Regulation from a European perspective

Stephen Kinsella & Vincent O'SullivanUL

Apologies for the Acronym Soup.

“Personal autonomy is the work of our imagination, not the way we live. Yet we have been thrown into a time in which everything is provisional. New technologies alter our lives daily. The traditions of the past cannot be retrieved.

At the same time we have little idea of what the future will bring. We are forced to live as if we were free.

The cult of choice reflects the fact that we must improvise our lives. That we cannot do otherwise is a mark of our unfreedom. Choice has become a fetish; but the mark of a fetish is that it is unchosen.”

––John Gray, Straw Dogs pp 109-110, emphasis my own.

Work building on

• O'Sullivan & Kinsella, 2009, 2010, 2011, 2012.

•Our project: describing and modelling the interactions between financial regulation and the balance sheets of the European Union macro economy, from 1980 and 2012

• Proposing alternative risk management mechanisms with respect to the Irish case, but generalizable to EU situation.

What caused the Irish banking crisis?KPVO’Sullivan et al (2010); Journal of Financial Regulation and Compliance

Vincent’s paper on the Irish banking crisis was the Outstanding Paper Award Winner at the Literati Network Awards for Excellence 2011. The paper explores the Irish banking crisis and explains how various factors contributed to a collapse in asset prices and an economic recession. The paper seeks to document the dangers of pro-cyclical monetary and government policies, particularly in an environment of benign financial regulation and pent-up demand for credit.

Link to publication

This paper describes the EU recapitalisation proposals which were announced as part its road map to stability and growth on 12 October 2011. The plans are calling for ‘significantly’ higher capital reserves to help  banks  replenish their balance sheets to withstand market turmoil amid the eurozone’s sovereign debt crisis.  The papers details how extra capital requirements may result in significant restructuring across European banks given the high costs of raising capital.

An architecture for meta-risk regulation in banking

KPV O’Sullivan and S. Kinsella (Ed.) (2011); Journal of Banking Regulaton

Link to publication

Is Ireland really the role model for austerity?

Stephen Kinsella (2011); Publishers: Cambridge Journal of EconomicsStephen’s paper describes the causes and consequences of Ireland’s economic crisis in the context of the policy solution implemented to contain that crisis: protracted fiscal austerity. The paper describes the causes of the recent crisis in Ireland, and looks at the logic of austerity within a simple model. It discusses the measures implemented to date in the current crisis, tracing their effects and, asks whether Ireland is, indeed, the role model for fiscal austerity in the Eurozone.

Link to publication

This lead article describes the EU recapitalisation proposals which were announced as part of the road map to stability and growth on 12 October 2011. The plans call for ‘significantly’ higher capital reserves to help  banks  replenish their balance sheets to withstand market turmoil amid the eurozone sovereign debt crisis.  The papers details how extra capital requirements may result in significant restructuring across European banks given the high costs of raising capital.

Recapitalising European banksKPV O’Sullivan and S. Kinsella (Ed.) (2011); Financial Regulation International

Link to publication

This paper looks at complexity and uncertainty associated with the Capital Requirements Directive (CRD) IV regime in Europe. It investigates current debates around giving member states additional discretion in applying further requirements than proposals, particularly as it pertains to macroprudential supervision. It examines current technical standards associated with own funds which have been released by the European Banking Authority and looks at the whole question of bail-in funds.

Regulatory Complexity and Uncertainty: CRD IVKPV O’Sullivan and S. Kinsella (in press); Harvard Law Forum

Link to publication

Supervision of banking system in IrelandKPV O’Sullivan et al (2008); Publishers: Cesifo Group

Vincent’s article looks at financial supervision in Ireland and the likely knock-on impact that the US subprime crisis could have on the Irish financial system. It demonstrates that a benign financial regulator allowed Irish banks to lend imprudently during the domestic property boom and are now heavily leveraged and expose to fluctuations in property prices. The paper shows that Irish banks exposure to US subprime mortgages (either directly or through securitization) was minimal.

Link to publication

UK Regulatory ReformKPV O’Sullivan with PwC; Compliance Officer Bulletin

PwC’s FS Regulatory Centre of Excellence wrote the entire April 2012 edition of the Compliance Officer Bulletin. Vincent wrote an article on the new European financial institutional architecture – in particular the establishment of the European Supervisory Authorities and the movement towards a single rule book for financial regulation in Europe. Vincent also wrote a piece on macroprudential supervision and the current difficulties in developing models to capture the propagation of systemic risk.

