Introduction
$10,000,000,000,000. The global cost of the credit crunch to date.
Lord Turners much anticipated report into the financial crisis was published on the 18th of March 2009. In it he discusses the causes of the crisis and gives key recommendations toward changes that should be implemented to correct the lapse in regulation that allowed the crisis to happen.
In all lord Turner makes 32 recommendations over 14 categories. These categories are listed below in . For the sake of coverage provides an account of what effects each recommendation will have on stability. These recommendations are designed to move regulation toward emerging systemic risk trough the use of macro prudential tools. As a package these recommendations include changes in policy, regulations and whose responsibilities these should be as well as the tools which should be implemented in order to drive these recommended changes.
In this report I will look to analyse how effective a select few of these recommendation, if implemented will be in providing future stability to the banking sector.
These recommendations come as a complete package where anyone of them has merit but cannot be expected to provide any real economic benefit if not implemented alongside the majority of the others. In addition to this globalisation has ensured that the implementation of these recommendations will have little effect if other countries do not adopt similar protocols. This is a view that the report subscribes to and tackles from both a global and EU perspective.
From I will discuss in detail the fundamental changes recommended regarding capital, accounting and liquidity, deposit insurance, credit default swaps, remuneration and cross border banking.
Capital, Accounting and Liquidity
Quantity and quality of capital
The Turner Review identifies the importance of treating adequate capital as a going concern, proposing an increase in the quality and quantity of capital held by banks of systemic importance, creating a greater focus on Core Tier 1 and Tier 1 capital.
Lord Turners report suggests a minimum regulatory requirement significantly above existing Basel rule should be implemented. The current ratio of total capital could be replaced with a new structure of 4 per cent Core Tier 1 and 8 per cent Tier 1 or alternatively by increasing the risk-weightings applied to assets for an optimum ratio.
The Turner Review highlights that international co-ordination and agreement on these capital requirements is necessary and should not be implemented until the economic cycle is stable.
This will stabilize the banking sector as it will reduce the probability of future banking failures. The system will also be able to absorb shocks better and prevent economic harm by retaining the ability to extend credit onto the economy. This proposal will mean that returns on equity will be lower resulting on a lower risk in the banking sector.
There is evidence however that the proposed recommendations may not be as effective in stabilising the banking industry as hoped. In a paper by Diamond and Rajan (2005) it was argued that:
An increase in capital requirements can cause a credit crunch for the cash poor and alleviate the debt burden on the cash rich; greater safety has adverse distribution consequences.
In addition to this Eichberger and Summer (2005) who carried out a study on the effects of capital adequacy regulations on the banking sector concluded that the introduction of capital adequacy regulations could actually increase the level of systemic risk and could not guarantee a reduction in risk exposure.
The trading book capital
The Turner review highlights the inadequacy of the Value at risk (VAR) methodology in measuring trading book risk as it fails to give a true reflection of the risks to banks at system level and generates procyclical behavior. The VAR method the not a reliable method of measuring trading book risk as there is no single set of parameters, data, assumptions and methodology that is accepted as the correct approach (Beder, 1995)
The Turner Review stresses the importance of the Basel proposals that will be implemented in late 2010, including the incremental credit risk charge and stressed VAR. The FSA however, proposes that a more radical approach need to be taken by reviewing risk measurement in the trading book. By defining the assets appropriately booked in the trading/banking books, VAR rules and whether approaches should vary according to trading book activity.
Pro-cyclicality and counter-cyclical buffers
In a system that is based on risk sensitivity it is inevitable that Procyclicality will exist at one level or another. During a downturn the quality of credit deteriorates and requirement for capital rises. The Basel II capital regime was introduced to the UK in early 2008, however the framework has "excessive" pro-cyclicality tendencies (de Larosiere report, 2009)
The Basel II framework uses point of time to estimate credit risk which uses market based information such as share prices to measure risk. This type of empirical approach typically produces cyclical and volatile measures of default risk, reflecting market behavior (Illing and Paulin, 2005).
The Turner review recommends a shift toward a through the cycle method of estimating credit risk to avoid the Basel 2 regime creating undue procyclicality. This approach measures the expected performance of an asset based on a plausible convergence of adverse events. Because of this the parameters to the approach are normally constant. This produces a stable measure of exposure to credit risk over the economic cycle.
Turner also recommends that counter-cyclical buffers should be introduced in order to offset unavoidable impact elsewhere, by creating capital buffers. The creation of counter-cyclical buffers may significantly reduce the procyclicality impact of the Basel II frameworks, by lowering capital requirements in good economic times when loan losses are below long run averages, creating capital buffers which would be drawn down in recession years as losses increase.
