1 1 1 1 Module VII: Safety and Soundness of Module VII: Safety and Soundness of Financial Institutions Financial Institutions James R. Barth Auburn University and Milken Institute [email protected]2009 International Housing Finance Program 2009 International Housing Finance Program Housing Finance in a Changing Global Environment Housing Finance in a Changing Global Environment Wharton School, University of Pennsylvania Wharton School, University of Pennsylvania June 10, 2009 June 10, 2009
Transcript
1111
Module VII: Safety and Soundness of Module VII: Safety and Soundness of Financial InstitutionsFinancial Institutions
James R. BarthAuburn University and Milken Institute
2009 International Housing Finance Program2009 International Housing Finance ProgramHousing Finance in a Changing Global EnvironmentHousing Finance in a Changing Global Environment
Wharton School, University of PennsylvaniaWharton School, University of PennsylvaniaJune 10, 2009June 10, 2009
22
Current Crisis: Implications for Regulatory Reform
33
Global financial crisis has wiped out trillions Global financial crisis has wiped out trillions of dollars in global stock market capitalizationof dollars in global stock market capitalization
Daily, January 1, 2004 Daily, January 1, 2004 –– June 1, 2009June 1, 2009
Sources: Bloomberg.
20253035404550556065
2004 2005 2006 2007 2008 2009
US$ trillionsHighest point: $62.6 trillion on October 31, 2007
44
Global financial crisis leads to dramatic Global financial crisis leads to dramatic widening of emerging market bond spreads widening of emerging market bond spreads
Yield difference between emerging market bonds and U.S. TreasuriYield difference between emerging market bonds and U.S. Treasurieses
Source: JP Morgan Emerging Markets Bond Index Global (EMBI Global).
0
500
1000
1500
2000
2500
Jan2007
Apr2007
Jul2007
Oct2007
Jan2008
Apr2008
Jul2008
Oct2008
Jan2009
Apr2009
B ratedBB ratedInvestment grade
U.S. financial crisis started, August 2007
Lehman Brothers filed for bankruptcy, September 14, 2008
Basis points
55
Sharp increases in sovereign credit default Sharp increases in sovereign credit default swap premiums for transition economiesswap premiums for transition economies
0
1,000
2,000
3,000
4,000
5,000
6,000
01/07 07/07 01/08 07/08 01/090
200
400
600
800
1,000
1,200
Ukraine (right axis)Russia (left axis)
Basis points
Sources: International Monetary Fund; Datastream.
0
200
400
600
800
1,000
1,200
1,400
01/07 07/07 01/08 07/08 01/09
HungaryLatviaPoland
Basis points
66
Sizeable increases in sovereign credit default Sizeable increases in sovereign credit default swap premiums for many countriesswap premiums for many countries
Huge losses/writeHuge losses/write--downs, capital raised bydowns, capital raised byfinancial institutions worldwidefinancial institutions worldwide
Sources: Bloomberg, Milken Institute.
1,103.9 1,288.1 Grand total 633.2621Others23.742.2HSBC, United Kingdom78.542.7Bank of America, United States12.145.3Washington Mutual, United States32.150.6UBS, Switzerland29.955.9Merrill Lynch, United States30.871.3Fannie Mae, United States51.681.6Freddie Mac, United States91.787.3AIG, United States
109.388.3Citigroup, United States11.0101.9Wachovia, United States
Capital raisedLoses/Write-downsUS$ billions, through April 10, 2009
OverviewOverviewFactors that contributed to credit boom and bustFactors that contributed to credit boom and bust
Lax monetary policy and global imbalancesReach for yield, short-term wholesale funding and risky/substantial leverageFinancial innovationOpacityProcyclicality of regulation and mark-to-market accountingToo big to failIncentive/compensation systemPublic policyFlight to safety
1313
Overview of the U.S.Overview of the U.S. housing markethousing market
Note: total residential and commercial mortgages = $14.6 trillion at year-end 2008.
Sources: Federal Reserve, Milken Institute.
Equity in housing stock$7.8 trillion
Mortgage debt $10.5 trillion Prime
92.7%
Subprime7.3%
Securitized60%
Non-Securitized
40%
Government -controlled
48%
Privatesector -
controlled52%
1414
The U.S. mortgage problem in perspectiveThe U.S. mortgage problem in perspective
Note: The data is at year-end 2008.Sources: U.S. Census, Freddie Mac, Mortgage Bankers Association, Milken Institute.
25 million or 31% are paid off80 million houses
55 million have mortgages 49 million or 89% are paying on time
6 million are behind11% of 55 million with 3% in foreclosure
This compares to 50% seriously delinquent in the 1930s.
15151515
I. Low interest rates I. Low interest rates and a credit boomand a credit boom
16161616
Fed lowers interest rates too much and for too long
Federal funds rate vs. rates on FRMs and ARMs
Sources: Federal Reserve, Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.
Largest share of Largest share of ARMsARMsgo to subprime borrowersgo to subprime borrowers
Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.
23232323
Subprime mortgages increase rapidly Subprime mortgages increase rapidly before big declinebefore big decline
Originations Outstandings
Sources: Inside Mortgage Finance, Milken Institute.
