(p. ix) Preface to Paperback Edition
(p. ix) Preface to Paperback Edition
We started commissioning chapters for the Oxford Handbook in Banking in early 2007. At that time, we did not know that the world economy would soon be embroiled in a global financial crisis. As the crisis was in full force toward the end of 2008, we realized that many of the chapters that were being written for the Handbook would soon become outdated. We reached out to the contributing authors and they agreed to update, augment, and change the orientation of their respective chapters to reflect events. The result we believe is an up-to-date look at a broad range of research in banking that will help both the beginner and experienced researcher attain a breadth of knowledge, and use this as a base for understanding key events such as the recent financial crisis.
Global banking and financial markets do not stand still. Many countries are still suffering the effects of the crisis. There were signs of recovery during 2009 (evidenced by gains in equity markets). This trend, however, has stalled with the onset of the sovereign debt crisis that befell various European economies (particularly Greece, Ireland, Portugal, and Spain) during 2010. Government debt and deficits led to a crisis of confidence that resulted in widening bond yield spreads and risk insurance on credit default swaps between these countries and other EU members, most notably Germany. In May 2010, the Eurozone countries and the International Monetary Fund agreed to a €110 billion loan for Greece, conditional on the implementation of tough austerity measures. Later in May, Europe's Finance Ministers established the European Financial Stability Facility (comprising of a broad rescue package amounting to $1 trillion) aimed at ensuring financial stability across the Eurozone. After the Greek bailout, Ireland had to be supported to the tune of €85 billion in November 2010, followed by a €78 billion support program for Portugal in May 2011. This helped many European banks (particularly in Germany and France) that are large holders of sovereign debt although in the majority of countries large banks still have had to raise massive amounts of new capital and are continuing to struggle to achieve returns in excess of the cost of capital. The collapse and reorganization of the Spanish savings bank sector, coupled with the continuing decline in property prices, makes Spain another potential candidate for a bailout at the time of writing (June 2011). Banks in Europe and many other jurisdictions have become increasingly conservative, raising capital, restricting lending, and boosting their liquidity positions. The large, (p. x) internationally active banks in Europe are also subject to increased capital and liquidity requirements under Basel III.
In the US over the last two years, there has been some improvement in the condition of the banking sector. According to the Federal Deposit Insurance Corporation (FDIC), this has been most pronounced among large banks. The industry reported earnings of $21.6 billion in the second quarter of 2010 (compared to a $4 billion loss in the corresponding quarter of 2009). Nevertheless, small banks, particularly those with large exposures to commercial real estate, are continuing to fail at high rates and many are on the FDIC problem bank list. Like their counterparts in Europe, the biggest banks have pursued capital raising activities. The nineteen largest US banks raised approximately $205 billion of private capital, and redeemed $220 billion of preferred shares issued under the Treasury's Capital Assistance Program. Pressure to continue capital-raising and liquidity strengthening on these large institutions is likely to be ongoing given the new international capital requirements embodied in Basel III. In addition to this, US banking organizations with over $50 billion in assets are considered to systemically important under the Dodd-Frank law (see below) and may be subject to additional capital requirements by the Federal Reserve. Clearly, the US banking system has not yet fully recovered from the crisis. Both Standard & Poor's (S&P) and Moody's credit rating agencies have cautioned against overestimating the recovery in profitability, since a large part of improved performance has come from a slowing in loan-loss provisioning that may prove to be premature. IMF stress tests on fifty-three bank holding companies in July 2010 suggested that a modest downturn in the macroeconomy would make a third of these undercapitalized, forcing them to have to raise $22 billion just to reach regulatory minimums.
Governments in many countries are also striving to recoup taxpayers' money used to save their respective banking systems during the financial crisis. There is consensus that the domestic and international regulatory frameworks put in place to protect depositors, investors, and financial systems prior to the recent crisis were wholly inadequate. Incentives were misaligned, encouraging individuals and institutions to take on excessive risk without proper regard to the consequences. With the onset of the crisis, policy action was fast and effective, and a meltdown in banking and financial systems around the world was prevented. A common feature of the banks that went bust was that they relied on market liquidity (via wholesale funding) rather than more traditional and stable retail and corporate deposits. Banks that engaged in mortgage-backed securities suffered most. Risks were mispriced by banks, credit rating agencies, and investors.
