Recovering from the Global Financial Crisis

Recovering from the Global Financial Crisis

Achieving Financial Stability in Times of Uncertainty
Marianne Ojo

Recovering from the Global Financial Crisis: Achieving Financial Stability in Times of Uncertainty Copyright Business Expert Press, LLC, 2013. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any meanselectronic, mechanical, photocopy, recording, or any other except for brief quotations, not to exceed 400 words, without the prior permission of the publisher. First published in 2013 by Business Expert Press, LLC 222 East 46th Street, New York, NY 10017 www.businessexpertpress.com ISBN-13: 978-1-60649-700-5 (paperback) ISBN-13: 978-1-60649-701-2 (e-book) Business Expert Press Finance and Financial Management collection Collection ISSN: Forthcoming (print) Collection ISSN: Forthcoming (electronic) Cover and interior design by Exeter Premedia Services Private Ltd., Chennai, India First edition: 2013 10 9 8 7 6 5 4 3 2 1 Printed in the United States of America.

Dedicated to my mother, father, and the entire familyfor their continued and never ending support. Also specially to Flo, my soul mate, love of my life and incredible lifes partner, whose inspiration, love, support and faith in my abilities, has helped in overcoming many challenges and also in achieving our goals and dreams during our journeys and life experiences. Last but not the least, to the Almighty heavenly Father who provided this opportunity and also those wonderful people who have contributed immense efforts in generating a book which is aimed at producing ideas and solutions in addressing one of the most challenging nancial crises experienced in modern history.

Abstract
Why are some global nancial crises more difcult to recover from and overcome than others? What steps are necessary in ensuring that nancial stability and recovery are facilitated? What kind of environment has the previous nancial environment evolved to and what kind of nancial products have contributed to greater vulnerability in the triggering of systemic risks? These are among some of the questions which this book attempts to address. In highlighting the role and importance of various actors in post-crises reforms as well as the huge impact of certain factors and products that are contributing in exacerbating the magnitude and speed of transmission of nancial contagion, the book provides an insight into why global nancial crises have become more complicated to address than was previously the case. Whilst considering and highlighting why matters related to procyclicality and capital measures should not constitute the sole focus of attention of the G20s initiatives, the book is aimed at identifying other important issues such as liquidity risks and requirements which have constituted, to a large extent, the focus of international standard setters and regulators. It also aims to direct regulators, central bank ofcials and supervisors, academicians, business and legal professionals, and other relevant interested parties in the eld toward current and previously ignored issues such as the cartelization of capital markets. The need and concern for increased regulation of bond, equity markets, as well as other complex nancial instruments which can be traded in Over-the-Counter (OTC) derivative markets is evidenced by Basel IIIs focuswhich is addressed in the book. Cartelization and organized activities, relating to rate rigging in global capital marketsas evidenced recently by sophisticated Euro Interbank Offered Rate (EURIBOR) and London Interbank Offered Rate (LIBOR) rigging practices and occurrences, are also covered. The aims and objectives of the book would not be complete by merely identifying and highlighting the general root causes of global nancial crises and the current issues. Hence each chapter will also

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ABSTRACT

recommend (as well as bring to the fore) measures that should be (and have been) put forward in order to address the issues and factors that contribute to the magnitude and severity of global nancial crises.

Keywords
nancial stability, procyclicality, supervisors, systemic risks, counterparty risks, shadow banking, Basel III, capital, liquidity standards, over-thecounter derivatives, central banks

Contents
List of Abbreviations .............................................................................. xi Introduction ........................................................................................ xiii Chapter 1 Great Expectations, Predictable Outcomes, and the G20s Response to the Recent Global Financial Crisis: When Matters Relating to Liquidity Risks Become Equally as Important as Measures Addressing Procyclicality ...............1 Chapter 2 Redening a Role for Central Banks: The Increased Importance of Central Banks Roles in the Management of Liquidity Risks and Macroprudential Supervision in the Aftermath of the Financial Crisis ...... 9

