1. Regulation since the Crisis: What has changed and is it enough?
Howard Davies
Director, LSE
ICEF Seminar
HSE Cultural Centre
29 November 2010

2. Six Topics Global Regulatory Architecture
European Regulatory Architecture
Basel 3
Derivatives
Bankers’ Pay
Governance

3. A. Global Regulatory Architecture

4. The Pre-Crisis Architecture

5. Six Problems with the System
Complexity
Built on the old three-sector model
Unrepresentative membership
US dominance
No single European voice
No authority or hierarchy

6. The Post-Crisis Architecture

7. B. European Regulatory Architecture

8. Ambassadors (legislative)
EU: Pre-Crisis
FSC
Financial
Services
Committee
EFC
Economic
and Financial
Committee
Council of Ministers
(ECOFIN)
European Parliament
European Commission
Council
Working Groups
(legislative)
CoRePer
Ambassadors (legislative)
Government Level
(Finance Ministries +
Observers from
regulatory level)
ESC
European
Securities
Committee
ARC
Accounting
Regulatory
Committee
EIOPC
European Insurance
and Occupational
Pensions Committee
EBC
European
Banking
Committee
EFCC
European
Financial
Conglomerates
Committee
AURC
Audit
Regulatory
Committee
Regulatory Level
(Competent
Authorities)
CESR
Committee of
European
Securities
Supervisors
CEIOPS
Committee of
European Insurance
and Occupational
Pension Supervisors
CEBS
Committee of
European
Banking
Supervisors
IWCFC
Interim Working
Committee on
Financial
Conglomerates
EGAOB
European Group
of Audit
Oversight
Bodies
3L3 Committee
ECB
Banking
Supervision
Committee
of the ECB
Central Bank Level
Outside Commission
Committee Framework 8

9. EU: Post-Crisis European Systemic Risk Board (ESRB)
Members of
ECB/ESCB
General Council
European Systemic Risk Board (ESRB)
(Chaired by President ECB)
Chairs of
EBA, EIA
& ESMA
European
Commission
European System of Financial Supervision (ESFS)
Banking
Authority
(EBA)
Insurance
(EIA)
Securities and
Markets
(ESMA)
National Banking
Supervisors
National Insurance
National Securities +
Information on micro-prudential
developments
Early risk warning
Macro-prudential supervision
Micro-prudential supervision
Source: De Larosière Report, February 2009.

10. So now we have
A more representative but (probably) less effective overarching body with highly diverse views
The same complexity below
A little more discipline in the system through the FSB, but with no new powers
A partial European reform
Weakened US leadership, but no replacement for it

11. C. Basel 3

12. A capital shortage: The charge: The response:
Banks were allowed to operate with too little capital. Leverage grew, and revenues were inadequate to cover losses when asset prices fell.
‘Basel 3’ will triple capital in the trading book, outlaw ‘soft’ capital, increase capital backing for securitizations and strengthen balance sheets generally. BUT will the reforms damage the system and make credit scarce and too costly?

13. Bank Balance Sheets expanded
Large-cap banks’ aggregate assets rose to 43x tangible book equity, 2000 – 2007
Source: Silverlake, Capital IQ.

14. UK banks leverage grew sharply from 2003 onwards
Major UK banks’ leverage ratio, %,
Note: Leverage ratio defined as total assets divided by total equity excluding minority interest. Excludes Nationwide due to lack of interim data.
Source: Bank of England, Financial Stability Report, Issue 24, 28 October 2008.

15. Investment Bank leverage grew
Leverage ratios,

16. Off-balance sheet vehicles: The Canary in the Coalmine
The charge:
The response:
Credit creation expanded off banks balance sheets, as banks took advantage of regulatory arbitrage opportunities to skimp on capital. Regulatory capital rules parted from the economic reality, as banks had to support these vehicles when they went under.
An economic approach, requiring on-balance sheet treatment of SPVs in future. BUT will this prevent any revival of the securitisation markets and thereby constrain credit unduly?

17. The growth of securitised credit
Securitisation issuance trends in the UK, £ Billion,
Source: The Turner Review. A regulatory response to the global banking crisis. March 2009.

18. Procyclicality The charge:
The response:
The capital rules tended to accentuate the cycle, allowing banks to hold less capital as asset prices rose, as back-testing revealed low losses and loss given default over previous years.
Macro-prudential requirements – which will allow regulators to tighten capital in anticipation of price bubbles bursting – ‘leaning into the wind’. Stress-testing. BUT how do we know when there is a bubble? Why not use interest rates ?