160200
310
540
625 600
191
230
100
200
300
400
500
600
700
2001 2002 2003 2004 2005 2006 2007 Q22008
US$ billions
2008
US$ billions
479574
699
973
1,200 1,240
940 770
0
200
400
600
800
1,000
1,200
1,400
2001 2002 2003 2004 2005 2006 2007 2008
Average annual growth rates1995–2006: 14%2006– 2008: -21%
24242424
IV. Mortgage product IV. Mortgage product innovationinnovation
25252525
ARM hybrids dominate subprime ARM hybrids dominate subprime originations (2006)originations (2006)
Fixed
Other ARM7%
23%
70%
ARM hybrids
Fixed
Other ARM7%
23%
70%
ARM hybrids
Other ARM7%
23%
70%
ARM hybrids
ARM balloon
Other ARM 4%
Fixed 9%
30-year
with 40- to 50-year
amortization26%
2- and 3-year hybrids 61%
ARM balloonARM balloon
Other ARM 4%
Fixed 9%
30-year
with 40- to 50-year
amortization26%
2- and 3-year hybrids 61%
Other ARM 4%
Fixed 9%
30-year
with 40- to 50-year
amortization26%
2- and 3-year hybrids 61%
Sources: Freddie Mac, Milken Institute.
SubprimePrime conventional Alt-A
Fixed 31%
Other ARM23%
ARM hybrids46%
Fixed 31%
Other ARM23%
ARM hybrids46%
26262626
V. SecuritizationV. Securitization
2727
The mortgage model switches fromThe mortgage model switches fromoriginateoriginate--toto--hold to originatehold to originate--toto--distributedistribute
Sources: Federal Reserve, Milken Institute.
Household mortgage debt2008=$10.5 trillion
Held in portfolio40%
Securitized60%
Household mortgage debt1980=$958 billion
Held in portfolio89%
Securitized11%
Household mortgage debt2008=$10.5 trillion
Held in portfolio40%
Securitized60%
Household mortgage debt1980=$958 billion
Held in portfolio89%
Securitized11%
28282828
Securitization becomes the dominant Securitization becomes the dominant funding source for subprime mortgagesfunding source for subprime mortgages
Sources: Inside Mortgage Finance, Milken Institute.
2005: The collapse begins2005: The collapse begins
Sources: S&P/Case-Shiller, OFHEO, Moody’s Economy.com, Milken Institute.
-20
-15
-10
-5
0
5
10
15
20
25
1988 1992 1996 2000 2004 2008
Home price indices, percent change from a year earlier
OFHEO
S&P/Case-Shiller national
S&P/Case-Shiller 10-city
35353535
VIII. Delinquencies and VIII. Delinquencies and foreclosuresforeclosures
3636
0
500
1,000
1,500
2,000
2,500
Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008
SubprimeFHA and VAPrime (includes Alt-A)
Number of home mortgage loan foreclosures started (annualized rate in thousands)
Q4 2008Subprime: 12% of loans serviced
3636
Subprime mortgages accounted for half Subprime mortgages accounted for half or more of foreclosures since 2006or more of foreclosures since 2006
Sources: Mortgage Bankers Association, Milken Institute.
37373737
Subprime Subprime ARMsARMs have have the worst default recordthe worst default record
Sources: Mortgage Bankers Association, Milken Institute.
Home mortgage loans delinquent or in foreclosure (percent of number)
0
5
10
15
20
25
30
35
40
45
Q21998
Q11999
Q41999
Q32000
Q22001
Q12002
Q42002
Q32003
Q22004
Q12005
Q42005
Q32006
Q22007
Q12008
Q42008
Q4 2008Subprime ARM: 39.5%Subprime FRM: 16.0%FHA and VA: 7.2%Prime: 4.4%
38383838
IIX. Credit crunch and X. Credit crunch and liquidity freezeliquidity freeze
3939Sources: Federal Reserve, Freddie Mac, Merrill Lynch, Bloomberg, Milken Institute.
Increasing spreads between corporate bonds, Increasing spreads between corporate bonds, mortgage securities, and target federal funds rate mortgage securities, and target federal funds rate
Asset-backed commercial paperNon-asset-backed commercial paper
US$ trillions August 8, 2007: $1.2 trillion
April 15, 2009: $681 billionJan. 7, 2004: $659 billion
4242
Market for liquidity freezesMarket for liquidity freezes3030--day commercial paper yield spreads over 1day commercial paper yield spreads over 1--month Treasurymonth Treasury
Sources: Federal Reserve, Milken Institute.
0
100
200
300
400
500
600
January-07 July-07 January-08 July-08 January-09
Asset-backed commercial paperFinancial commercial paper
AA rated, daily, basis points The Fed announced Commercial Paper Funding Facility (CPFF) on Oct. 7, 2008
4343
Note: Counterparty Risk index averages the market spreads of the credit default swaps (CDS) of fifteen major credit derivatives dealers, including ABN Amro, Bank of America, BNP Paribas, Barclays Bank, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs Group, HSBC, Lehman Brothers, JPMorgan Chase, Merrill Lynch, Morgan Stanley, UBS, and Wachovia. Sources: Datastream, Milken Institute.
Federal Reserve assets increased Federal Reserve assets increased but asset quality deterioratedbut asset quality deteriorated
Sources: Federal Reserve, Milken Institute.
0.0
0.5
1.0
1.5
2.0
2.5
2003 2004 2005 2006 2007 2008 2009
Total assets of Federal Reserve banksTreasury securities held outright
US$ trillions
December 17, 2008: $2.3 trillion
5050
OverviewOverviewU.S.U.S. government responses to liquidity freeze and credit crunchgovernment responses to liquidity freeze and credit crunch
Government/private sector purchases of toxic assetsGuarantees for selected assets and liabilities Capital injections into financial institutionsSubsidization of loan modifications by financial institutions Debt for equity swapsEasier monetary policies, including lowering interest rates and quantitative/ credit easingCoordinated responses by countries (e.g., U.S. and other central banks engage in currency swaps)
5151
Estimated U.S. total bailout costs Estimated U.S. total bailout costs The government has extended the bailouts to nearly $US10 trillioThe government has extended the bailouts to nearly $US10 trillionn
Source: The Milken Institute.