Chapter 3 Central Banks and Different Policies Implemented in Response to the Recent Financial Crisis ..........................21 Chapter 4 The Role of Monetary Policy in Matters Relating to Financial Stability: Monetary Policy Responses Adopted During the Most Recent Financial Crisis ..........41 Chapter 5 Fair Value Accounting and Procyclicality: Mitigating Regulatory and Accounting Policy Differences Through Regulatory Structure Reforms and Enforced Self-Regulation ................................................................49 Chapter 6 Capital, Liquidity Standards, and Macroprudential Policy Tools in Financial Supervision: Addressing Sovereign Debt Problems ................................................59 Chapter 7 LIBOR, EURIBOR, and the Regulation of Capital Markets: The Impact of Euro Currency Markets on Monetary Setting Policies ................................................73

CONTENTS

Chapter 8 Financial Stability, New Macroprudential Arrangements, and Shadow Banking: Regulatory Arbitrage and Stringent Basel III Regulations ........................................81 Chapter 9 Volcker/Vickers Hybrid? The Liikanen Report and Justications for Ring Fencing and Separate Legal Entities...............................................................101

Chapter 10 Conclusions and Implications of Regulatory Reforms and Policy Measures ......................................109 Notes .................................................................................................113 References ...........................................................................................143 Index .................................................................................................157

List of Abbreviations
ABCP BBA BIS BCBS CCP CCR CDO CDS CEBS EBA ECB EFSF EIOPA ESA ESFS ESMA ESR ESRB EU EURIBOR FASB FEE FSA FSB FSF HRE IASB IRB LCR LIBOR Asset-Backed Commercial Paper British Bankers Association Bank for International Settlements Basel Committee on Banking Supervision Central Counter Party Credit Counterparty Risk Collateralized Debt Obligations Credit Default Swap Committee of European Banking Supervisors European Banking Authority European Central Bank European Financial Stability Facility European Insurance and Occupational Pensions Authority European Supervisory Authorities European System of Financial Supervisors European Securities and Markets Authority European Securities Regulators European Systemic Risk Board European Union Euro Interbank Offered Rate Financial Accounting Standards Board Federation des Experts Comptables Europeens Financial Services Authority Financial Stability Board Financial Stability Forum Hypo Real Estate International Accounting Standards Board Internal Ratings Based Liquidity Coverage Ratio London Interbank Offered Rate

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LIST OF ABBREVIATIONS

LTRO NSFR OTC SRR

Longer Term Renancing Operation Net Stable Funding Ratio Over-the-Counter Special Resolution Regime

Introduction
Experience has shown that political institutions often do not maintain stable prices. They have several powerful incentives to expand the money supply beyond the rate of real growth in the economy. In non-democratic societies, the control of the money supply is an important instrument of economic policy that can address various political needs, most notoriously the nancing of government needs. It is against this background that independent central banks nd their contemporary justication: central bank independence is conceived as a means to achieve the goal of price stability. Central bank independence has been the preferred institutional arrangement to promote monetary stability since the end of the 1980s and beginning of the 1990s. A number of factors have contributed to this development.1 Rosa Maria Lastra, Legal Foundations of International Financial Stability, 2006

How Independent Are Highly Independent Central Banks?

Theories that appear to suggest that absolute independence exists (i.e., the theory that recognizes no limits on central bank independence, so long as the bank itself is reliably pre-committed to achieving price stability2), indeed, cannot be sustainable. A sufcient and appropriate degree of central bank independence is denitely necessary for the goal of achieving price stability. However, despite the levels of independence claimed to be enjoyed by several central banks, recent events indicate shifts in focus of monetary policy objectives by various central banks, notably, that of the Fed Reserve. The impact of political and government inuences on central banks monetary policies has been evidenced from the recent nancial crisis and in several jurisdictions. Many central banks have adjusted monetary policies having been inuenced by political pressures that have built up

