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Risk Management of Financial Institutions after the Financial Tsunami---Current Reactions

Hsien-hsing LiaoDepartment of FinanceNational Taiwan University

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Contents

The financial failure 2007-?

Basel III

Some points from “NYU Stern

Working Group on Financial

Reform”

Understanding financial failure (G20, June 2010, Toronto )

• Originate-to-distribute model: complex derivatives, but simple maturity mismatches

• Leverage and deleveraging cycle (Minsky-moment)• Contagion cycle: financial real political• Contagion: liquidity solvency Amplifiers • Endogenous risk (behavioural) • Counterparty risks• Off-balance sheet, contingent lines - paradox of trust• Excess reliance on ‘wholesale’ finance

Broad principles underlying reform and regulatory change (G20, June 2010, Toronto )

•Undercapitalized financial system

•Limits of micro-prudential (individual) rationality in regulation, supervision

•Limit size, complexity, in some cases interconnectivity of financial institutions.

•Risk allocation

•Ex-ante incentives (bail-in) vs. ex-post (bail-out, levy, taxes)

•Continuous markets (risk pricing, market clearing, basic transformation functions – ‘market-maker of last resort’)

Summary: status of core issues

High conceptual clarityHigh/reasonable prospect (with modifications)High level consensus

Capital adequacy; capital standards ; trading book changes; leverage ratios; liquidity ratios; countercyclical buffers

Reasonable conceptual clarityReasonable prospect (in some jurisdictions more than others)Some consensus

Charges on SIFI; other macro-prudential systemic risk measures – FAT, FSC (IMF); Financial Crisis Responsibility (FCR) fee (Obama-TARP levy 0.15% of LFI liabilities); market stabilization fund (Germany, US); bonus/payroll taxes (UK, France) Resolution plans –living wills;Volcker-rule

Basic concept, low clarityUncertain prospectsNo consensus

Cross-border resolution regime- its link with national measures (punitive charges, stability funds); bank-tax/levy; FTT/CTT

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Basel III

• The Basel Committee on Banking Supervision reached board “Basel III” agreement on 12 Sep. 2010

• “Basel III” tightens the definition of

regulatory capital;• increases the min. requirement of Tier

1 Capital;• establishes conservation /

countercyclical capital buffers; • introduces a leverage ratio;• a new liquidity coverage ratio and a net

stable funding ratio

• To be phased-in between 1 Jan. 2013 and

1 Jan. 2019

Basel III Proposed Capital Reforms

• Quality, consistency & transparency of the capital base.

• Enhance risk coverage.• Introduce a leverage ratio.• Deal with Pro-cyclicality.• Address systemic risk &

interconnectedness.

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NYU Stern Working Group on Financial Reform

Financial ArchitectureIf the financial system continues to be dominated by institutions with high levels of systemic risk:The creation of a new systemic risk regulator is necessary This new regulator would supervise the growing cohort of financial conglomerates institutions are encouraged to follow more specialized business strategies.

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Systematic Risk• Measuring Systemic Risk

• Managing Systemic Risk

• Taxing Too-Big-to-Fail Institutions

• Capital and Liquidity Requirements

• Is Breaking Up the Big Financial Companies a Good Idea? Size or activities

• Contingent Capital

• Financial Institutions Subject to the Bankruptcy Code

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Markets and Institutions

Securtization reforms Securitization created serious systemic problems

that played a major role in the financial crisis.

Transparency

More Regulations vs. Cost Efficiency

Credit Agenciescentral players in the subprime residential

mortgage crisis