Federal Reserve, Treasury, FDIC:
$362
FDIC: $926
Treasury: $2,466Federal Reserve:
$6,139
Estimated U.S. total bailout costs as of March 2009 (including guarantees and all commitments):
US$9.9 trillion
US$ billions
5252
TARP allocated so farTARP allocated so farStatus of Troubled Asset Relief ProgramStatus of Troubled Asset Relief Program funds as of March 27, 2009funds as of March 27, 2009
Source: Wall Street Journal.US$ billions
40
24.5
238.9
0 100 200 300 400 500 600
Already disbursed
Maximum announced funding level
15
Banking system
AIG
Auto companies and suppliers
Small business
Life insurers (estimated)
522.5
70
29.9
25
5353
Selected banking crises and government responsesSelected banking crises and government responses
3178.666.757.128.611.9Total Yes in all 42 crises (%)6921.433.342.971.488.1Total No in all 42 crises (%)
More than 10 years after7 to 9 years after4 to 6 years after1 to 3 years after
Was bank credit/GDP higher compared to the level the year before the crisis?
Country Name
55555555
X. What went wrongX. What went wrong
56565656
2,443
879
1,410
2,067
944886
0
500
1,000
1,500
2,000
2,500
3,000
Fannie Mae:total assets
Fannie Mae:total MBS
outstanding
Freddie Mac:total assets
Freddie Mac:total MBS
outstanding
Commercialbanks: total
residential realestate assets
Savingsinstitutions:
totalresidential realestate assets
US$ billions
The importance of Fannie Mae The importance of Fannie Mae and Freddie Mac for the housing marketand Freddie Mac for the housing market
Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute.
5757
Leverage ratios of selected financial firms Leverage ratios of selected financial firms December 2008December 2008
Note: Leverage ratios for Freddie Mac and Fannie Mae are as of June 2008. The two institutions have negative common equities as of December 2008.Sources: FDIC, FHL Banks Office of Finance, National Credit Union Administration, Freddie Mac, Fannie Mae, Milken Institute.
9.3
10.6
11.1
31.6
26.2
21.5
67.9
0 10 20 30 40 50 60 70 80
Credit unions
Commercial banks
Saving institutions
Brokers/hedge funds
Federal Home Loan Banks
Fannie Mae
Freddie Mac
Leverage ratio, total assets/common equity
(June 2008)
(June 2008)(June 2008)
5858
Too much dependence on debt?Too much dependence on debt?Leverage ratios at biggest investment banksLeverage ratios at biggest investment banks
2219
28 26
18
31
19
2724 23
33 32 3431
13
33 34
2422
13
0
5
10
15
20
25
30
35
40
Morgan Stanley Merrill Lynch Bear Stearns Lehman Brothers Goldman Sachs
2000 2005 2007 2008
Total assets/total shareholder equity
March 2008
June 2008
Sources: Bloomberg, Milken Institute.
5959
Too much dependence on debt?Too much dependence on debt?LLeverage ratios at bank holding companieseverage ratios at bank holding companies
Sources: Bloomberg, Milken Institute.
13
17
1311
19
14 13 1312 13
10
13
0
5
10
15
20
25
Citigroup Bank of America JPMorgan Chase
2000 2005 2007 2008
Total assets/total shareholder equity
13
17
1311
19
14 13 1312 13
10
13
0
5
10
15
20
25
Citigroup Bank of America JPMorgan Chase
2000 2005 2007 2008
Total assets/total shareholder equity
60606060
15
38
63
76
17
50
71
84
24
66
8794
0
10
20
30
40
50
60
70
80
90
100
AAA AA(+/-) A(+/-) BBB(+/-)
S&PMoody’sFitch
Percent downgraded
Subprime mortgage-backed securities downgrades
2005–2007 issuance
56 percent of MBS issued were eventually downgraded
2005–2007 issuance
Sources: Sources: Inside Mortgage Finance, Milken Institute.
S&P Total DowngradedDowngraded as a percentage of
total
AAA 1,032 156 15.1%
AA(+/-) 3,495 1,330 38.1%
A(+/-) 2,983 1,886 63.2%
BBB(+/-) 2,954 2,248 76.1%
BB(+/-) 789 683 86.6%
B(+/-) 8 7 87.5%
Total 11,261 6,310 56.0%
61616161
Credit ratings of selected S&P 500 companies and Credit ratings of selected S&P 500 companies and associated CDS spreads as of October 17, 2008associated CDS spreads as of October 17, 2008
Note: Credit ratings of S&P 500 companies and the associated CDS spreads for those firms for which both ratings and CDS spreads are available.A bond is considered investment grade if its credit rating is BBB- or higher by S&P.
Sources: S&P, Bloomberg, Datastream, Milken Institute.
Speculative gradeInvestment grade
62626262
When is a AAA not a AAA?When is a AAA not a AAA?Multilayered mortgage productsMultilayered mortgage products
Sources: International Monetary Fund, Milken Institute.
Origination ofmortgage loans High-grade CDO
Senior AAA 88%Junior AAA 5%
Pool of mortgage AA 3%loans: prime or subprime A 2%
Leverage vs. issuer ratingLeverage vs. issuer rating
Sources: Bloomberg, Milken Institute.
18
19
20
21
22
23
24
10 15 20 25 30 35Total assets/total equity capital
Fitch long term issuer default rating
Citigroup
JP Morgan
Bank of America
Lehman Brothers
Morgan Stanley
Bear Stearns
Merrill Lynch
Morgan Stanley
Goldman Sachs
Merrill Lynch
Merrill Lynch
● 2000 ● 2005 ● 2007AAA
AA+
AA
AA-
A+
A
A-
6464
Leverage vs. CDS premiumsLeverage vs. CDS premiums
Sources: Datastream, Bloomberg, Milken Institute.