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as a result of recent nancial and sovereign debt crises. However, such lack of absolute independence (from political spheres) could prove symbiotic, in the sense that, despite the need for a certain degree of independence from political interference, certain events which are capable of devastating consequences, namely, a drastic disruption of the systems nancial stability, need to be responded to as quickly and promptly as possible. Is it possible for a central bank with absolute independence to operate effectively, particularly, given the close links between many central banks and their Treasury in several countries? It may be inferred that central banks crucial roles in establishing a macroprudential framework provide the key to bridging the gap between macroeconomic policy and the regulation of individual nancial institutions. This however, on its own, is insufcientclose collaboration and effective information sharing between central banks and regulatory authorities is paramount. Consequences of lack of close collaboration, coordination, and timely exchange of information between tripartite authorities, such as the relationship which exists between the United Kingdoms Financial Services Authority (FSA), the Bank of England, and the Treasury, were witnessed during the Northern Rock Crisis. The Bank of England could not effectively perform its traditional role as lender of last resort for a limited time without such a role being made public. The need for the establishment of bridge banks and special resolution regimes (SRRs) has also been acknowledged in various jurisdictions. Hence, whilst a certain degree of independence from political interference is necessary, as well as an afrmation of the commitment to monetary policy objectives, absolute independence could also result in a process whereby the necessary coordination required between regulatory and government authorities exacerbate problems which they (the authorities) were designed to solve. Here, Rosa M. Lastras observation does appear to be manifesting itself ever increasingly: Perhaps in the twenty-rst century we shall witness the emergence of a rebalanced framework of macroeconomic policy (with scal policy regaining part of its earlier role) that may lead to a

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realignment of the goals to be pursued by the monetary authorities, which in turn will lead to a new wave of legal reforms. Other consequences of the recent nancial crisis include increased implementation of scal policy measuresin respect of taxing and spending activities [which are distinguished from proposals relating to quantitative easing measures (an inationary policy measure)in respect of the need to address the Eurozone sovereign debt crises]. As regards the implementation of scal policy measures, caution is to be had to the implementation of scal measures which are such that whilst they generate corrective effects, they do not impede the prospects of growth and development of the economy. Even though the Fed Reserve is not involved in determining scal policy measures (the Congress and the Administration being responsible for this), scal policy measures impact the Feds monetary policy decisions. The indirect effect of scal policy on the conduct of monetary policy through its inuence on the aggregate economy and the economic outlook and the impact of federal tax and spending programs on the Fed Reserves key macroeconomic objectivesmaximum employment and price stability and in making appropriate adjustments to its monetary policy toolsis notable in several situations and instances. Hence, how independent is the Fed really from government and scal policy inuences? Could it not be said that the government really has a dual role in scal and monetary policy setting? As indicated initially, an appropriately and sufciently independent central bank has a crucial role in ensuring price stability objectives. The following remark highlights the level of impact as well as the inuence of political pressures on the Feds monetary policy objectives: for several decades, a generally healthy monetary policy balance produced good results. The Feds focus has shifted dramatically to the short-run objective of lowering unemployment and recently the willingness to (temporarily?) set aside its ination target.3 In view of such political interference, would it be wise to thrust more powers into the hands of the Fed Reserve, namely, through a

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widening of its scope of powers since the executive (Government), as well as Congress, have a degree of inuence over the decision-making capacities of the Fed Reserve. Further, and addressing the issue independently of political inuences on the Fed Reserve, would it really be in the interest of accountability to delegate more powers to an already relatively powerful Fed Reserve? Recent changes in the delegation of supervisory responsibilities in the United Kingdom, namely the transfer of bank supervision from the FSA back to the Bank of England, and the resulting increased scope of the Bank of Englands powers, would appear to suggest that in certain cases, regulatory bodies as well as central banks should assume greater functions in certain capacities. Accordingly, jurisdiction specic cases have to be viewed individually and based on prevailing circumstances. Hence, ensuring that absolute independence is achieved, in respect of central bank nancial independence, constitutes a difcult task. Is it possible for a central bank to operate effectivelygiven the presence of absolute independence? Close collaboration and exchange of information between the tripartite authorities in the United Kingdom (the FSA, the Treasury, and the Bank of England), as highlighted by the Northern Rock Crisis, if effective as it should have been, could have helped, not only in identifying the problems which existed at Northern Rock, but more importantly, facilitated timely intervention which would have averted the scale of the crisis. Crisis faced by IKB, Landesbanken, and Hypo Real Estates not only revealed an absence of an SRR for banks, but also raised the issue of optimal measures which could be implemented to control (in part) privately owned but publicly sponsored or (in part) publicly owned nancial enterprises.4

Jurisdictional Approaches to Central Bank Independence and Monetary Policy

Mervyn Kings reference5 to central bank independence in the United Kingdom highlights the importance being accredited to the ever increasing and signicant role of monetary policy. He adds: How much

