The G20 Brisbane communique included a paragraph on financial stability reform, and refers specifically to the Financial Stability Review proposals to strengthen capital requirements for globally significantly banks.
Strengthening the resilience of the global economy and stability of the financial system are crucial to sustaining growth and development. We have delivered key aspects of the core commitments we made in response to the financial crisis. Our reforms to improve banks’ capital and liquidity positions and to make derivatives markets safer will reduce risks in the financial system. We welcome the Financial Stability Board (FSB) proposal as set out in the Annex requiring global systemically important banks to hold additional loss absorbing capacity that would further protect taxpayers if these banks fail. Progress has been made in delivering the shadow banking framework and we endorse an updated roadmap for further work. We have agreed to measures to dampen risk channels between banks and non – banks. But critical work remains to build a stronger, more resilient financial system. The task now is to finalise remaining elements of our policy framework and fully implement agreed financial regulatory reforms, while remaining alert to new risks. We call on regulatory authorities to make further concrete progress in swiftly implementing the agreed G20 derivatives reforms. We encourage jurisdictions to defer to each other when it is justified, in line with the St Petersburg Declaration. We welcome the FSB’s plans to report on the implementation and effects of these reforms, and the FSB’s future priorities. We welcome the progress made to strengthen the orderliness and predictability of the sovereign debt restructuring process.
It is sometimes hard to read the meaning behind the words, but Mark Carney, Governor of the Bank of England made some important comments in a speech in Singapore on his way home from Brisbane.
Banks are now much more resilient. They have more capital, more liquidity and are less susceptible to procyclical spirals. Capital requirements for banks are much higher, as are risk weights and the quality of bank capital. In all, new capital requirements are at least seven times the pre-crisis standards for most banks. For globally systemic banks, they are more than ten times. Large internationally active banks are on course to meet the new requirements 4 years ahead of the 2019 deadline. Despite the scale of the changes, the aggregate shortfall of those banks that still have shortfalls was €15bn at end 2013, having been €115bn two years ago.
It is just as clear that banks’ liquidity positions before the crisis were precarious. Now, for the first time, global standards have been agreed to place requirements on the liquid asset buffers banks must hold and on the extent of maturity transformation in which they can engage. The rapid contagion during the crisis showed how the system magnified shocks. Two particular fault lines made the system procyclical.
First, banks were heavily exposed to movements in market prices and volatility around them, creating a cycle in which falls in prices caused banks to retrench and reduce their positions, leading to further falls in asset prices. That issue has been addressed through strengthening regulatory requirements on trading books – a move that has contributed to the share of banks’ assets accounted for by trading assets almost halving.
Second, banks and shadow banks were entwined in a dangerous funding spiral. Incredibly low initial margins on repo transactions facilitated the build-up of excessive leverage and maturity mismatches in shadow banks. The first wave of losses led banks to tighten margin requirements, effectively reducing financing available to the non-bank financial system, causing those institutions to deleverage through asset sales, driving a death spiral of falling asset prices and rising margin requirements.
Such dynamics have now been mitigated through agreed minimum haircuts for securities financing transactions and the net stable funding ratio for banks.
As the memory of the crisis fades, it will be ever more important to explain the benefits of reform to counter the fatalism. So let me take this opportunity to take stock of the benefits of reforms, both of those already agreed and of the next phase of reform I have outlined. While we all recognise that future crises can never be ruled out, the steps taken to make banks safer and simpler have certainly reduced the likely frequency and severity of future financial crises. In doing so, they have reduced the exorbitant costs of instability. The Basel Committee assessed in 2010 that the economic cost of the median financial crisis amounted, over time, to 60% of national income. With a 5% probability of a crisis each year, that is equivalent to annual costs of 3% of GDP. For the G20 as a whole that is $2trn. By eroding these costs, financial reform alone can therefore more than deliver the G20 commitment to raise GDP by more than 2%. The Basel Committee found these costs to be minimised only if risk-weighted bank capital ratios were raised above 15%. The Basel III requirements did not go this far, in part because they anticipated the additional requirements for loss absorbing capacity that G20 Leaders have just endorsed.
Once implemented, the combined effects of the reforms will take the system much closer to the degree of safety needed to minimise the costs of financial crises. That authorities have reached this point in a measured way – allowing both equity and forms of debt to qualify as loss absorbing capacity – shows our sensitivity to the potential costs of greater safety. What are those costs? Three points are worth emphasising.
First, the Basel Committee study judged that each 1% increase in capital ratios could reduce output by just 0.1% as higher bank funding costs were passed through to borrowers. However, even that small number seems an upper bound. It fails to take account of the fact that monetary policy can offset the impact of higher lending spreads on effective borrowing rates.In fact, the need to offset the impact of higher lending spreads is one reason why some advanced economy central banks, such as the Bank of England, are so clear now that interest rate increases, when they come,will be gradual and limited.
Second, the transitional costs of moving to higher capital requirements were found to be a little higher than the long-run costs. But that result depends on the starting position. Outside of financial booms, under capitalised banking systems do not provide the credit needed for economic growth, regardless of capital requirements.Where banking systems have raised capital and restored trust in their creditworthiness, access to credit has returned. This central lesson from the US and the UK recoveries could not be clearer. The evidence internationally suggests much the same. With the possible exception of parts of the euro area, lending spreads have fallen and credit volumes have increased at the same time as capital has gone up. In other words, if anything, regulators may have significantly overestimated the transitional costs, or even possibly got the sign wrong.
Third, although tighter regulatory requirements have caused bank balance sheets to shrink, that does not translate fully into reduced access to credit for real economy borrowers. As I said, some of the reduction in bank-based intermediation has been substituted with market-based finance for the real economy. Moreover,as bank balance sheets have shrunk, and as they have rebalanced more towards traditional banking than trading, they have become more focussed on the real economy.
In short, any serious look at the experience of post-crisis reform shows that reform and regulation support –not damage – long-term prosperity.Furthermore, the reforms have also brought benefits in terms of the distribution of the costs and benefits of finance. The removal of the implicit taxpayer subsidy transfers the costs of excessive risk taking to private creditors and away from the taxpayer.And by making resolution of failing institutions a real possibility and facilitating smooth exit, the reforms willalso promote competition. Before the crisis, the largest and most systemic firms enjoyed the largest subsidies. Now, over time, the absence of that subsidy will create a level playing field, transferring the benefits of finance to customers and clients.These benefits will accrue slowly over time. Indeed, they may never be obvious to many who don’t recall a different world. That is why it is vital that our sons and daughters are taught not that financial crises are inevitable, but that they are both avoidable and tremendously costly for jobs, growth and prosperity. The lessons of the crisis need to be learned and handed down to future generations in order that the next phase of reform is sustained.Those reforms have the potential to make finance more effective in serving the real economy
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