0
20
40
60
80
100
10 15 20 25 30 35Total assets/total equity capital
Average CDS premium, basis points
JP Morgan
Bank of America
Morgan Stanley
Bear Stearns
Merrill LynchGoldman Sachs
● 2004 ● 2005 ● 2007
Lehman Brothers
Bear StearnsLehman Brothers
Merrill LynchCitigroup
Morgan Stanley
65656565
XI. Policy lessons from XI. Policy lessons from the current crisis and the current crisis and
proposals for reform in proposals for reform in regulatory oversightregulatory oversight
6666
OverviewOverviewReforms to prevent/mitigate credit booms and bustsReforms to prevent/mitigate credit booms and busts
Reform structure of regulatory systemMacro-prudential regulation (i.e., establish a systemic risk regulator or market stability regulator)
Strengthen regulatory capital requirementsCountercyclical regulation (e.g., dynamic capital and/or provisioning regulations)
Liquidity regulation to take into account maturity mismatches due to short-term funding of longer-term, illiquid assets
6767
OverviewOverviewReforms to prevent/mitigate credit booms and bustsReforms to prevent/mitigate credit booms and busts
A regulation that internalizes (taxes) a financial institution’s contribution to systemic risk (to address too-big-to-fail issue)
Greater transparency such as by requiring clearing and settling of credit default swaps to be conducted through clearing houses or on exchanges, which provides for greater monitoring of exposures and posting of necessary collateral
Consider establishing greater co-operation among regulators in countries or establish centralized supervision or deposit insurer in some regions
6868
OverviewOverviewReforms to prevent/mitigate credit booms and bustsReforms to prevent/mitigate credit booms and busts
Change fee structure for credit rating agencies, eliminate the Nationally Recognized Statistical Rating Organization (NRSRO) designation, and decrease use of ratings in regulatory system Consider eliminating treatment of residential mortgages as non-recourse loans (i.e., secured only by the underlying property), merging Freddie Mac and Fannie Mae, and requiring mortgage originators to have “skin in the game”
Consider modifying incentive/compensation systems to discourage excessive risk taking
6969
What is the most appropriate What is the most appropriate structure and scope of the structure and scope of the
regulatory system?regulatory system?And who should be the systemic And who should be the systemic
risk regulator?risk regulator?
70707070
Countries with single vs. multiple supervisory authorities Countries with single vs. multiple supervisory authorities Income
level Single supervisor
(127 countries) Multiple supervisors
(7 countries) Anguilla Cyprus Hong Kong,
China Liechtenstein Singapore Netherlands Saudi Arabia
Antigua and Barbuda Czech Republic Iceland Luxembourg Slovenia South Korea United States Australia Denmark Ireland Macau, China Spain Austria Estonia Isle of Man Malta Switzerland Bahrain Finland Israel Montserrat Taiwan, China Belgium France Italy New Zealand Trinidad & Tobago Canada Germany Japan Norway United Kingdom
High income
Cayman Islands Greece Kuwait Portugal Sweden Argentina Costa Rica Grenada Lithuania Seychelles Malaysia
Belize Croatia Hungary Mauritius Slovak Republic Botswana Dominica Kazakhstan Mexico St. Kitts and Nevis
Brazil Equatorial Guinea Latvia Oman St. Lucia Bulgaria Romania Lebanon Poland St. Vincent and the Grenadines
Chile Gabon South Africa Russia Uruguay
Upper middle income
Panama
Guatemala Bosnia and Herzegovina Egypt Lesotho Peru
Algeria Cameroon El Salvador Macedonia, FYR Philippines
Angola China Fiji Maldives Sri Lanka Armenia Colombia Guyana Moldova Suriname Belarus Jordan Honduras Morocco Syrian Bhutan Congo Indonesia Nicaragua Thailand
Lower middle income
Bolivia Dominican Republic Jamaica
Bangladesh Chad India Pakistan Togo Nigeria Zimbabwe Benin Côte d'Ivoire Kenya Senegal Uganda
Burkina Faso Ethiopia Kyrgyz Republic Tajikistan Mali Burundi Ghana Malawi Tanzania Niger
Low income
Central African Republic Guinea-Bissau Mozambique
71717171
Countries with the central bank as a supervisory authority Countries with the central bank as a supervisory authority
Income level
Central bank only (75 countries)
Central bank among multiple
supervisors (7 countries)
Central bank not a supervisory authority
(52 countries)
Anguilla Estonia Israel Montserrat Slovenia Netherlands South Korea Australia Denmark Isle of Man Norway
Antigua and
Barbuda Germany Italy New
Zealand Spain Saudi Arabia United States Bahrain Finland Japan Sweden
Austria Greece Kuwait Portugal Taiwan, China Belgium France Luxembourg Switzerland
Cyprus Hong Kong, China Liechtenstein Singapore Trinidad &
Tobago Canada Iceland Macau, China United Kingdom
High income
Czech Republic Cayman
Islands Ireland Malta