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discretion to give to the Monetary Policy Committee and how much should remain with the Chancellor is an interesting question that was raised, but not fully resolved, in 1997, referring to the date when the bank gained operational independence.6 However, despite the growing importance of and emphasis on central bank independence as highlighted previously, lack of absolute independence (from political spheres) could prove symbiotic in the sense that, despite the need for a certain degree of independence from political interference, certain events which are capable of devastating consequences, namely, a drastic disruption of the systems nancial stability, need to be responded to as quickly and promptly as possible. Further, subjecting actions and decisions of the central bank to other authorities could actually incorporate greater accountability and transparency into the supervisory and regulatory framework. In relation to legislative reforms that result in a reduction in central bank autonomy, it has been noted by several commentators generally, that a reduction in central bank autonomy by subjecting its actions and decisions to legislative procedures and approvals could result in more serious problems which would aggravate the stability of the economy and nancial system. However, it needs to be added that the issue does not necessarily relate to a subjection of actions and decisions for approvals, but how well the authorities involved are able to communicate and coordinate information between them effectively.

Central Bank Independence: Its Relevance in Developed and Less Developed Economies and Political Systems
Even though a sufcient and appropriate degree of central bank independence is widely acknowledged to be necessary for the goal of achieving price stability, it has also been concluded by Hayo and Hefeker that central bank independence is neither necessary nor sufcient for monetary stability.7 Maliszweski8 further, concludes: statistical signicance of central bank independence at the high level of liberalisation, as well as the timing of stabilisation

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INTRODUCTION

attempts and reforms of central bank laws, suggest that the independence is a powerful device for protecting price stability, but not for stabilising the price level. Central bank independenceimpact and signicance on the economy, nancial system, and the goal of achieving price stabilityrequires a consideration of historical, legal, jurisdictional, political, and other economic factors. As regards jurisdictional factors and with respect to less developed countries (and not so well developed economies), the need for central bank independence (and in particular operational and nancial independence from political institutions), it appears, assumes greater importance. According to the Memorandum Submitted to the National Assembly in Respect of the Proposed Amendments to the Central Bank of Nigeria (CBN) Act, 2007:9 Financial independence for a central bank has four ingredients namely: The right to determine its own budget; The application of central bank-specic accounting rules; Clear provisions on the distribution of prots; and Clearly dened nancial liability for supervisory authorities.

Further the Memorandum states that these are particularly relevant especially in not-well-developed political systems where central banks are most vulnerable to outside inuence.10 Whilst a reduction in central bank autonomy is occurring in jurisdictions such as Nigeria, in India, calls have been made for legislative reforms aimed at preventing the continual undermining and reduction of the institutional autonomy of the Reserve Bank of India. The following are highlighted as issues in need of urgent redress:11 The over dependency of the government on the Reserve Bank of India in generating much needed economic growth through rate cuts;

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The conferment by the Reserve Bank of India Act 1934, of a temporary status on the Reserve Bank of India, which is considered to be an issue which requires urgent and immediate redress; The central banks role as an investment bank for governmentissued debt. The aforementioned clearly indicates tensions between government and central bank relations. Consequently, this has also had repercussions for the implementation of scal and monetary policy measures. Whilst political pressures denitely have consequences for price and monetary stability, a decision or response on whether a reduction or increase in central bank autonomy is required, will ultimately hinge on jurisdictional specic factors which include legal, historical, economic, and political factors. In an empirical analysis, performed by Moser,12 a distinction is made between three groups of countries: those with strong checks and balances in their legislation, those with weak checks and balances, and those with no check and balances. Moser nds that:13 1. Countries with strong checks and balances have more independent central banks compared to those with weak or no checks and balances. 2. The countries in the last group have the most dependent central banks. Such results conrm the importance and need by less developed countries, for a greater level of central bank independence (both operational and nancial), autonomy and independence from political institutions, as well as greater measures to ensure that accountability, transparency and enhanced disclosures are facilitated.