Since mid-2007, the scale of government-backed bank bailouts, recapitalization plans, liquidity injections, and credit guarantee schemes raises extreme concerns about the current business models pursued by banks in many parts of the developed world. Large-scale banking rescues have raised serious concerns about the social and economic costs of ‘Too-Big-To-Fail’ (TBTF). In some cases, bailed-out (p. xi) banks were not particularly large, but nevertheless were of systemic importance (via the connectivity to other institutions within the financial system). An important question for policymakers is whether limits should be placed on bank size, growth or concentration, to minimize the moral hazard concerns raised by banks having achieved TBTF status.
Clearly, governments and their respective regulators have moved rapidly to close the gaps and weaknesses in the system for bank regulation and supervision. The passing of the US Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010, the biggest financial reform in the US since the Great Depression, is a good reflection of this trend. Key features of the legislation are as follows:
• Establishing a Financial Stability Oversight Council (FSOC) to identify and address systemic risks posed by large, complex companies, products, and activities before they threaten the stability of the economy. (Board membership comprises ten financial regulators, an independent member and five non-voting members—the Council is chaired by the Treasury Secretary.) Key responsibilities of the Council are to recommend tougher capital, liquidity, and risk management when banks get ‘too big’. By 2/3 vote the Council can require systemically important financial intermediaries (banks and non-banks) to be regulated by the Federal Reserve. (It is anticipated that around thirty-five systemically important institutions will be Fed-regulated, including all banking organizations with over $50 billion in assets.) Also (again based on a 2/3 vote) the Federal Reserve can breakup complex financial intermediaries that impose ‘grave’ systemic threats to the system. Finally, a broad overall goal remit of the Council is to monitor risk in the financial system.
• Ending ‘Too-Big-Too-Fail’. The Act clearly states that ‘taxpayers will not be on the hook’ and the FDIC is prohibited from losing money on systemically important financial intermediaries. The so-called Volcker Rule is to be introduced that prohibits banks from proprietary trading and limits investments in hedge funds/private equity fund sponsorship to 3 percent of capital. Systemically important institutions will have to provide ‘living wills’ (their plans for rapid and orderly shutdown in case of bankruptcy). The Act also creates orderly liquidation mechanisms for the FDIC to unwind failing systemically significant companies.
• Creating the Consumer Financial Protection Bureau, a new independent watchdog, housed at the Federal Reserve, with the authority to ensure American consumers get the clear, accurate information they need to shop for mortgages, credit cards, and other financial products, and protect them from hidden fees, abusive terms, and deceptive practices. It will have examiner authority over banks and credit unions with over $10 billion of assets, mortgage brokers, payday lenders, and others (although oversight excludes auto dealers).
(p. xii) • Reforming the Federal Reserve. The emergency lending powers of the Federal Reserve (established in 1932 under Section 13(3) of the Federal Reserve Act) give it authority to lend to non-depository institutions (investment banks, insurers) in ‘unusual and exigent circumstances’. Dodd-Frank now makes this lending conditional on approval from the Secretary of the Treasury. The Federal Reserve will have to disclose all its 13(3) lending details and will be subject to a one-time Government Accountability Office (GAO) audit of emergency lending during the recent crisis. A new post of the Federal Reserve Vice Chairman for supervision will be created and the GAO will also examine governance issues and how directors are appointed.
• Improving Transparency and Accountability in Derivatives. The Act forces most derivatives trading onto central clearing houses and exchange trading. Regulators and exchanges are to determine what should be exchange traded. Exchange-traded derivatives are more transparent than their OTC counterparts and the credit risks shift to the exchange.
• New Rules for Credit Rating Agencies. A new Office of Credit Ratings will be set up within the Securities and Exchange Commission (SEC) to examine rating agencies and investors will be allowed to sue agencies for ‘knowing and reckless’ behavior.
• CEO Compensation. Shareholders are to have more say in pay and golden parachutes and banking organizations must publish the ratio of CEO compensation to average worker compensation. There will be provisions for compensation clawback if financial performance/projections are found to be inaccurate.
• Other Reform. The Office of Thrift Supervision will be abolished (thrifts will now be regulated by the Office of the Comptroller of the Currency, OCC): the Fed will be required to examine non-bank financial services' holding companies; repeal the prohibition on paying interest on business checking accounts; establish a new Federal Insurance Office (to oversee the insurance industry); provide more financial resources to the SEC; permanently increase deposit insurance to $250,000; force securitizers of risky mortgages to have ‘skin in the game’ (a minimum of 5%); lenders must assure that borrowers can repay home loans by verifying income, credit history, and job status (no more ‘liar loans’); restrictions placed on prices of consumer payments; restrictions on swipe fees for debit cards (expected to cost the banking industry billions of dollars).
