Finalising Basel III

After several years, Basel III has (almost) been finalised. Basel III is the third iteration of the Basel Accords, minimum international standards for prudential regulation of banks. It started after the financial crisis, when it was clear that Basel II was insufficient to ensure the solvency of the sector. Some bits of Basel III have already been implemented (buffers, liquidity regulation) but some others were still subject to discussion. This came to an end last December, one year later than promised. Now, apart from some details, the reforms have been agreed and there is a calendar for implementation. The document summarising these reforms can be found here. In the following weeks, I will go over some of them.

When I was at the Bank of England, I was involved in supporting the seniors in finalising Basel III, so this is also a small victory of mine. I am joking, it is not, and it certainly does not feel like it. The other policy work I was involved in was the regulatory treatment of sovereign exposures. The BCBS has also published a Discussion Paper on this (can be found here). They mention, however, that they are not consulting on it yet: there is no consensus regarding whether the existing treatment needs to be changed. This is disappointing in so many levels: after the European sovereign debt crisis, it should have been obvious that sovereign exposures are not risk-free. And I bet that, if the ECB had not stepped in (“whatever it takes”), we would already have changes in this. But it turns out that this ex-post interventions might also increase the moral hazard of policy-makers.

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Mankiw and Weinzierl 2011

While working on a project in its very early stages, I stumbled upon this paper by Mankiw and Weinzierl from 2011 in the Brookings Papers of Economic Activity. It is a very simple macro model with monetary and fiscal policy where the economy can hit the zero lower bound. I found this paper very interesting for two main reasons:

  1. it discusses a lot of issues (monetary policy through short-term rate vs long-term money supply, zero lower bound, role of fiscal policy) in a very simple framework; and
  2. this framework can be adapted to study the interaction of monetary policy with other policies—for instance, financial regulation—especially in the zero lower bound.

It is also quite thought-provoking to read the discussants and the general discussion: particularly useful to get ideas for future research.

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Post-crisis regulation and bond liquidity

One of the best blogs to follow about research on banking is the blog by the NYFed, Liberty Street Economics. In a recent post, they discuss the results of their JME paper on whether post-crisis regulation is affecting bond liquidity via constraints on dealers’ balance sheets. The question is very important to understand all the consequences of such regulations, both intended and unintended, which is key to evaluate them. The summary that they wrote is very nice so I will not add more than just to recommend the reading.

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What will happen with Dodd-Frank?

Post-crisis banking regulation seems to be under thread given the direction that the Trump presidency is taking on this matter. We have a US Representative asking Yellen to basically sit down and do nothing until the President figures out how he wants the new banking regulation to look like; we have the chair of the Financial Services Committee saying that Dodd-Frank is a disaster for the economy; and the President has asked the Treasury Department to review financial regulation.

What should we expect? There is little certainty (after all, this is Trump’s era) but one of the principles highlighted by the US President is to “prevent tax-funded bailouts”. A somehow optimistic view would suggest that the US might be dropping some of the restrictions imposed in the Act (many coming from the Volcker Rule) and maybe focus more on capital, in line with the Minneapolis Fed approach. This seems to be the FT preferred approach.

A less optimistic view, on the other hand, would suggest a clear walking back of many of the post-crisis regulatory reforms, lifting the restrictions of banks to engage in proprietary trading and investment-banking-type of activities, as well as reducing the amount of capital the largest banks need to hold. A key insight of the crisis is that banks were clearly undercapitalised relative to the riskiness of their balance sheets; walking back on these reforms is a clear sign that the policy cycle has shifted and that the “this time is different” myopia has come way faster than expected.

I finish by leaving Larry Summer’s views on the matter, which are interesting as always.

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QE – The story so far

Three months ago, Andy Haldane came to Cass to give the Dean’s Lecture. The lecture was about Quantitative Easing. It is now available on Youtube here, so enjoy! The working paper version of this work can be found here.

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Ending too big to fail

One of the most interesting sessions in Chicago during the last ASSA Annual Meeting was about ending too big to fail. Neel Kashkari presented the Minneapolis Fed plan and Markus K. Brunnermeier and Randall Kroszner gave their view on the plan.

The plan involves a massive increase in common equity requirements for systemic banks, to 23.5% in the first instance, potentially going up to 38%. Kashkari’s rationale for the plan is clear: the resolution framework, which should make bondholders absorb losses before considering a bailout, will not work in a crisis. Therefore, the total loss absorbing capacity of the bank should be formed of common equity.

For the resolution framework to work it needs to be credible. If nobody believes it will work—i.e., if nobody believes that the junior bonds will absorb losses if the bank enters into resolution—prices will not incorporate this possibility. You need a critical mass of market participants to anticipate the losses. If that is not the case, once a supervisor tries to trigger losses on bondholders we can have an extreme re-pricing of other bonds, potentially leading to a negative contagion effect.

So is the resolution framework credible? Unfortunately, we might only find out in a crisis. Even if some bondholders absorb losses in some cases—for instance, Banco Espirito Santo—these are typically not full-blown crises but instead individual failures. And even in such cases, the political appetite does not seem to be imposing losses on bondholders, such as with Monte Paschi de Sienna.

If the resolution framework is not credible, Kashkari argues, we should make sure that all loss-absorbing capacity is made up of common equity rather than junior and senior bonds. Hence, for systemic banks, the equity requirement should be around 23.5% of risk-weighted assets, similar to the phased-in TLAC requirements plus Basel III buffers (18% + 2.5% CCoB + GSIB buffer + CCyB).

The requirements would continue to increase up to 38% as long as the bank continues to be systemic. Interestingly, the net benefits of the first step (23.5%) are higher than those of the second step (38%). If the cost-benefit analysis is credible, they should then stop at 23.5%, but Kashkari justified going up further by claiming that systemic crisis and bailouts have broader costs than just output losses: for instance, political polarisation and social unrest. For this reason, he said, they wanted to decrease the probability of such crisis below 10% in the next 100 years.

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The “crisis” of economics

Andy Haldane, chief economist at the Bank of England, has recently repeated the claims about the crisis of the economics profession. I have discussed this issue with many people since the financial crisis, and I was going to write something about it here, but David Miles did it first and much better in the FT today. A must read.

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