Fiscal and Monetary Policy Objectives: The Essence of Narrowing the Scope of Ination Targeting
The distinction between scal and monetary policy objectives as well as the focus of scal policy objectives on growth and employment, and the

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INTRODUCTION

focus of monetary policy objectives on price stability, is certainly not a contentious matter. Lastra makes reference to the dual nature of monetary stabilityin addition to the internal dimension, there is also an external dimension, which refers to the value of the currency. The stability of exchange rates (the exchange rate being the price of a currency in another currency) and the issue of which is the best exchange rate arrangement for a given country. Under the Keynesian policy modalities of the 1950s and 1960s scal policy had primacy and demand management policies (goals of growth and employment) were prevalent. Should ination targeting be accorded a more prominent role in many jurisdictions or what factors are necessary in order for greater focus to be accorded to monetary policy objectives? What reforms will be required in order to achieve the objective of according greater priority to ination targeting? Currently in the United Kingdom, efforts are being undertaken to recommence with bond purchasing or reduce interest rates although it is added that more fundamental changes and reforms will be required as opposed to a proposed ne tuning of the present scope of ination targeting. Other areas worthy of consideration include: Merits of targeting the size of the economy in cash terms instead of ination. Reviewing the arrangements for setting monetary policies. Would merely a cut in interest rates be sufcient to boost the economy, given several considerations (among which include the fact that banks, building societies interests also need to be taken into account)? To what extent does unemployment need to fall before a central bank decides to raise interest rates? Why should greater preeminence be given to monetary policy objectives than was previously the case? It has been demonstrated in several jurisdictions that ination rates are usually higher than their targets and this being consistently the case given the impact and inuence of government scal measures on monetary policy

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objectives. However, an absolute independence of the central bank from government (which is certainly not logical or feasible) is not advocated for, since there should be some degree of communication between Treasury and the central bank. The consequences of lack of effective communication between the regulator of nancial services (the FSA), the central bank (Bank of England), and the Treasury were evident during the Northern Rock Crisis. Hence regulatory structural reforms are also required in addition to the implementation of certain measures aimed at ensuring that the central bank is not overly inuenced by those authorities responsible for determining scal policy measures, or aimed at ensuring that the central bank is well placed at the required level of communication with those authorities responsible for setting scal policy measures. Furthermore a grant of greater or reduced powers to the central bank would also require consideration of the system of checks and balances in operation. In view of regulatory reforms, two categories merit consideration: 1. Reviewing the structure of nancial regulation (which involves whether the structure of regulation is that of a unied nancial services regulator or functional regulator. It also involves whether greater powers should be granted or entrusted to central banks). There are several debates revolving around whether the Fed should be granted more powers, given the degree of powers it already possesses. However, there are also several grounds for arguing that supervisory powers should be transferred back from the United Kingdoms FSA to the Bank of England. 2. Reviewing the system of regulation (on site and off site system of supervision which embraces the nancial regulators use of external auditors in exercising certain regulatory functions). The use of external auditors should also serve as a means of incorporating increased checks and accountability into the regulatory process. The transfer of supervisory powers back to the Bank of England in July 2013 should signify an era which introduces (or rather reintroduces) greater implementation of external auditors expertise in contrast to that which embraced the reduced level of use of external auditors by its predecessor, the FSA.

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INTRODUCTION

Focus on low long-term interest rates appear to be a recipe for the success attained by Canadas central bank. Should such a policy simply be adopted by other jurisdictions or should present existing institutional frameworks and historical considerations be taken into account before deciding to adopt certain measures? Certainly jurisdictional specic factors, as well as legal, political, economic, and other factors which vary over time, need to be considered, even though regulatory structural reforms may still be required. Sola et al.14 argue that the central bank in Brazil has been able to gain increasing discipline over the monetary system, partly owing to: The economic stabilization plan and, not; As a result of prediction premised on conventional wisdom, namely, not on the basis of the argument that price stability follows from an autonomous central bank. Further, they argue that economic stabilization has less to do with getting the institutions right and that it is more consequential of a dynamic bargaining game between the federal executive, legislators and sub national governments. The substantial shift in the political game between legislators, executive, and governors during the 1990s is also highlighted. Rogolon adds that the positive theory reveals that the degree of independence is negatively correlated with the mean ination, the ination variability, and the inationary uncertainty, but is positively correlated with the credibility of monetary policy. And further, that practice as regards the Brazilian experience involves discussions of the importance of the Central Bank of Brazils independence for the efciency of the stabilization policy, focusing on the periods of high ination (1980/ 1993) and moderate ination (1994/).15

Conclusion
It was illustrated in the previous section that whilst regulatory structural reforms are required in certain jurisdictions before goals relating to price stability can be achieved, certain country and jurisdictional experiences highlight the fact that economic stabilization has less to do with getting