Argentina Bulgaria Lithuania Russia St. Kitts and Nevis Malaysia Chile Gabon Latvia Panama
Belize Croatia Mauritius Seychelles St. Lucia Costa Rica Hungary Lebanon Poland
Botswana Dominica Oman Slovak Republic
St. Vincent and the
Grenadines Equatorial
Guinea Kazakhstan Mexico
Brazil Grenada Romania South Africa Uruguay
Upper middle income
Algeria
Angola Egypt Jamaica Maldives Sri Lanka Bolivia China Dominican Republic Honduras
Armenia Fiji Jordan Moldova Suriname Bosnia and Herzegovina Colombia El Salvador Nicaragua
Belarus Guyana Lesotho Morocco Syrian Cameroon Congo Guatemala Peru
Lower middle income
Bhutan Indonesia Macedonia, FYR Philippines Thailand
Bangladesh Ghana Kyrgyz Republic Tajikistan Pakistan Nigeria Zimbabwe Benin Chad Mali Senegal
Burundi India Malawi Tanzania Uganda Burkina Faso Côte d'Ivoire Niger Togo Low income
Ethiopia Kenya Mozambique Central African Republic
Guinea-Bissau
72727272
Scope of supervisory authority for countries Scope of supervisory authority for countries Income
level Only banks
(96 countries) All of the main financial institutions
(38 countries) Anguilla Greece Luxembourg Slovenia Australia Denmark Japan Singapore
Antigua and Barbuda Hong Kong, China Montserrat South Korea Austria Estonia Liechtenstein Sweden
Canada Isle of Man Netherlands Spain Bahrain Germany Macau, China Taiwan, China
Cyprus Israel New Zealand Switzerland Belgium Iceland Malta Trinidad & Tobago
Finland Italy Portugal United States Cayman Islands Ireland Norway United Kingdom
High income
France Kuwait Saudi Arabia Czech Republic Argentina Croatia Mauritius Seychelles Hungary Kazakhstan Latvia Malaysia
Belize Dominica Mexico Slovak Republic Uruguay Botswana Equatorial Guinea Oman South Africa
Brazil Gabon Panama St. Kitts and Nevis Bulgaria Grenada Poland St. Lucia
Chile Lebanon Romania St. Vincent and the Grenadines
Upper middle income
Costa Rica Lithuania Russia Algeria Congo Jamaica Sri Lanka Armenia Colombia Honduras Nicaragua
Angola Dominican Republic Jordan Suriname Bhutan Fiji Lesotho Peru
Belarus Egypt Macedonia, FYR Syrian Bosnia and
Herzegovina Guatemala Maldives
Bolivia El Salvador Moldova Thailand Cameroon Guyana Morocco
Benin Ethiopia Mali Tajikistan Burkina Faso Ghana Mozambique Tanzania
Burundi Guinea-Bissau Niger Togo Central African
Republic India Nigeria Uganda
Low income
Chad Kenya Pakistan Zimbabwe
7373
The U.S. regulatory regime: The U.S. regulatory regime: In need of reform?In need of reform?
Sources: Financial Services Roundtable (2007), Milken Institute.
National banks State commercial and savings banks
Federal savings banks
Insurance companies
Securities brokers/dealers
Other financial companies, including mortgage
companies and brokers
• Fed• OTS
• OCC• FDIC
• State bankregulators
• FDIC• Fed--state member
commercial banks
• OTS• FDIC
• 50 State insuranceregulators plusDistrict of Columbiaand Puerto Rico
• FINRA• SEC• CFTC• State securities
regulators
• Fed• State licensing
(if needed)• U.S. Treasury
for some products
• OCC• Host county
regulator
• Fed• Host county
regulator
• OTS• Host county
regulator
Federal branch
Foreignbranch
Limited foreign branch
Fed is the umbrella or consolidated regulator
Primary/secondaryfunctionalregulator
Notes:Justice Department: Assesses effects of mergers and acquisitions on competitionFederal Courts: Ultimate decider of banking, securities, and insurance productsCFTC: Commodity Futures Trading CommissionFDIC: Federal Deposit Insurance CorporationFed: Federal ReserveFINRA: Financial Industry Regulatory Authority GSEs: Government Sponsored Enterprises OCC: Comptroller of the CurrencyOTS: Office of Thrift SupervisionSEC: Securities and Exchange Commission
• Federal Housing Finance Agency
Fannie Mae, Freddie Mac, and Federal Home Loan Banks
Financial, bank and thrift holding companies
Justice Department• Assesses effects of mergers and acquisitions on competition
Federal courts• Ultimate decider of banking, securities, and insurance products
7474
Strengthen regulatory capital Strengthen regulatory capital requirementsrequirements
7575
Name
Alternative capital ratios (percent)
Market value (as of 3/11/2009) to
total assets(percent)
Total risk-based capital ratio
Tier 1 risk-based capital
ratio
Tier 1 risk-based capital ratio without TARP
capitalTotal equity to
total assets ratioTangible
common equity ratio
JPMorgan Chase 14.8 10.9 8.9 7.7 3.8 3.8
Citigroup 15.7 11.9 9.9 7.3 1.6 0.4
Bank of America 13.0 9.2 7.9 9.7 2.8 2.0
Wells Fargo 11.8 7.8 5.6 7.6 1.6 4.1
Goldman Sachs 18.9 15.6 13.1 7.5 4.9 5.4
Morgan Stanley 26.8 17.9 14.3 7.7 4.4 3.9
PNC Financial 13.2 9.7 6.6 9.5 1.9 4.1
US Bancorp 14.3 10.6 7.7 9.9 2.6 8.5
Bank of NY Mellon 17.1 13.3 10.7 11.8 1.6 11.6
SunTrust Banks 14.0 10.9 7.9 11.8 5.0 2.3
Sources: Bloomberg, company data, Milken Institute.