Link to publication

This editorial examines global efforts to regulate the shadow banking system, in particular the green paper released by the European Commission in March 2012. It suggests that the financial market landscape in Europe is currently in flux and large swings in market activity — either through financial innovation, changing market preferences or regulatory arbitrage — may unravel the work done by regulators in shoring up their financial systems.

Europe prepares to regulate shadow banksKPV O’Sullivan and S. Kinsella (Ed.) (2012); Journal of Banking Regulaton

Link to publication

What causes banking crises?S. Kinsella (in press) What causes banking crises?’ Research Int. Biz and Fin.

Selected work

Link to publication

• O’Sullivan, K.P.V. and Kennedy, T. (2008) ‘Supervision of the Irish Banking System: A Critical Perspective”, CESifo DICE Report (3), 22- 26.

• Kinsella, S. (2009) ‘Financial Fragility and Corporate Governance in Ireland’, in Ronan Keane and Ailbhe O’Neal, (eds), Corporate Governance and Regulation: An Irish Perspective, Dublin: Roundhall Press, 147-170.

• O’Sullivan, K.P.V. and Darragh, F. (2012) ‘A Discussion on the resilience of command and control regulation with regulatory behaviour theories,’ Journal of Governance and Regulation, 1(1), 23-45.

• Kinsella, S. and O’Sullivan, K.P.V (2012) ‘Financial and Regulatory Failure: The Case of Ireland’, Journal of Banking Regulation, advance online publication, January 18, 2012.

• Kinsella, S. (in press) ‘What causes banking crises?’ Research in International Business and Finance.

• Kinsella, S. and O’Sullivan, K.P.V. (forthcoming) “Regulatory Complexity and Uncertainty: the Capital Requirements Directive IV”, The Harvard Law Forum on Corporate Governance and Financial Regulation.

• O’Sullivan, K.P.V and Kinsella, S (2011), Recapitalising European Banks, Financial Regulation International, 14(8), 1-8 (lead article).

• O’Sullivan, K.P.V. and S. Kinsella (2012) ‘2012: the year of deleveraging in Europe?, Financial Regulation International’, 15.1, pp 1-6 (lead article).

• O’Sullivan, K.P.V. and S. Kinsella (2012) EC examines structural policy in banking, Financial Regulation International 15(3), pp 1-5 (lead article).

• O’Sullivan, K.P.V. (2012) Concern mounts over ESMA's workload 15(3), pp 4-9.

• O’Sullivan, K.P.V and Kinsella, S (2012), ‘Regulating Financial Market Infrastructures, 15(4), 1-8 (lead article).

Other regulatory/macro research

Why is this topic important?

• Pace of regulatory reform has been feverish since the financial crisis in Europe

• Higher capital requirements for banks (CRD III)

• Regulating Credit Rating Agencies (CRA I, II)

• Further transparency and disclosure requirements (Regulators: we need more and higher quality data!) (COREPS)

• Recovery and resolution plans

• New governance and internal controls requirements (remuneration)

What about regulators?

• New pan-European regulators across all financial sectors:ØEuropean Banking Authority (based in London)ØEuropean Securities and Markets Authority (based in Paris)ØEuropean Insurance and Occupational Pensions Authority (based in

Frankfurt)

• New EU macroprudential regulator, the European Systemic Risk Board

• Push towards a ‘single rule’ book for financial regulation across the EU to help promote the single market

• New ‘intrusive’ and ‘judgements’ based supervisory philosophy (out with the ‘principles-based’, ‘risk-based’ failed regime)

Lots more to come

KeyRRPs: Recovery and Resolution PlansD-F: Dodd–Frank Wall Street Reform and Consumer Protection ActRDR: Retail Distribution ReviewCOREPS: Common Reporting EMIR: European Market Infrastructure RegulationAIFMD: Alternative Investment Fund Managers DirectiveFICOD: Financial Conglomerates DirectiveCRD/R: Capital Requirements Directive/RegulationMAD/R: Markets Abuse Directive/ RegulationPRIPS: Packaged Retail Investment ProductsIORP: Institutions for occupational retirement provisionMiFID/R: Markets in Financial Institutions Directive/RegulationCRA: Credit Rating AgenciesUCITS: Undertakings for Collective Investment in Transferable Securities

A need for further research

• The regulatory agenda in Europe has lacked rigorous macroeconomic analysis (cost-benefit analysis accompanying regulations is not adequate in the presence of so much institutional uncertainty, see OECD, 2012).

Practical implications

• This lack of analysis could be an obstacle preventing authorities pushing forward needed reforms in the face of mounting opposition.

