ‘procyclicality on stilts’. This occurred because Basel regulation is too focussed on micro-prudential oversight: improving the condition of the individual bank It is a fallacy of composition to believe that, if each individual institution behaves ‘prudently’, the system as a whole will be safe.

Endogenous risk Indeed most systemic crises arise because of the responses of the banks, and other financial intermediaries, to exogenous shocks, not just from such latter shocks. Two main such self-amplifying mechanisms are the loss spiral and the margin spiral.

Repo Haircuts Source: IMF GFSR

Capital requirements for systemic risk Our theme is that the Basel approach (Basel I and II) has focussed excessively on the risks of individual banks; Micro-prudential rather than macro-prudential Valuable but insufficient. Measures of systemic cyclical variation:- 1) Leverage (FDICIA; SNB) 2) Credit expansion (Banco de Espana) 3) Maturity Mismatch We suggest all three.

Applying capital requirements for systemic risk How applied :- Provisions (Spain) Separately to capital (FDICIA; SNB) Interactive with Basel II (US) (Helps to avoid ‘gaming’) But which Basel ratio? Details and coefficients to be estimated. Absolute need for precommitment/rule, and graduated ladder of responses.

To whom should such capital requirements apply? Taxonomy (a) Individually systemic (identify in advance, if possible) (b) ‘Systemic as part of a herd’ (c) Non-systemic, but large (d) Tinies Main problem is (b), largely hedge funds. Macro-prudential, but also micro-prudential? Home/host issues: Cycles differ from country to country. Also cross-border banks are “international in life, but national in death”.

Liquidity Financial risk arises from a combination of asset price volatility and maturity mismatch. Both the asset and liability structure are crucial. Crisis arose from excessive confidence in continued ability to fund, or roll-over, in short-term wholesale financial markets.

Proposed liquidity regulation Need for liquidity regulation based on maturity mis-match, enforced by explicit capital charges Proposal on ‘Mark to Funding’ The ability to hold to maturity depends on funding structure Problem: incentives to finance potentially illiquid assets on the basis of short-term debt, both in good and bad times We need to counter-balance that

Other regulatory issues (a) Remuneration Supervisor should set higher capital charges for more risk-promoting remuneration schemes (b) Loan-to-Value Ratios in Mortgages (c) Credit Rating Agencies (d) Year-end Spikes

The structure of regulation We advocate enhancing macro-prudential regulatory requirements to support and to accompany existing Basel micro-prudential requirements. The two involve a different ethos and professionalism:- Macro-prudential Central Bank Micro-prudential FSA Cross-border, home/host issues Cycles differ between countries Common Principles, differing application Europe? FSF Problems (1) Democratic legitimacy (2) G7 representation (3) Warning procedure