This notion is supported by the FSF (2009) as they suggest that:
countercyclical capital buffer will make the banking sector more resilient to stress and contribute to dampening the inherent procyclicality of the financial system and broader economic activity.
The benefits of this recommendation are similar to those discussed in the next two subsections.
Offsetting Procyclicality in Publish Accounts
The current accounting system in the UK is one which looks to provide raw facts regarding a businesses financial performance in to the public domain. This is done so through best estimates of financial positions at key dates.
The turner report highlights the advantages and disadvantages of this current method stating that the current system fails to provide for regulators and systemic financial risk. These failings were evident during the crisis through irrational exuberance fuelling higher published profits and the drying up of seemingly liquid markets when too many firms tried to liquidate their assets.
Lord Turners recommendation is to include future losses in the annual reports of financial institutions. This would be achieved through the introduction of an Economic Cycle Reserve (ECR) where the appropriate amount of profits in good years would be set aside to compensate for the predicted losses in future years. The FSA hope that the introduction of the ECR into the procyclical banking industry (Berger and Udell,2004) will help create a buffer for future losses.
An approach similar to this was adopted in Spain called dynamic provisioning. Since 2000 Spanish banks have been provisioning against the credit risks appearing in their balance sheets. This meant that by 2007 as the economy started a downturn the provisions covered 1.3% of the countries consolidated assets. This provided the banks with protection against their losses for a period (Jess Saurina, 2009).
The recommendation to adopt this anticyclical approach in the UK could help to deal with the procyclicality in banking and help increase the stability of the financial sector through earlier detection of losses in loan portfolios.
Leverage ratio backstop
The current risk based measures set out in Basel 1 and 2 can create situations where banks balance sheets are increasingly levered due to the exposure on low risk weightings requiring only small amounts of capital to be set aside. The crisis has shown that assets perceived to be low risk due to their liquidity can become highly illiquid in the presence of systemic risk. It is accepted that this excessive leveraging in banks helped cause the financial crisis.
Lord Turners recommendation is for the inclusion of a gross leverage ratio. This can be used as a prudential tool to control for: banks balance sheets growing too large with leverage and reducing regulatory arbitrage. However the report recommends the maximum leverage ratios a backstop against lenient treatment.
It has been shown that risk sensitive capital requirements cannot be provided by banks independently (Blum, 2008). This study explains that when threatened with a penalty banks will lie about their leveraging to avoid incurring it. The introduction of a leverage ratio can eliminate the benefit of a company misinterpreting their risk as companies who announce themselves as risky must have enough capital to avoid financial distress. This value is below the leverage ratio so these banks will hold the minimum leverage ratio in any case leaving the leverage ration non binding.
Because of these characteristics the gross Leverage ratio restriction could control against the risk of lenient treatment from regulators as it would ensure that the truthful discloser of risk is the optimal strategy.
Containing liquidity risks
The turner reports final recommendation regarding capital, accounting and liquidity is the introduction of a core funding ratio. This tool would work much in the same fashion as the leverage ratio and act as a ceiling as to how much asset growth a company can fund through unstable sources.
This will be achieved by banks core funding being built with long term wholesale funding in appose to the short term money market instruments that were used in the run up to the crisis. This will help ensure stability by minimising against the systemic risks that occur in liquidity when multiple firms try to liquidate their positions.
Other important regulatory changes
Credit Default Swaps
The years previous to the crisis have seen a rise in the value of over the counter derivative (OTCs) contracts traded especially credit default swaps (CDS). This has created new challenges for prudential regulators as OTC transactions are not always cleared through clearing houses. This has increased the difficulty in measuring counterparty risk which has only aggregated the daisy chain effect (Calomiris, 2009). This lack of transparency not only creates risk management problems but also problems for regulators as they cannot control or measure individual institutions risk or aggregate risk using macro prudential analysis as risk cannot be measured effectively.
The Turner Review addresses concerns about the size and complexity OTC derivatives market and provides recommendations to reduce systemic risk and provide additional transparency in the credit derivative market. The Review proposed that in order to cover the standardized OTC contract which accounts for the majority of CDS trading, clearing and central counterparty systems should be developed.
The FSA strongly supports the objective of achieving robust and resilient central clearing house arrangements for CDS clearing and has been working with other regulatory authorities in the US and Europe and potential market infrastructure providers to facilitate this progress.