• We are already seeing significant pull-(and push-) back from Øregulators (who have insufficient resources)Øfirms (concerned about additional costs-particularly in raising

high quality capital)Øinvestors (facing lower returns on equity)Øindustrial organisations (worried about a fall-off in lending to

the economy)Øgeneral public (frustrated by the slow pace of changes)

What is regulation? Recognition that banking is unstable, important to impose rules to constrain

risky behavior

Specifically:

1. Capital adequacy ratios (Basel I, II, III). Now Min. 8% of Risk weighted assets.

Tier 1 Capital Equity capital, highly sub. Bonds

Other sub. Bonds

2. Valuation issues abound. Concept of VaR during crises

Our theoretical frame

• Kindleberger/Minsky/Koo (not Eggerston/Krugman), See Kinsella 2009.

• Credit creates its own reversal, essentially. Regulation is necessary to attenuate scale of the crisis.

• In the absence of effective monetary/fiscal policy, regulation is the third best solution, but actually given where we are, is the most likely route to successful reform.

• However, remember John Gray: regulation, like choice can become a fetish. We must be aware of its limitations.

Defining Regulation more carefully Standard Definition: an effort exerted by an authoritative agency to

change the behaviour of economic agents to a certain, pre-defined condition.

Effort-some element of standard setting, information gathering and monitoring.

Changing behaviour- the purpose regulation is usually to influence individual and firm-level behavioural patterns

Authoritative agency- recognises the growing importance of non-state institutions as regulators.

Economic agents- reflects regulation as fundamentally a politico-economic concept which can be best understood in relation to economic or legal organisation.

Why Regulate?1. Market Failure (Public choice theories)

1. Externalities Monopoly / oligopoly

2. Information failure

3. Principal/agent problem – Information failures

2. Economic Theory (Private Choice Theories): “regulation is acquired by certain interests who design and operate it for their own benefit” (Stigler 19710)

3. Institutional theory: Organisations create regulations and regulate new areas to establish legitimacy, expand their budgets and, ultimately, survive.

Why has regulation become important?

Growth of the ‘risk society’ (Scott2000),where governments are increasingly responsible for regulating risk.

Privatization of semi-state firms during the Reagan/Thatcher administrations.

Propagation of the “regulatory state”, big government and the European Union (Majone 1994).

Industrial and financial failures(e.g. Collapse of Enron resulted in the Sarbanes-Oxley Act).

Balance sheet damage

Complexity

Coordination

Fiscal constraints

Perfect storm

Contagion

Current Balance Sheet View:

Taylor, 2010, pg. 135

Macroeconomics: It's all b/s

HouseholdsHouseholds FirmsFirms GovernmentGovernment Central BankCentral Bank

AssetsMoneyBondsEquityHousing

LiabilitiesMortgagesNet Worth

Assets Capital

Liabilities LoansBondsEquityNet Worth

Assets “Faith & Credit”

Liabilities Bonds

AssetsBondsReserves (Int’l)

Liabilities Bank Reserves

Commercial BanksCommercial Banks SPVsSPVs Leveraged FinanceLeveraged Finance Rest of WorldRest of World

Assets LoansMortgagesBank Reserves

Liabilities MoneyEquity

Assets MortgagesNAMA’d stuff

Liabilities CDOs

Assets CDOsRepos

Liabilities LoansReposEquity

Assets Liabilities Int’l Reserves (net worth

Taylor, 2010, pg. 135

Macroeconomics: It's all b/s

Fiscal Issues

Imbalances

Balance sheet damage

Complexity

Coordination

Fiscal constraints

Perfect storm

Contagion

Concentration & Complexity are features of modern banking.

P. Gai, A. Haldane, S. Kapadia, Complexity, Concentration and Contagion, Journal of Monetary Economics 58(2), 2011

• Coordination as patchwork recognized back in1996 as a potential disaster wrt regulatory arbitrage.

• Supervisory authorities on top of national regulators include AFME, AIMA, EACH, EBF, FOA, ICMA & ISDA.

• One rule book approach still developing

• No solution to ‘financial innovation’ just yet.

See Adrienne Heritor The accommodation of diversity in European policy-making and its outcomes: Regulatory policy as a patchwork, Journal of European Public PolicyVolume 3, Issue 2, 1996.

Concentration & Complexity are features of modern banking.

• Complexity of rules ensure heterogenous implementation & are inimical to coordination.

Andrew Haldane, Executive Director, Financial Stability, Bank of England, Capital Discipline, speech at the American Economic Association, Denver (Jan. 9, 2011) at http://www.bankofengland.co.uk/publications/speeches/2011/speech484.pdf

Concentration & Complexity are features of modern banking.

