Financial sector reform: how far are we?

• Author: Fischer, Stanley
• Position: The 2014 Martin Feldstein Lecture

Although the recession in the United States that started in December 2007 ended in June 2009, the impact of the Great Recession, which began when Lehman Brothers filed for bankruptcy on September 15, 2008, continues to be felt in the United States, Europe, and around the world. (1) After the bankruptcy of Lehman Brothers, policymakers, working through the G-20, quickly reached agreement on the macroeconomic policies needed to minimize the damage done by the crisis. For their part, central bankers and supervisors of financial systems, working through the newly established Financial Stability Board (FSB) and the newly enlarged Basel Committee, rapidly developed a program for reform of the financial sector and its supervision.

In this lecture I will ask how much has been achieved so far in implementing the ambitious financial sector reform program that was widely agreed at the early stages of the global financial crisis. From among the range of topics in which financial sector reforms have been instituted since 2008, I focus on three: capital and liquidity for banks and other financial institutions, macroprudential supervision, and the problem of too big to fail (TBTF).

What Happened?

The 2007-09 crisis was both the worst economic crisis and the worst financial crisis since the 1930s. Following the collapse of Lehman Brothers, many thought that we were about to witness a second Great Depression. That did not happen, in large part because policymakers had learned some of the lessons of the Great Depression. Nonetheless, the advanced economies were put through severe economic and political tests. Fortunately, policymakers succeeded in dealing with the situation better than many had feared they would; unfortunately, we are still dealing with the consequences of the collapse and the steps necessary to deal with it.

Former Congressman Barney Frank has been heard to say that economists have a wonderful technique, that of the counterfactual, to analyze what has been achieved by preventing disasters, but that real people base their judgments more on the current state of the world than on disasters that have not happened. True as that may be, we should from time to time allow ourselves to recognize that as bad as the Great Recession has been, it would have been much worse had policymakers not undertaken the policies they did--many of them unorthodox and previously untried--to deal with the imminent crisis that confronted the United States and global economies after the fall of Lehman Brothers. And for that, we owe them our gratitude and our thanks.

The Financial Sector Reform Program

Several financial sector reform programs were prepared within a few months after the Lehman Brothers failure. These programs were supported by national policymakers, including the community of bank supervisors.

The programs--national and international--covered some or all of the following nine areas: (2) (1) to strengthen the stability and robustness of financial firms, "with particular emphasis on standards for governance, risk management, capital and liquidity"; (3) (2) to strengthen the quality and effectiveness of prudential regulation and supervision; (3) to build the capacity for undertaking effective macroprudential regulation and supervision; (4) to develop suitable resolution regimes for financial institutions; (5) to strengthen the infrastructure of financial markets, including markets for derivative transactions; (6) to improve compensation practices in financial institutions; (7) to strengthen international coordination of regulation and supervision, particularly with regard to the regulation and resolution of global systemically important financial institutions, later known as G-SIFIs; (8) to find appropriate ways of dealing with the shadow banking system; and (9) to improve the performance of credit rating agencies, which were deeply involved in the collapse of markets for collateralized and securitized lending instruments, especially those based on mortgage finance.

Rather than seek to give a scorecard on progress on all the aspects of the reform programs suggested from 2007 to 2009, I want to focus on three topics of particular salience mentioned earlier: capital and liquidity, macroprudential supervision, and too big to fail.

Capital and Liquidity Ratios

At one level, the story on capital and liquidity ratios is very simple: From the viewpoint of the stability of the financial system, more of each is better.

This is the principle that lies behind the vigorous campaign waged by Anat Admati and Martin Hellwig to increase bank capital ratios, set out in their book, The Bankers New Clothes: What's Wrong with Banking and What to Do about It, and in subsequent publications. (4)

But at what level should capital and liquidity ratios be set? In practice, the base from which countries work is agreement among the regulators and supervisors who belong to the Basel Committee on Banking Supervision (BCBS). At one time the membership consisted of the members of the G-10 plus Switzerland. It now includes the membership of the G-20 plus a few other countries. (5)

Following the global crisis, the BCBS moved to the Basel III agreement, which strengthens capital requirements, as opposed to Basel II, which tried to build primarily on measures of risk capital set by internal models developed by each individual bank. This approach did not work, partly because the agreed regulatory minimum capital ratios were too low, but also because any set of risk weights involves judgments, and human nature would rarely result in choices that made for higher risk weights. In the United States, the new regulations require large bank holding companies (BHCs) to use risk-weighted assets (RWAs) that are the greater of those produced by firms' internal models or the standardized risk weights, some of which have been raised, thus mitigating the problem of the use of internal risk ratings.

What has been achieved? Globally:

* The minimum tier 1 capital ratio has been raised from 4 percent to 6 percent of KWA.

* There is a minimum common equity tier 1 capital ratio of 4.5 percent of RWA.

* There is a capital conservation buffer of 2.5 percent of RWA, to ensure that banking organizations build capital when they are able to.

* A countercyclical capital buffer has been created that enables regulators to raise risk-based capital requirements when credit growth is judged to be excessive.

* A minimum international leverage ratio of 3 percent has been set for tier 1 capital relative to total (i.e., not risk-weighted) on-balance-sheet assets and off-balance-sheet exposures.

* There is a risk-based capital surcharge for global systemically important banks (G-SIBs) based on these firms' systemic risk.

In addition, in the United States:

* The Federal Reserve is planning to propose risk-based capital surcharges for U.S. G-SIBs, based on the BCBS proposal for G-SIBs. (6)

* The relevant U.S. regulators (the Fed, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation (FDIC)) have raised the Basel III leverage ratio for U.S. G-SIBs to 5 percent; U.S. G-SIBs that do not achieve this ratio will face limits on their ability to distribute dividends and to pay discretionary employee bonuses."

* Foreign banking organizations with U.S. nonbranch assets of $50 billion or more will have to form U.S. intermediate holding companies that will have to meet essentially the same capital requirements as U.S. BFFCs with $50 billion or more of assets.

* Many of these rules do not apply to community banks, in light of their different business models.

One more point on bank capital: The Swiss and Swedish regulators have already gone far in raising capital requirements, including by requiring bail-in-able secondary holdings of capital in the form of contingent convertible capital obligations (CoCos). The United States may be heading in a similar direction, but not by using CoCos, rather by requiring minimum amounts of "gone-concern" loss absorbency--in the form of long-term debt--that would be available for internal financing recapitalization through a new orderly liquidation mechanism created by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).

In addition to enhanced capital ratios and tougher measures of risk-based capital, the Basel III accord includes bank liquidity rules, another key element of global financial regulatory reform. The Basel Committee has agreed on the Liquidity Coverage Ratio (LCR), which is designed to reduce the probability of a firm's liquidity insolvency over a 30-day horizon through a self-insurance regime of high-quality liquid assets (HQLA) to meet short-term stressed funding needs. The BCBS is also working to finalize the Net Stable Funding Ratio (NSFR), which helps to ensure a stable funding profile over a one-year horizon.

The bottom line to date: The...