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the institutions right and that it is more consequential of a dynamic bargaining game. Certain jurisdictions have been engaged in legislational reforms not necessarily aimed at increasing central bank independence but targeted at achieving price and economic stabilization. Hence it is to be concluded that central bank independence, though an essential contributor to price stabilitydepending on jurisdictional considerationscannot be considered to be the sole determining factor in predicting a country or economys state of monetary stability. Theory appears to support the widely accepted view that central bank independence is a principal contributory factor to price and monetary stability. However investigations and empirical evidence relating to developed, transition, and developing economies highlight distinct trends in relationships between central bank independence, price stability, and levels of ination. As concluded by Sola et al., in studying monetary authority and central bank institutions, the analyst should identify the relevant actors, their interests, and how economic and political conjunctures are able to shift the relevant bargaining position of those very actors.16 Moreover, as highlighted also by Lastra, central bank independence remains an important tool in maintaining price stability, particularly in economies where the control of the money supply is an important instrument of economic policy that can address various political needs, most notoriously the nancing of government needs. To which it is also to be added that in studying and investigating monetary policies and central bank independence, legal, political, historical considerations as well as various other jurisdiction specic factors also merit special focus.

CHAPTER 1

Great Expectations, Predictable Outcomes, and the G20s Response to the Recent Global Financial Crisis: When Matters Relating to Liquidity Risks Become Equally as Important as Measures Addressing Procyclicality
1.1 Introduction
The meeting of the Governors and Heads of Supervision on September 12, 2010, their decisions in relation to the new capital framework known as Basel III, as well as the endorsement of the agreements reached on July 26, 2010, once again reect the typical situation where great expectations with rather unequivocal, and in a sense, disappointing results are delivered. The outcome of various consultations by the Basel Committee on Banking Supervision (BCBS), consultations which culminated in the present Basel III framework, also reects the focus on measures aimed at addressing problems attributed to Basel II, that is, measures aimed at mitigating procyclicality. This is rather astonishing given one critical lesson which has been drawn from the recent nancial crisiscapital measures on their own were, and are, insufcient in addressing and

RECOVERING FROM THE GLOBAL FINANCIAL CRISIS

averting the nancial crisis. Furthermore, banks which have been complying with capital adequacy requirements could still face severe liquidity problems. In addition to an increase of the minimum common equity requirement from 2 to 4.5%, the recent agreement and decisions of the Governors and Heads of Supervision also include the stipulation that banks hold a capital conservation buffer of 2.5%, hence consolidating the stronger denition of capital (as agreed in the previous meeting held by the Governors and Heads of Supervision earlier in July 2010). This chapter considers and highlights the reasons why matters related to procyclicality and capital measures should not be the sole focus of attention of the initiatives of the G20. In so doing, it kicks off with a section which introduces the topic procyclicality, a subsequent section that aims to highlight the importance of liquidity risks, and a third section that looks into the degree of prominence that the G201 has accorded to these respective issuesnamely, procyclicality and liquidity risks. Having considered these aims, the chapter nalizes with a concluding section.

1.2 Procyclicality
Procyclicality is a term used to denote the tendency for periods of nancial/economic downturn or boom to be further exacerbated by certain economic policies. An example of a fundamental source of procyclicality, as provided by the Committee of European Banking Supervisors (CEBS),2 is attributed to excessive risk-taking during periods of expansion, which results in the buildup of vulnerabilities. Recommendations Put Forward and Highlighted as Means of Addressing Procyclicality The Basel Committee has proposed to build up buffers aimed at addressing and mitigating procyclical effects through a combination of countercyclical capital charges, forward-looking provisioning, and capitalconservation measures.