Alternative capital measures for U.S. banksAlternative capital measures for U.S. banksDecember 31, 2008December 31, 2008
7676
A question of equity: Stress tests?A question of equity: Stress tests?U.S. regulatory capital requirements and selected capital ratiosU.S. regulatory capital requirements and selected capital ratios
The Foundation IRB Approach The Standardized Approach
If yes, which variant are you planning on adopting:Is your country planning on adopting Basel II
8282
The three pillarsThe three pillars
1. Minimum regulatory capital requirement2. Supervisory review process3. Market discipline
8383
Regulation of riskRegulation of risk--adjusted capital asset ratiosadjusted capital asset ratios
The Basel Accord specifies1. How to measure capital2. How to measure risk-adjusted assets
• Weights for balance sheet items• Weights for off-balance sheet exposures
3. Minimum acceptable ratios
8484
Core capital (Tier 1)Core capital (Tier 1)
Common stockholder’s equityNoncumulative perpetual preferred stock
• “Innovative instruments” limited to 15% of Tier 1Minority interest in consolidated subsidiariesLess Goodwill
• Must equal or exceed 4% of risk-weighted assets• No limit on core capital
8585
Supplementary capital (Tier 2)Supplementary capital (Tier 2)
Allowance for losses on loans and leases (general reserve only) [Limited to 1.25%]Perpetual and long-term preferred stock (original maturity 20 years or more) [No limit within Tier 2]Hybrid capital instruments (including perpetual debt and mandatory convertible securities) [No limit within Tier 2]
• In Norway maximum 15 percent, in most other European countries 20-35%, Germany 50%
• Increased to 30% and 50% in Sweden and Denmark
8686
Tier 2 capital (Continued)Tier 2 capital (Continued)Subordinated debt and intermediate-term preferred stock
• Limited to no more than 50% of Tier 1• Average maturity no more than 5 yearsRevaluation reserves (equity and building)Total of Tier 2 is limited to 100% of Tier 1 in meeting total capital requirement
8787
DeductionsDeductionsInvestments in unconsolidated banking and finance subsidiariesReciprocal holdings of bank issued capital securitiesOther deductions (such as other subsidiaries or joint ventures) as determined by supervisory authority
8888
Total capitalTotal capitalCore capital
+ Supplementary capital− Deductions
Total capital• Must equal or exceed 8% of risk-weighted
assets• Core component must equal or exceed 4%
of risk-weighted assets
8989
Total capital was evaluated relative to riskTotal capital was evaluated relative to risk--weighted assetsweighted assets
Assets (and off balance sheet positions) were sorted into 4 broad risk buckets based largely on the identity of the borrower or counter-party
Category 3: Category 3: 50 percent weight for mortgage loans50 percent weight for mortgage loans
Claims secured by first mortgages on 1-4 family residential property, that do not exceed 80% of the appraised value of the property, that are performing in accordance with the original terms and certain mortgage-backed securities representing indirect ownership of such loans.
9191
Pillar 1: Minimum capital requirements Pillar 1: Minimum capital requirements 2 approaches2 approaches
1. The Standardized Approach2. The Internal Rating-Based (IRB) Approach
• The Foundation IRB Approach (FIRB)• FIRB < The Standardized Approach
• The Advanced IRB Approach (AIRB)• AIRB<FIRB
9292
The Standardized ApproachThe Standardized ApproachRelative to the1988 Accord
• More risk buckets• Use of external credit ratings• Recognition of some credit mitigation techniques• Removal of 50% risk weight cap on derivatives• Increase to 20% credit conversion factor for
commitments under 1 yearRisk weights continue to be determined by category of borrower – sovereign, bank or corporateMuch greater complexity
9393
IRB ApproachIRB ApproachEligibility requirements
• Risk rating system that differentiates borrowers & facilities across all levels of risk
• No excessive concentrations at any level of risk• Rating assignment before commitment & reviewed by
independent source• Board & senior management must oversee all aspects of
IRB framework• Collect and store historical data on actual defaults, rating
decisions, rating histories, rating migration, info to assign ratings, PD estimates, borrower & facility characteristics
• Appropriate disclosure
9494
Two versions of IRBTwo versions of IRB
Bank estimateBCM
Bank estimateBCEAD
Bank estimateProvided by Basel Committee (BC)
LGD
Bank estimateBank estimatePD
Advanced IRBFoundation IRB
9595
Foundation IRB ApproachFoundation IRB ApproachBanks provide PD over 1 year
• Must be grounded in historical experience and empirical evidence while being “forward looking and conservative”
Supervisors provide• Loss given default (LGD)
• 45% for unsecured senior claims; 75% for subordinated claims
• Exposure at default (EAD)• 75% for irrevocable, undrawn commitments
• Remaining maturity of facility (M)• 2.5 years; 6 months for REPO style transactions
For each exposure, the risk weight is a function of PD, LGD, and M• PD quantifies borrower specific factors• LGD takes account of facility specific factors such as collateral, terms and
1. Banks must have process for assessing overall capital relative to risk profile & strategy to maintain capital
2. Supervisors should review and take action if not satisfied capital is adequate
3. Supervisors should expect banks to hold excess capital & have the power to compel them to do so
4. Supervisors should intervene at an early stage to prevent capital from falling below minimal levels and should require rapid remedial action if capital is not maintained or restored
9797
Pillar 3: Market disciplinePillar 3: Market disciplineQuantitative & qualitative disclosures in 4 key areas
1. Scope of application 2. Composition of capital3. Risk exposure assessment and management
processes4. Capital adequacy
9898
Basel II enhancements Basel II enhancements
Enhancements to help ensure that the risks inherent in banks’ portfolios related to trading activities, securitizations and exposures to off-balance sheet vehicles are better reflected in minimum capital requirements, risk management practices and accompanying disclosures to the public.
9999
Basel II enhancements (Basel II enhancements (concon’’tt.).)
The proposed changes to capital requirements cover: 1. trading book exposures, including complex and illiquid
credit products; 2. certain complex securitizations in the banking book
(e.g., so-called CDOs of ABS); and 3. exposures to off-balance sheet vehicles (i.e., asset-
backed commercial paper conduits).
100100
Basel II enhancements (Basel II enhancements (concon’’tt.).)
Proposed standards to promote more rigorous supervision and risk management of risk concentrations, off-balance sheet exposures, securitizations and related reputation risks. Proposed enhanced disclosure requirements for securitizations and sponsorship of off-balance sheet vehicles, which should provide market participants with a better understanding of an institution's overall risk profile.