In a similar nature to the Turner Report the de Larosiere report (2009) recommended that OTC derivatives should be both simplified and standardized. In the short term, focus should be made to mitigate counterparty risks by the introduction of well-capitalized central clearing houses for CDS in the EU. In addition the de Larosiere report (2009) recommends that issuers of complex securities should retain underlying risk that is non-hedged. This will help to restore confidence in securitized markets by containing the risk. In practice clearing can reduce counterparty risk exposure as it allows positive and negative counterparty exposures to be netted against each other more easily. An effective clearing system mitigates systemic risk by reducing the probability of defaults proliferating from one party to another.
It is recommended that greater transparency of risk can be achieved through the introduction of clearinghouses. This is because the clearing house assumes the counterparties bilateral risk therefore mitigating the difficulties involved in measuring counterparty risk and the daisy chain effect. This should allow regulators to measure the risks taken on by counterparties creating a more stable banking sector.
Clearing houses for derivative trading can result in effective banking systems as clearing houses that act as counterpartys can diversify and mange the risks associated with the failure of individual parties and easily absorb failures as long as they have sufficient guaranteed funds. If a dealer uses a clearing house then all the exposure in the contracts which are cleared are netted. The OTC market only allows netting contracts with a single counterparty. Therefore, clearing houses can reduce total counterparty exposure. This can improve the stability of the banking system (Stulz, 2009).
Clearing houses could further improve this stability due to their relatively low default risk which would translate into an increase in market confidence. However, as the number of clearing houses increases, so too will the total exposure they will pose to their counterparties. This will increase the number of systemically important financial institutions whose risks must be monitored by regulators. Recent research by Duffie and Zhu (2009) suggests that, for the current structure of OTC derivative markets, assigning clearing houses to credit default swaps increases the mean counterparty exposures when all types of over-the-counter derivatives are considered. This is because of the reduced opportunity to net credit derivatives exposures against other over the counter derivatives exposures (Duffie and Zhu, 2009).
Although clearing does not require exchange trading, it has been suggested that CDS trading should be conducted only on exchanges, which offer clearing as well as superior price transparency. The prices and quantities of each trade would become publicly available. Of course, as usual for exchange trading, the counterparties to trades would remain private, just as they are in the over-the-counter market. The benefits of exchange trading, however, are to be traded against the benefits of innovation and customization that are typical of the over-the-counter market.
Remuneration
While not a direct cause of the financial crisis, remuneration has been at the forefront of public outrage over its handling. Public disgruntlement over bankers earning rewards for investments which turned toxic in the long term and city bankers retaining pensions in the light of record losses1 has contributed to the Turner reports recommendations on remuneration.
While the public focus has been upon the unfair rewards for poor performance there is a darker side to certain remuneration packages such as executive compensation which can create incentives for bankers to take greater risks. It is this side of remuneration that the Turner report addresses.
The logic behind compensation is to attempt to tie performance to pay so as to encourage managers to work hard to increase the companys share price. In the past the FSA has paid little attention to the remuneration packages issued by companies. As a result the Turner report highlights areas of improvement like compensation being better tailored to companies effective risk management and awards to be made on overall performance rather than financial metrics.
However the use of certain remuneration packages could be argued to have been at least partly responsible for the crisis through providing managers with risk incentives. By tying mangers compensation pay with performance it provided them with an incentive to work hard to earn more. However it is possible to earn more by using riskier investments as risk and return are positively related as discusses 40233 The additional risk adopted by the manager represents a potential reward if it pays off but no penalty if it fails as their compensation is over and above salary. This is a view that has been empirically endorsed by academics (Rajgopal and Shevlin, 2002) who identify an increase in risk taking in the presence of a remuneration reward like executive stock options.
In order to better control of these negative effects the Turner report has suggested that the bulk managers rewards be deferred or vested2 based on the level of risk inherent to the return. It has been suggested that this vesting period will allow banks to reclaim the compensation should the investment become toxic3. In addition to this vesting period the FSA will now take a more active involvement in the risk mitigation of remuneration policies.
Cross Border Regulation
In the pre crisis days there existed a system, as there still does, where by foreign banks were able to conduct business in other countries (passporting). This was a contributing factor to exacerbating the crisis.
Previously the duty of regulating these foreign banks fell to the home nations regulator and not the host nations. It was the responsibility of the home nation to ensure the prudential soundness of each bank. If this was the case the bank was permitted to conduct cross border business. This meant that host nation savers were exposed to the risk of defaulting banks when the home nation regulator was unable to effectively regulate or offer sufficient deposit guarantee schemes. This was the case with banks like Lehman brothers and Landsbanki whose home nations allowed them to fail at a cost to host nations.