GREAT EXPECTATIONS, PREDICTABLE OUTCOMES

The promotion of nancial stability through more risk-sensitive capital requirements constitutes one of Basel IIs primary objectives.3 However, some problems identied with Basel II are attributed to procyclicality and the fact that not all material credit risks in the trading book are adequately accounted for in the current capital requirements.4 The procyclical nature of Basel II has been criticized since capital requirements for credit risk as a probability of default of an exposure decreases in the economic upswing and increases during the downturn,5 hence resulting in capital requirements that uctuate over the cycle. Other identied6 consequential effects include the fact that uctuations in such capital requirements may result in credit institutions raising their capital during periods when it is costly7 for them to implement such a rise, which has the potential of inducing banks to cut back on their lending. It is concluded, risk sensitive capital requirements should have pro cyclical effects principally on under capitalised banks.8 Regulators will be able to manage systemic risks to the nancial system during such periods when rms that are highly leveraged become reluctant to lend where more market participants such as credit rating agencies are engaged in the supervisory process. The Annex to Pro cyclicality9 not only signicantly emphasizes the fact that regulatory capital requirements do not constitute the sole determinants of how much capital banks should hold, but also highlights the role of credit rating agencies in compelling banks to increase their capital levels even where such institution may be complying with regulatory requirements. Even though the implementation of higher levels of capital buffers could serve as a means for the management of systemic risks, liquidity requirements have also been acknowledged by many as having a fundamental role to play in mitigating contagion, thus assuming a role which is similar to that of capital buffers. The link between countercyclical buffers, capital, and liquidity standards is further demonstrated through the impact generated as a result of the implementation of capital and liquidity standards. Countercyclical buffer schemes could serve as a means of enhancing the following effects generated by higher capital and liquidity standards, namely,10

RECOVERING FROM THE GLOBAL FINANCIAL CRISIS

making the nancial system more resilient and reducing the amplitude of the business cycles within the nancial system. The association between systemic risks and liquidity risks and the rather apparent lack of due recognition accorded to liquidity risks under Basel II constituted other reasons (apart from procyclicality) for the growing criticism of Basel II.

1.3 Liquidity Risk

The denition of liquidity, as provided by Bank for International Settlements (BIS), is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. The fundamental role of banks in the maturity transformation of short-term deposits into long-term loans makes banks inherently vulnerable to liquidity risk, both of an institution-specic nature and that which affects markets as a whole.11 In their report, Addressing Pro cyclicality in the Financial System: Measuring and Funding Liquidity Risk, The Financial Stability Forum (FSF) noted that at the onset of the recent nancial crises, the complex response of nancial institutions to the deteriorating market conditions was, to a large extent, attributed to liquidity shortfalls that reected on and off balance sheet maturity mismatches and excessive levels of leverage.12 This has resulted in an increasingly important role for liquidity provided by central banks in the funding of bank balance sheets.13 Furthermore, the FSF highlighted the urgency of both authorities, namely, supervisors (in their monitoring of liquidity risks at banks) and central banks (in their design and implementation of market operations) collaborating in order to restore the functioning of inter bank lending markets.14 As identied in the European Central Banks (ECBs) Financial Stability Review (December 2009), the specic knowledge that banks

GREAT EXPECTATIONS, PREDICTABLE OUTCOMES

possess about their borrowers make bank loans particularly illiquid.15 The connection between liquidity and systemic risks is further highlighted in the review where it elaborates on possible consequences resulting from a banks failure:16 the destruction of such specic knowledge which banks have about their borrowers and the reduction of the common pool of liquidity.17 Such reduction in the common pool of liquidity may also trigger the failure of other banks with the result that (a) the value of such illiquid bank assets diminishes and (b) further problems within the banking systems are aggravated.18 Endogenous risks could also be generated depending on the type of information which the bank possesses about their borrowers and how the dissipation of such information to the public, if it has the potential to trigger a bank run, can be prevented. According Greater Attention to Liquidity Risks In February 2008, the Basel Committee on Banking Supervision (BCBS) published a paper titled Liquidity Risk Management and Supervisory Challenges, which highlighted the fact that many banks had ignored the application of a number of basic principles of liquidity risk management during periods of abundant liquidity.19 An extensive review of its 2000 Sound Practices for Managing Liquidity in Banking Organisations report was also carried out by the Basel Committee as a means of addressing matters and issues arising from the nancial markets and lessons from the nancial crises.20 In order to consolidate the BCBSs Principles for Sound Liquidity Risk Management and Supervision report of September 2008, which should lead to improved management and supervision of liquidity risks of individual banks, supervisory bodies will be required to develop tools and policies to address the procyclical behavior of liquidity at the aggregate level.21 In responding to the apparent gaps which exist with Basel II, as revealed by the recent crises, proposals that are aimed at imposing penalties for the occurrence of maturity mismatches22 have been put forward.23 The degree of disparity which exists between the maturity of assets and liabilities is crucial to determine the state of a companys liquidity. Such penalties aimed at deterring the occurrence of maturity

RECOVERING FROM THE GLOBAL FINANCIAL CRISIS

mismatches could include higher capital requirements for banks which nance their assets with overnight borrowing from the money markets than banks which nance similar assets with term deposits.24 The inability of bank capital to address funding and liquidity problems on its own has been acknowledged by many academics. As a result, further proposals, in addition to the above-mentioned amendment to Basel II, have been put forward. These include coupling of the existing regulatory framework with capital insurance or liquidity insurance mechanisms.