19. a. Tier 1 Capital a1. BASEL II: a2. BASEL III:
Tier 1 Capital Ratio = 4%
Core Tier 1 Capital Ratio = 2%
The difference between the total capital requirement of 8% and the Tier 1 requirement can be met with Tier 2 capital
a2. BASEL III:
Tier 1 Capital Ratio = 6%
Core Tier 1 Capital Ratio (Common Equity after deductions) = 4.5%
Core Tier 1 Capital Ratio (Common Equity after deductions) before 2013 = 2%, 1st January 2013 = 3.5%, 2014 = 4%, 2015 = 4.5%
The difference between the total requirement of 8% and the Tier 1 requirement can be met with Tier 2 capital

20. b. Capital Conservation Buffer
b1. BASEL II: 
No Capital Conservation Buffer
b2. BASEL III:
Banks required to hold a Capital Conservation Buffer of 2.5% to withstand future stress bringing the total common equity requirements to 7%
Capital Conservation Buffer will be met with common equity
Capital Conservation Buffer before 2016 = 0%, 1st January 2016 = 0.625%, 2017 = 1.25%, 2018 = 1.875%, 2019 = 2.5%
The purpose is to ensure that banks maintain a buffer of capital to absorb losses during periods of stress. When regulatory capital ratios approach the minimum requirement, constraints imposed on earnings distributions

21. c. Countercyclical Capital Buffer
c1. BASEL II:
- No Countercyclical Capital Buffer
c2. BASEL III:
A Countercyclical Buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances
Banks with a Capital Ratio lower than 2.5% will face restrictions on payouts of dividends, share buybacks and bonuses
Phased in from January 2016 to January 2019
Countercyclical Capital Buffer before 2016 = 0%, 1st January 2016 = 0.625%, 2017 = 1.25%, 2018 = 1.875%, 2019 = 2.5%

22. d. Capital for Systematically Important Banks only
d1. BASEL II:
No explicit Capital for Systemically Important Banks
d2. BASEL III: 
Systemically Important Banks should have loss absorbing capacity beyond the standards. Work continues in the Financial Stability Board and the Basel Committee
The Committee and the FSB are developing an integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingent capital and bail-in debt

23. D. Derivatives

24. “There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped make the banking and overall financial system more resilient.
The improved resilience may be seen in fewer bank failures and more consistent credit provision. Consequently the commercial banks may be less vulnerable today to credit or economic shocks.”
IMF Global Financial Stability Report
April 2006

25. Derivatives: The Problem
The capital value of global derivatives peaked at $760 trillion in June 2008 (equals last 20 years of global GDP!).
Derivatives, supposedly designed to spread and diversify risk, created new risks and caused financial instability.
The complexity of products was impossible for regulators, customers and even originators to understand.
Opacity created additional risks: when the crisis hit, no one knew who held the losses.

26. Derivative volumes quadrupled in five years
OTC derivative volume by product type, volume ($ Trillion),
Jun 2003 – Jun 2008
Source: The Turner Review. A regulatory response to the global banking crisis. March 2009.

27. Derivatives: Solutions
More capital in the trading book against derivative exposures (see Basel 3).
Central Counterparty (CCP). New margin requirements, standardised contracts.
(US) Dodd-Frank requires banks to move (some) derivatives out of banks.

28. E. Bankers’ Pay

29. Bankers’ Pay: Problems
Moral hazard: If the bank is profitable, the managers earn huge amounts, if it fails, the taxpayers pay: Heads they win, tails we lose.
Pay incentives drive risk-taking behaviour which can reward individuals in the short-term, but cause the bank losses in the long term.
Bankers are simply paid too much.

30. Bankers’ Pay: Solutions
Different regimes have been introduced by country:
EU: 60% of bonuses deferred for 3 – 5 years. Retention period for share-based incentives. Upfront cash capped at 20%.
UK: Additional proposals for disclosure of high earners’ pay. Bonus tax.
US: No detailed rules. 75% in shares for senior executives.

31. Why are bankers paid so much?
Lack of competition?
Winner takes all?
Insider dealing?
Opacity?

32. F. Governance

33. Financial Institutions Management and Governance: Problems
Bank boards did not understand the risks they were taking on.
Bank directors were often too old and too ignorant.
Risk management was undervalued.

34. Financial Institutions Management and Governance: Solutions
(UK) Bank directors interviewed by the FSA and assessed for competence.
(UK and US) Board-level risk committees now established.
Chief Risk Officers report to CEOs.
Regulators attention focussed on risk management.

35. Is it enough?
The ‘plumbing’ of the financial system and its regulation has been overhauled, but problems remain:
Highly complex regulatory structure with no central authority.
Many conflicts of interest.
Regulators still struggle to catch up with markets.
Global imbalances, which were at the heart of the crisis, persist.

36. Regulation since the Crisis: What has changed and is it enough?
Howard Davies
Director, LSE
ICEF Seminar
HSE Cultural Centre
29 November 2010