Guy Hargreaves ACE-102

Recap of yesterday Key risks managed by banks Tools used to manage bank balance sheet risks Pros and cons of regulations for balance sheet risk management 2

Today’s goals Appreciate the reasons for strong bank regulation Understand the history of bank regulation Describe the typical types of financial crises Discuss the causes and effects of the GFC Appreciate the impacts of financial crises on the real economy Review current and future proposed bank regulation 4

Why do we need bank regulation? Financial systems suffer periods of instability Business cycle, fundamental changes, technology can all cause instability The banking sector is vulnerable to this instability due to its in-built high leverage An unstable banking system can cause “bank runs” when depositors lose confidence Central bank regulation of banks and the banking system is vital to minimise the chances of banking system instability and to protect bank customers 5

Types of bank regulation Bank regulations come in the form of either Systemic Regulation of Prudential Regulation Systemic regulation is usually: Government deposit insurance Lender of last resort Prudential regulation is usually: Capital rules Liquidity rules Code of conduct 6

History of bank regulation Each local financial system has its own history of bank regulation Globally a number of major regulatory milestones have had widespread impact: 1933 Glass-Steagall – separation of Investment and Corporate Banking in the US (largely repealed in 1999) 1988 first Basel Capital Accord “BIS I”. Concept of Tier 1 (Equity) and Tier 2 (sub debt, hybrids, other) and Risk Weighted Assets (RWAs). Tier 1 + Tier 2 capital = 8% * RWA 1996 second Basel Capital Accord “BIS II”. Three “Pillars” – 1: capital, 2: supervisory review, 3: disclosure 7

BIS II Currently the “global” banking system is supposed to be operating under BIS II Pillar 1: Risk Weightings aligned to actual expected credit risk Credit risk calculation could be “Standardised” or “Internal Ratings Based” Market and Operational risk also included Pillar 2: Boosting regulatory powers to review and supervise banks Pillar 3: More disclosure of risk, capital adequacy and risk management 8

Financial Crises There are many types of financial crises, including: Banking crises Currency crises Speculative asset price bubbles Economic crises GFC was mostly a banking crisis but it came from a speculative asset bubble Economic crises are usually deep recessions or depressions where GDP falls sharply 9

Banking Crises Loss of confidence in a bank or number of banks leading to bank run where depositors withdraw funds rapidly Often associated with periods of poor lending decisions leading to high loan portfolio loss provisions High leverage in the banking system means confidence is fragile Small loan losses can quickly turn into a banking crisis 10

Currency Crises A large increase in country risk can cause foreign investors to lose confidence in the country Country risk might come from a local economic crisis or perhaps political change Foreign investors will sell a currency quickly if they lose confidence 25%+ fall on relevant FX rate Often the Central Bank will try to support the currency by increasing local interest rates 1997 Asian Currency Crisis is classic example of currency crisis – began in Thailand and flowed across the region 11

Currency Crises - IDR 12 Indonesian Rupiah – USD FX rate:

Speculative Asset Price Bubbles A speculative asset price bubble is a large increase in the price of an asset, often over longer periods, which leaves the asset valuation out of line with underlying fundamental valuations Dutch tulip bubble of Wall St crash 1980s Japan property bubble Late 1990’s “dot-com” bubble US housing price bubble Bubbles usually end with a large price crash! 13

Global Financial Crisis 14 GFC had its roots in US property prices

Global Financial Crisis 15 US property prices from 1987:

Over-investment in property Both US Agency lenders (Fannie Mae and Freddie Mac) lent aggressively to US home buyers in Securitised lenders also lent aggressively over this time – Investment Banks arranged funding of their using securitisation Loans for “sub-prime” borrowers were made at 100% LVR! By 2006 the US property market was a bubble financed by lenders and investors all over the world, often using large amounts of leverage 16

The property bubble bursts In 2006 the US property market bubble burst and mortgage borrowers started defaulting in large numbers Banks had massive exposure to the mortgage loan business through loans and securitised products By 2007 banks around the world were reporting huge losses and confidence in the global banking system had collapsed Extraordinary measures were taken by 2009 to rescue the system USD 700m TARP recapitalised the US banking system USD short term interest rates were lowered to near 0% Banks and insurers were forced into mergers or government ownership Etc etc! 17

Fed Funds 18 Fed Funds lowered to historic levels:

Impact on the “real economy” 19 US GDP growth collapses during the crisis:

Impact on the “real economy” 20 US unemployment rises sharply from 2008:

Impact on the “real economy” 21 US automobile industry goes bankrupt and needs government bailout AIG – large international insurer - nationalised Bank of America forced to buy Merrill Lynch Property market collapse worsens US government injects USD2 billion+ into the economy through fiscal measures Etc etc!

Conclusion: improve bank regulation 22 The wasn’t just a US crisis – Europe has had enormous problems as well Result was fast track Basel / BIS III US passed “Dodd Frank” law Reduce bank trading Increase derivative transparency through clearing Allow for orderly bank closures Rid system of “too big to fail” Reform mortgage market Toughen consumer finance protection laws

BIS III Required Capital – increase required capital – Tier 1 up from 4% to 6% Introduce Leverage Ratio – ratio of Tier 1 capital divided by “total exposure” to be a minimum of 3% Introduce Liquidity Cover Ratio – High quality liquid assets divided by net cash outflow over the next 30 days >100% Introduce Net Stable Funding Ratio – Long Term Stable Funding divided by Long Term Assets (> 1-year) > 100% 23

BIS III Introduce counter-cyclical capital buffers – increase capital in good times so banks have more protection for bad times Strengthen risk frameworks across a lot of areas of the banks eg: Credit Valuation Adjustment (CVA) for swap counterparty risk management OTC derivative clearing through centralised exchanges BIS III is costly for banks and will be less efficient (ie a burden for the global economy) - but should strengthen the banking system Timetable for introduction

Banking of the future? Banking in the future may look nothing like the past! Same basic functions of financial intermediation and direct finance will probably exist “Fintech” or Financial Technology is changing the banking landscape dramatically 2000: 300M internet users mostly on dial-up 2015: 3,000M internet users mostly on 4G smartphones Cryptocurrencies – what if Bitcoin is the future? P2P decentralised “trustless” “currency” No Central Bank can control supply of cryptocurrencies The “Blockchain” may change banking forever! 25

Fintech at a glance 26

Fintech is the place to be! Retail branch banking will die out with our parents! Everyone has a smartphone and can use it to bank Banking has been slow to change and adopt technology in the past 20 years Disruption is the BIG economic theme of the 2010s and probably the next two decades Think Uber, Paypal, iTunes Store, Amazon, Alibaba, Tencent 27