1.4 Mitigating the Procyclical Effects of Basel II

Basel III and Recent Efforts to Address Procyclical Effects of Basel II In response to the recent nancial crisis and to the realization that capital levels (which banks operated with) during the period of the crisis were insufcient and also lacking in quality,25 the Basel Committee responded by raising the quality of capital as well as its level.26 Further consequences of the recent Basel reforms also include:27 a tightening of the denition of common equity; limitation of what qualies as Tier-1 capital; an introduction of a harmonized set of prudential lters; and the enhancement of transparency and market discipline through new disclosure requirements.

The introduction of Basel II resulted in changes being made to the 1988 Basel Capital Accord to provide for a choice of three broad approaches to credit risk.28 This was introduced into Basel II in view of the realization that the optimal balance may differ signicantly across banks.29 The increased focus on risk (and particularly credit risk) resulted from growing realization of the importance of risk within the nancial sector. The range of approaches to credit risk, as introduced under Basel II, and which also exists for market risk, consists of the standardized approach (which is the simplest of the three broad

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approaches), the internal ratings based (IRB) foundation approach, and the IRB advanced approach.30 Under the standardized approach, regulatory capital requirements are more closely aligned and in harmony with the principal elements of banking risk owing to the introduction of wider differentiated risk weights and a broader recognition of techniques which are applied in mitigating risk.31 However, problems with Basel II internal credit risk models (which relate to the fact that such a banks internal credit risk models were overly sensitive in their implementation32 for the calculation of regulatory capital, and generated procyclical effects) were realized during the recent nancial crisis, as particularly exemplied by the case of Northern Rock. Do the recent Basel III efforts reect a situation where some apparent lessons from the recent nancial crisis have deliberately been ignored by the G20, or is it yet another case of typical summits which generate great expectations but fail to deliver the expected and correspondingly expected results?

1.5 Conclusion
Whilst efforts taken by the Committee (Basel Committee) appear to have focused on capitalas evidenced by its Consultative Document on Counter Cyclical Capital Buffer Proposalmore forward-looking provisions as well as provisions that are aimed at addressing losses and unforeseen problems attributed to maturity transformation of short-term deposits into long term loans would be greatly welcomed. To an extent, this move could address the problem attributed to liquidity risks. Further, the CEBS has acknowledged that tools which could be implemented as measures for mitigating cyclicality exist beyond those measures proposed by the Basel Committee. As a result, it has taken up initiatives in relation to measures such as dynamic provisioning and supplementary measures that include leverage ratios.33 Recent efforts aimed at addressing the nancial crisis also include two new liquidity requirements, namely, the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR), which serve the

RECOVERING FROM THE GLOBAL FINANCIAL CRISIS

purposes of ensuring that banks have adequate funding liquidity to survive one month of difcult funding conditions (the LCR), and to address the mismatches between the maturity of a banks assets and that of its liabilities (the NSFR).34 Whilst such liquidity requirements would help to address the critical issues arising as a result of maturity mismatches, the implementation of countercyclical capital buffers as well as these new liquidity requirements (the LCR and the NSFR) would be bolstered by introducing more forward-looking provisions. Despite the above liquidity-related efforts, the results and efforts relating to liquidity risks do not correspond to its overwhelming contribution to the recent nancial crisis; neither they accord justice to its signicance. The G20s response to the recent crisis could also be regarded as a case aimed at appeasing the needs and demands of various jurisdictions, in relation to those who had favored tougher rules and those who had appealed for not too stringent rules. Whilst such a tendency to appease the needs of different jurisdictions may serve as a formidable weapon in achieving the goal of regulatory convergence, it may also serve as a hindrance in the realization of the all-importance objective of deterring regulatory arbitrage. Furthermore, given the urgency of addressing liquidity risks and maturity mismatches, the transition periods for implementing the two new liquidity requirements are questionable even though as with capital, consideration is to be had to the impact of limited transition periods. In the new economy, information, education, and motivation are everything. Bill Clinton