(p. xiii) In the UK, an Independent Banking Commission was established to consider structural and related non-structural reforms to the UK banking sector to promote financial stability and competition. On September 12th 2011, the Commission published a Final Report that sets out views on possible reforms stating that:
• Retail banking activity is to be ring-fenced from wholesale and investment banking.
• Different arms of the same bank should have separate legal entities with their own boards of directors.
• Systemically important banks and large UK retail banking operations should have a minimum 10% equity to assets ratio.
• Contingent capital and debt should be available to improve loss absorbency in the future.
• Risk management should become a self-contained, less complex business for retail banking, but remain complex for wholesale/investment banking.
In addition to domestic issues, there are ongoing policy discussions as to how to improve coordination of international bank regulation, with a focus on improving the responsibilities of home and host countries in the event of large bank failures that span different jurisdictions. Opportunities for regulatory arbitrage across national boundaries are being examined with the objective of eliminating regulatory gaps. During the crisis, meetings of the G7 and G20 were used as fora for international discussion of various forms of policy intervention. There are obvious differences of emphasis and approach among governments, and sometimes coordinated policy action is difficult to achieve. However, a trawl through the timeline of recent post-crisis policy events does suggest a strong correlation between US, UK and (to some extent) other European policy actions, which is unlikely to be purely coincidental. As banks become more international/global, the need to coordinate international policy actions (particularly at the time of crisis) also become important.
The credit crisis also exposed weaknesses in the current regime for the regulation of bank capital. Under the risk weighted capital regulation regime of Basel II, the use of backward-looking models for risk assessment created a procyclical (destabilizing) tendency for capital provisioning that appeared to amplify the economic cycle. In boom conditions, observed rates of borrower default decline. Accordingly, bank assets in all risk classes are assessed as having become less risky and require lower provisioning. In such circumstances capital buffers can support increased bank lending, which tends to amplify the upturn in the cycle. It is now widely accepted that banks should be required to accumulate capital during booms, so that reserves are available to draw upon during times of economic stress. Capital provisioning would thereby exert a countercyclical (stabilizing) effect. (p. xiv) Past regulation may also have overemphasized capital at the expense of liquidity. In the run-up to the crisis, many banks appear to have been operating with dangerously low liquidity, that is, the ratio of liquid assets to total assets. As has become clear, a liquidity crisis can easily trigger a full-blown capitalization crisis.
In response to these issues, the Basel Committee on Banking Supervision (BCBS) has set out guidelines for new capital and banking regulations—Basel III—that have to be fully implemented by the end of 2019 (and all major G-20 financial centers have to commit to have adopted the Basel III Capital Framework by the end of 2011). Basel III aims to strengthen global capital and liquidity regulations to improve the banking sector's ability to absorb shocks and reduce spillover from the financial sector to the real economy. The main features of Basel III are as follows:
• Proposes new capital, leverage, and liquidity standards to strengthen regulation, supervision, and risk management. This will require banks to hold more capital and higher quality capital than under current Basel II rules.
• Basel III will introduce a leverage ratio as a supplementary measure to the Basel II risk-based framework. The new proposals will also introduce a series of measures to promote the build up of capital buffers in good times that can be drawn upon in periods of stress (‘Reducing procyclicality and promoting countercyclical buffers’).
• Risk coverage of the capital framework will be further strengthened via: tougher capital requirements for counterparty credit exposures arising from banks' derivatives, repo, and securities financing transactions; additional incentives to move OTC derivative contracts to central counterparties (clearing houses); and incentives to strengthen the risk management of counterparty credit exposures.
• Basel III introduces a global minimum liquidity standard for internationally active banks that includes a thirty-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio called the Net Stable Funding Ratio.
Effective regulation has also been constrained by a lack of transparency concerning the banks' business models. While the crisis has forced banks to provide detailed information on their exposures, disclosure of business models, risk management, and valuation practices remain limited. Likewise, the restoration of confidence in over the counter (OTC) markets for securitized assets and credit derivatives will require increased transparency, reduced complexity and improved oversight. In the case of credit derivatives, counterparty risk has been a serious concern, with holders of credit default swaps (CDS) fearful that counterparties may default on their obligations in the event that the underlying asset defaults. (p. xv) Consequently, there has been a desire by policymakers to direct these transactions to clearing houses (as outlined in the Dodd-Frank Act and in Basel III).
As can be seen from above, the banking sector operating environment is changing rapidly, molded by economic, regulatory, and political forces. We trust the chapters included in The Oxford Handbook of Banking, which are written by many of the leading scholars in the field (and to which we are truly indebted), will stand the test of time and provide insights into such issues.
Allen N. Berger, Phil Molyneux, and John O. S. Wilson
September 2011 (p. xvi)