101101
Countercyclical regulationCountercyclical regulation(e.g., dynamic capital and/or provisioning (e.g., dynamic capital and/or provisioning
regulations)regulations)
102102
Swiss capital regulationSwiss capital regulationIn “bad times”, large banks have to meet minimum requirements:– Risk-Weighted: 100% according to “Pillar 1”– Leverage ratio: 3% on a consolidate basis
In “good times”, large banks have to exceed higher target levels:– Risk-weighted: 200% according to “Pillar 1”– Leverage ratio: the SNB expects at least 5%
New capital requirements have to be met in 2013, if necessary introduction can be extended further.
103103
Reserve coverage ratio ofReserve coverage ratio ofall FDICall FDIC--insured institutionsinsured institutions
Sources: Quarterly Banking Profile, FDIC, Milken Institute .
0
50
100
150
200
250
2005 2006 2007 2008020406080100120140160180200
US$ billions Percent
Noncurrent loans (left axis)
Loan-loss reserves (left axis)
Coverage ratio (right axis)
104104
Liquidity regulation to take into Liquidity regulation to take into account maturity mismatches due account maturity mismatches due
to shortto short--term funding of longerterm funding of longer--term, illiquid assetsterm, illiquid assets
105105
Declining reliance on liquidity and deposits at Declining reliance on liquidity and deposits at FDICFDIC--insured institutionsinsured institutions
Modest reliance on liquidity and deposits at Modest reliance on liquidity and deposits at some U.S. financial institutionssome U.S. financial institutions
December 31, 2008December 31, 2008
Sources: Bloomberg, Milken Institute.
107107
A regulation that internalizes (taxes) a A regulation that internalizes (taxes) a financial institutionfinancial institution’’s contribution to s contribution to
““A billion here, a billion there, and pretty soon youA billion here, a billion there, and pretty soon youare talking about real money.are talking about real money.””
trillion trillion
“too big to fail”
$2.2 trillion
$1.8 trillion
$1.9 trillion
$1.3 trillion
109109
Trillion dollar banks worldwideTrillion dollar banks worldwide20082008
1.021.101.111.121.311.331.431.461.461.551.581.62
Assets(US$
trillions)
U.S. Switzerland
JapanU.S.
JapanU.S.
FranceU.K.
FranceU.K.
GermanyU.K.
Country
ChinaBank of China241.82Bank of America12SwitzerlandCredit Suisse231.89UBS11
ChinaChina Construction Bank221.93Mitsubishi10
JapanSumitomo Mitsubishi211.94Citigroup9U.S. Wells Fargo202.12Japan Post Bank8
Are specific requirements for the extent or nature of
the audit spelled out?
Is it required by the regulators that bank
audits be publicly disclosed?
Are auditing practices for banks in accordance
with international auditing standards?
Is an external audit a compulsory obligation
for banks?
116116
Consider establishing greater coConsider establishing greater co--operation among regulators in operation among regulators in
countries or establish centralized countries or establish centralized supervision or deposit insurer in some supervision or deposit insurer in some
regionsregions
117117
Globalization of big banksGlobalization of big banks
7775641,46576Banco Santander, Spain
n/an/an/a1,310112Wells Fargo, United States
n/a25622,175118JPMorgan Chase, United Statesn/a121,107128China Construction Bank Corporation, China
Dec. 31, 2008Market
Capitalization(US$ Billions)
Total Assets (US$
Billions)
Assets Outside Home
Country (%)
Income Outside Home
Country (%)
Staff Outside Home
Country (%)
Industrial and Commercial Bank of China, China 174 1,430 3 3 0.6
HSBC Holdings, United Kingdom 117 2,528 55 70 65
Bank of China, China 98 1,019 4 3 9
Bank of America, United States 71 1,818 n/a n/a n/a
Mitsubishi UFJ Financial, Japan 70 2,000 23 19 27Citigroup, United States 37 1,938 38 43 54
118118
0
15
30
45
60
75
Austri
aSwitz
erlan
dBelg
iumNeth
erlan
dsSwed
en
Spain
U.K.
Irelan
dPor
tugal
France
German
y
Italy
U.S.
Latin AmericaDeveloping EuropeAsia & Pacific
Bank lending to emerging economies as % of each country's GDP
Banking exposure to emerging marketsBanking exposure to emerging markets20082008
11911911 Percent11 Percent 80 Percent80 Percent
ForeignForeign--Owned BanksOwned Banks’’ Share Share of Total Bank Assetsof Total Bank Assets
120120
80 76
56 54 534940 39
2221 20 1615 11 9 8 7 7 7 6 4 3 20
102030405060708090
Mexico
Uganda
South Korea
U.K
.TanzaniaG
hanaIndonesiaK
enyaEgyptM
alaysiaB
razilFranceA
ustraliaItalyU
.S.R
ussiaC
anadaIndiaG
ermany
JapanThailandN
igeriaC
hinaPercent Foreign ownership of banksForeign ownership of banks
121121
Percent of commercial banking assets and liabilities Percent of commercial banking assets and liabilities that are foreign currencythat are foreign currency--denominateddenominated
56
35 34 3228 27
24 2320 18 16
11 10 9 8 7 6 4
38 3631
3331
24 2421
17 16
511 9
410 9
3
56
0
10
20
30
40
50
60
U.K
.
Canada
Tanzania
Egypt
Russia
Uganda
Ghana
France
Indonesia
Mexico
Kenya
ThailandB
razil
South Korea
Nigeria
Italy
Malaysia
Australia
U.S.
India
Germ
any
Japan
China
Assets Liabilities
Percent
n/a n/a n/a n/an/a
122122
Size and composition of financial Size and composition of financial systems may dictate a different systems may dictate a different
regulatory regime and focusregulatory regime and focus
123123
Comparative information on population, GDP, size and Comparative information on population, GDP, size and composition of the financial sector: 2007composition of the financial sector: 2007
ManagementDevelopmentInvestmentSellingUnderwritingMutual FundsDealing and BrokeringUnderwriting
What kinds of real estate activities can banks engage in (other than real estate in which banking operations
are conducted or resulting from foreclosure on loans)?