It is clear that these current arrangements provide neither a sufficient level of regulation over cross border banks or procedures for mitigating the negative impact of their failure. The Turner review has identified an increase in; international cooperation and the focus on local legal entities as ways of preventing similar occurrences.
The Turner review recommends that this increased international cooperation can be achieved through improved communication between the regulatory bodies of the home and host nation. In order to facilitate this increase in communication the FSA will create a College of Supervisors for the 30 largest foreign banks. These colleges will look to exchange information such as analytical findings on the risks the company is undertaking and ideas on how to off set this risk.
The report highlights that this increase in international cooperation must be built upon a subsequent increase in national focus on legal entities. Lord Turner suggests this can be achieved through collecting information on the entire banking group rather than each specific branch operating in the UK. This wider scope of information would be used to enforce better liquidity requirements on these UK branches or even to enforce them to operate as UK subsidiaries. These better liquidity requirements will be achieved through improved quality and quantity capital requirements as specified in basel 2.
The hope is that the use of the college of supervisors will identify banks which could pose a risk to home nation savers. When this risk is identified the regulator will enforce the requirement that the bank meet certain liquidity requirements outlined in section 1 and/or operate as a UK subsidiary.
These precautions mean that any future liquidity problems faced by the bank or market can be accommodated for by reserves allowing banks to see themselves out of slumps rather than requiring lender of last resort intervention. In addition should the bank eventually fail the winding up of the bank can be conducted under UK bankruptcy laws therefore reducing the systemic effects to the economy.
Deposit Insurance
This new approach of increased international cooperation and national focus through improved communication and higher liquidity standards will improve the over all stability of the banking industry. However the natural business cycle will still lead certain banks into insolvency (Platt and Platt, 1994). Therefore these regulations need to contain contingencies for any failures. This has been looked at in part by the focus on forcing cross border operations to operate as UK subsidiaries. However specific legislation exists for the protection of the banks customers, namely its depositors.
During the early days of the crisis the UK government fully insured up to 2000 worth of retail deposits at any given bank and 90% up to 35,000. The idea for this was simple. Banks are expected to use the money deposited by creditors to finance investments and lending activities with debtors. This works on the premise that only a small percentage of creditors will want to exercise their financial claim at any given time1. In the absence of this premise the bank is exposed to liquidity risk as discussed 40334. Should liquidity risk be perceived by the banks customers a run could develop on the bank. This will require the bank (who holds roughly 8% of its value liquid) to borrow money from other banks through the inter-bank-market, which due to systemic risk could have an adverse effect on other banks. The inclusion of retail deposit insurance should in theory offer consumer protection and increase confidence and financial stability1.
This however was not the case for Northern Rock whose bank run led to its eventual nationalisation. This was caused in part by a lack of understanding in the British public toward retail insurance. To tackle this ignorance the FSA has proposed a communication plan in order to educate the public for the future, this education should help to improve stability by increasing consumer confidence in retail bankings safety1.
As an additional response to this as part of the new regulations, the Turner report has suggested (and already implemented by the FSA) that the deposit insurance thresholds be increased to 100% coverage up to 50,000 with consumer panels arguing for unlimited coverage to ensure customer protection and market confidence. However while this would give depositors complete piece of mind it may not provide the financial stability that is sought in future years.
I look at past empirical research to evaluate what effects past introductions of depositor insurance or its revamp had on banks behaviour and overall financial stability. First I looked at a study which evaluated the effects of the introduction of depositor insurance (DeLong and Saunders, 2008). They employ a 2 factor model to calculate weekly CAR of 60 institutions pre and post the 1933 introduction of fixed depositor insurance in the US. We have used factor models before in 40436 as a result I am able to interpret that the decreased R2 value post event means that banks took on additional risks. A similar study was undertaken by Ioannidou and Penas (2010) who come to similar conclusions and add that the increased risk undertaken post event is not off set by an increase in collateral arrangements or reduced loan maturity. Both papers do however record a decrease in depositor discipline. This loss of customer preference between banks increases stability as large banks are no longer deemed safer to deposit with. However Ioannidou and Penas (2010) do suggest that this increased stability in the first place is what motivates banks to take greater risks in the first place, thus creating a self deprecating loop.
As such the recommendation of an increase in depositor insurance may offer the UK economy stability in the short run but the use of regulations imposed on cross border and home banks alone cannot be expected to be a deterrent to risk taking.
References
1. Buckle. M, Thompson, J. The UK Financial System; Theory and Practice.
A.N. Berger, G.F. Udell (2004). The institutional memory hypothesis and the procyclicality of bank lending behaviour. Journal of Financial Intermediation 13 458495
