Basel 3, Financial Regulation Reform and Implications for

Australian Banks

Professor Kevin Davis

Research Director, Australian Centre for Financial Studies

A recipe for disaster?

• Create organizations which – Invest in assets which are non-marketable

and hard to value– Are very highly levered, and allow creditors

to withdraw funds at call– Are opaque – difficult for outsiders (or even

insiders) to understand value and risk– Reduce the level of regulation they are

subject to, particularly when technology is making the business more complex and risky

And it came to pass!

The GFC prompted a “Belts and Braces” Response

• Unfreeze/restore liquidity• Shore up public confidence• Bail-outs• Failure management• Temporary regulations• Macro-economic stimuli• Regulatory forbearance

And then:

The GFC experience prompted

A Global regulatory agenda (Basel, IOSCO, FSB, G20)

And national agendas

UK, EC,USA etc• Shift in views on working

of financial markets• A “grand vision” or

“tinkering at the edges”?– What are the

aggregate effects of plethora of changes?

Problems and Responses: The Global Agenda

Problem Response Excessive leverage increase capital requirements Liquidity/ counterparty spillovers

Central Clearing Counterparties, higher risk weights for financial sector counterparties, minimum liquidity & funding requirements

Inappropriate incentive structures

ad hoc interference in remuneration structures, codes of practice for credit rating agencies, etc.

Resolution and “exit” problems

expanded intervention powers for regulators, requirements for contingent capital and “bail-inable” debt, living will (recovery and resolution plan) requirements, G-SIFIs

Bank runs (actual or potential)

expand or introduce explicit deposit insurance

Banks arbitraging regulatory requirements

introduce more complexity into the risk-weighting system

National/Regional Responses

UK• Retail Ring-fencing proposal

– limiting implicit government guarantees– Reducing spillovers

• Higher Loss Absorbency (Capital)• Depositor Preference• Bail-in powersEurope• Tobin Tax proposal• Remuneration• D-SIBs (“Too big to Swallow”)USA• Dodd-Frank Act

A Changing Paradigm?• Applicability of Econ 101 model of market

efficiency to financial markets?

Slapped in the Face by the Invisible Hand:

Banking and the Panic of 2007

A Changing Paradigm?

• Recognition of importance of network externalities (adaptive systems)

A Changing Paradigm?

• Questioning of merits of larger financial sector– Not new ..we are throwing more and more of our

resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity. JAMES TOBIN (1984) – Nobel Laureate, Economics

• Questioning of merits of increasing complexity of regulation

Australian responses

• Financial sector emerged relatively unscathed from GFC (luck, management, supervision)– Apart from non-regulated sector failures,

securitization freeze, stock prices!• But lets not kid ourselves

– There was massive government/ regulator/ taxpayer support

• Wholesale debt guarantee subsidy• Deposit insurance and implicit guarantees• Expansion of RBA liquidity facilities• RBA-US Fed FX Swaps

Local Regulatory Agenda

FOFA

Competitive and Sustainable Banking System

Insolvency reforms

MySuper

National C

onsumer

Credit P

rotectio

n

Equity Market Trading Reforms

“If not w

hy not”

disclosure

OTC derivatives & CCCPs

Superstream

Short form

PDS &

prospectus

Covered Bonds

Managed Investments

Act review

LAGIC

Disability Insurance

National Disaster Insurance Scheme

Financial Market

Infrastructure

PriceSignaling

Superfund

Prudentia

l Standard

sFinancial

Claims Scheme

But banking regulation….

Much of the wide-ranging regulatory agenda affects banks, but:

“If it ain’t broke don’t fix it” attitude prevails

• Can it work better?• Might it break in the future?

Australian Bank Regulation• Implement Basel 3

– Continued “tougher” bank capital requirements – what is the cost?

– Liquidity requirements (LCR and NSFR)• RBA committed liquidity facility• Impacts on deposit markets and pricing

• Enhanced resolution and failure management powers for APRA

• “Living will” requirements • Potentially - Central Clearing Counterparties

(CCPs) for OTC derivatives trading?

The Unresolved Issues• Banking (whole of financial) sector competition

– Major banks dominate “financial sector supply chain”

• D-SIBs “too big to swallow” – and have similar exposures – systemic issues

• Designing policy for a world of implicit guarantees– Did we ever believe that big banks weren’t

guaranteed? • Charging for explicit guarantees (Financial

Claims Scheme)

Possible Responses• Retail Ring-Fencing a la UK

– Reduce risk of “utility” banking, reduce spillovers, limit implicit guarantees

• “Volcker rule” a la US– Separate trading activities from banking

Possible Responses

• Higher capital ratios (including contingent capital) for D-SIBS (or special taxes!)

• “Bail-in-able” debt• Charging for deposit insurance• “Nudge” bank management incentives

– Remuneration, director liabilities• More generally – “Tobin tax”

Happening overseas - reduced power of financial oligarchy to stymie change (failures, scandals (LIBOR, AML, “the whale” etc))

Consequences?• Banks and “shadow banks”

– Savings and investments institutions • where should govt. protection stop?

– Trading and dealing• If banks don’t do it, others will

– just shifting source of potential problems?• Banks and capital markets

– Strong incentives for growth of capital markets for funding (and as outlet for savings)

• Optimal size of financial sector– It may be smaller?

Conclusion• “You never let a serious crisis go to waste. And

what I mean by that it's an opportunity to do things you think you could not do before. “ Rahm Emanuel

• Have we? Or have we done lots of things without fully thinking through the consequences?

• A “Son of Wallis” Inquiry warranted– Stocktake of costs/benefits and consistency of

recent regulatory changes– Assessment of consequences of distortions

caused by tax, guarantees, compulsion– Consider how D-SIBS should be treated