Haldane, 2011:

“As a thought experiment, imagine instead we were designing a regulatory framework from scratch. Finance is a classic complex, adaptive system. What properties would a complex, adaptive system such as finance ideally exhibit to best insure about future crises? Simplicity is one. There is a key lesson, here, from the literature on complex systems. Faced with complexity, the temptation is to seek complex control devices. In fact, complex systems typically call for simple control rules. To do otherwise simply compounds system complexity with control complexity.”

Andrew Haldane, Executive Director, Financial Stability, Bank of England, Capital Discipline, speech at the American Economic Association, Denver (Jan. 9, 2011) at http://www.bankofengland.co.uk/publications/speeches/2011/speech484.pdf

• ESMA’s regulation of Credit Rating Agencies required the following:

• ESMA, Consultation Paper - Regulatory Technical Standards on the Information to Be Provided to ESMA by a Credit Rating Agency in its Application for Registration and Certification and for the Assessment of its Systemic Importance, ESMA/2011/302 (Sep. 19, 2011); ESMA, Consultation Paper - Regulatory Technical Standards on the Assessment of Compliance of Credit Rating Methodologies with the Requirements Set out in Article 8(3) of Regulation (EC) No 1060/2009, ESMA/2011/303 (Sep. 19, 2011); ESMA, Consultation Paper - ESMA’s Draft Regulatory Technical Standards on the Presentation of the Information That Credit Rating Agencies Shall Disclose in Accordance with Article 11(2) and Point 1 of Part II of Section E of Annex I to Regulation (EC) No 1060/2, ESMA/2011/304 (Sep. 19, 2011); ESMA, Consultation Paper - ESMA’s Draft Regulatory Technical Standards on the Content and Format of Ratings Data Periodic Reporting to Be Submitted from Credit Rating Agencies, ESMA/2011/305 (Sep. 19, 2011)

Example

Balance sheet damage

Complexity

Coordination

Fiscal constraints

Perfect storm

Contagion

Historical context

• All of this has happened before. It will happen again. Regulation is not the solution to attenuating the Minsky cycle, but part of it.

Schularick, Jorda, and Taylor, 2011

Digression on the Irish Crisis

All of the preceding data taken from regulator/CBI

“History repeats itself…

• ….. in financial matters because of a kind of sophisticated stupidity.”

• “Financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind.”

• “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable form.”

• “It [the collapse of 1837] introduced a distinctly modern attitude toward the loans that were outstanding...Anger was expressed that foreign banks and investors should now, in hard times, ask for payment of debts so foolishly granted and incurred. A point must be repeated: only the pathological weakness of the financial memory...allows us to believe that the modern experience of Third World debt...is in any way a new phenomenon.”

Galbraith 1993

Banking crises hits growth

Source: Richmond Fed, Nov 2011

Not that different from the past

Distance in years from first year of crisis Source: Citi Investment research Dec 2011 & IMF. * shortfall is compared to average for countries with systemic banking crises, 1980 –

2011)

Debt.

ECB: carry that load

Source: ECB

Flow of funds in the eurozone

Households Financial corporations

HouseholdsRest of World

Source: ECB, ICFR calculations

Deleveraging the Eurozone. VoxEU, 17 December 2011. (With KPV O’Sullivan)

Deleverage? Credit growth/decay

See Handout.

Current Challenges

• Crisis is evolving, today's solution is not tomorrow's.

• Low high-quality information environment.

• Banks are not passive actors, regulation does not help them.

• Balance is not something to strive for in this space.

Our ‘SADLIR’ Financial Regulatory Cycle

New Issue(s)

• How long can monetary and fiscal policy support banks?

• Raising capital

• Profitability

• Shadow banking. Huge issue, see O’Sullivan & Kinsella (2012)

• Macroprudential supervision: who, how and why?

• What about ‘good regulation’ principles? Are there any?

Core tier 1 capital of G-SIFIs

9% target set by the EU Leaders by July 2012

*= Global systemically important financial institutions as per IMF's (Nov. 2011) list: http://www.financialstabilityboard.org/publications/r_111104bb.pdf, excluding Banque Populaire which is not listed. Data sourced from Thomson Reuters.

Loan assets of financial institutionsBase Jan

2008=100

Deleveraging starting to bite in Europe

(net % of banks contributing to tighter lending standards, euro area)

Source: ECB bank lending survey January 2012, q1 2010-q4 21011

The Future?

Meta-risk regulation: Trades off Micro vs Macro stability.

Three Mile Island crisis in 1979.

Move from just inspecting compliance of rules to evaluating risk management systems.

Seeking to establish if senior managers have the “risk analysis intelligence” to deal with unforeseen events.

Regulator needs to establish institutional structures to support a more towards MMR

Connecting MMR into a macroeconomic framework is the next step