What kinds of insurance activities can banks engage in?What kinds of securities activities can bank engage in?
128128
Should supervision be on the basis of separate Should supervision be on the basis of separate industries or products/services?industries or products/services?
129129
1980, Total = $4.7 Trillion
ABS pools<1%
Hedge funds<1%
Other4%
Insurers14%
GSEs7%
Broker-dealers
6%
Pension funds17% Mutual funds
3%
Depositories49%
Wide diversity in types of Wide diversity in types of U.S. financial services firms U.S. financial services firms
2008, Total = $57.5 Trillion
Depositories27%
Mutual funds16%
Pension funds14%
GSEs6%
Broker-dealers
4%
Insurers10%
ABS pools16%
Hedge funds
3%
Other4%
130130
Financial services firms compete by offering Financial services firms compete by offering equivalent productsequivalent products
Banking vs. InsuranceBanking vs. InsuranceTime deposits vs. fixed annuitiesTime deposits vs. fixed annuitiesLetters of credit vs. surety bondsLetters of credit vs. surety bonds
Securities vs. BankingSecurities vs. BankingMoney market funds vs. demand depositsMoney market funds vs. demand depositsMediumMedium--term notes and commercial paper vs. term notes and commercial paper vs. commercial loanscommercial loans
Insurance vs. SecuritiesInsurance vs. SecuritiesVariable annuities vs. equity mutual fundsVariable annuities vs. equity mutual fundsReinsurance vs. catastrophe bondsReinsurance vs. catastrophe bonds
131131
Entry into banking requirementsEntry into banking requirements
Does the Banking Law establish predetermined levels of
solvency (capital or net worth) deterioration which forces
automatic actions (like intervention)?
Can the supervisory agency order the bank's directors or
management to constitute provisions to cover actual or
potential losses?
Are bank regulators/supervisors required to make public formal
enforcement actions, which include cease and desist orders
and written agreements between a bank regulatory/supervisory body
and a banking organization?
Are there any mechanisms of cease and desist type orders, whose infraction leads to the automatic imposition of civil and penal sanctions on the
banks directors and managers?
135135
Deposit Deposit insuranceinsurance
136136
Do Countries Have Explicit Do Countries Have Explicit Deposit Insurance Schemes?Deposit Insurance Schemes?
Yes49%No
51% Yes54%
No44%
Not Available2%
Survey III143 CountriesSurvey II
152 Countries
Countries recently adopting deposit insurance: Armenia, Hong Kong, Malaysia, Moldova, Russia, Singapore, Tajikistan, Uruguay, and Zimbabwe
137137
Government ownership of banksGovernment ownership of banks
138138
GovernmentGovernment--Owned BanksOwned Banks’’ Share of Total Bank Share of Total Bank AssetsAssets
74 Percent 69 Percent
139139
Government ownership of banksGovernment ownership of banks74
69 67
4540 39 38
21 21 19 159
4 0 0 0 0 0 0 00
1020304050607080
IndiaC
hinaEgyptB
razilG
ermany
Russia
IndonesiaTanzaniaG
hanaSouth K
oreaThailandItalyN
igeriaFranceA
ustraliaC
anadaU
.S.K
enyaU
gandaM
alaysiaJapanM
exicoU
.K.
Percent
n/a n/a n/a
140140
Case StudyCase StudyWhat Works Best for Banks?What Works Best for Banks?
Rethinking Bank Regulation: Till Angels Govern, Rethinking Bank Regulation: Till Angels Govern, coco--authored with authored with Gerard Gerard CaprioCaprio and Ross Levine, Cambridge University Press, 2006.and Ross Levine, Cambridge University Press, 2006.
What best promotes:What best promotes:Bank developmentBank developmentEfficiencyEfficiencyIntegrityIntegrityStabilityStabilityBank governance?Bank governance?
141141
Measuring Measuring ““What Works BestWhat Works Best””(Illustrative Proxies)(Illustrative Proxies)
Bank developmentBank developmentEfficiencyEfficiency
Net interest marginsNet interest marginsOverhead costsOverhead costsValuation of banksValuation of banks
Integrity of loans (corruption in lending)Integrity of loans (corruption in lending)Fragility (Systemic crises)Fragility (Systemic crises)
142142
Findings So Far ...Findings So Far ...
Until angels govern, the data suggest Until angels govern, the data suggest ……Avoid relying only on official oversight, restrictions etc. Avoid relying only on official oversight, restrictions etc. Emphasize private monitoring / incentivesEmphasize private monitoring / incentivesStress Basel Stress Basel IIII’’ss third pillar (not capital / official oversight)third pillar (not capital / official oversight)Increases in deposit insurance generosity increase moral Increases in deposit insurance generosity increase moral hazard and thereby increase fragilityhazard and thereby increase fragility
Supervisors have crucial roleSupervisors have crucial roleSupport market discipline, not supplant itSupport market discipline, not supplant itFoster / force information disclosureFoster / force information disclosure
143143
How Do Countries Choose?How Do Countries Choose?““Best practicesBest practices”” depend on political system.depend on political system.
Open, competitive, democratic institutions:Open, competitive, democratic institutions:Foster private monitoring, transparency.Foster private monitoring, transparency.Are less likely to limit bank entry, activities.Are less likely to limit bank entry, activities.Are less likely to have state banks.Are less likely to have state banks.
Closed, uncompetitive, autocratic institutions:Closed, uncompetitive, autocratic institutions:Do NOT favor transparency.Do NOT favor transparency.Limit bank entry, activities.Limit bank entry, activities.Tend to have state banks.Tend to have state banks.
