The Fundamental Principles Of Financial Regulation

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Geneva11 latest.qxp07/05/200916:48Page iThe Fundamental Principles ofFinancial RegulationGeneva Reports on the World Economy 11

Geneva11 latest.qxp07/05/200916:48Page iiInternational Center for Monetary and Banking Studies (ICMB)International Center for Monetary and Banking Studies11 A Avenue de la Paix1202 GenevaSwitzerlandTel (41 22) 734 9548Fax (41 22) 733 3853Website: www.icmb.ch June 2009 International Center for Monetary and Banking StudiesCentre for Economic Policy Research (CEPR)Centre for Economic Policy Research53-56 Great Sutton StreetLondon EC1V 0DGUKTel: 44 (0)20 7183 8801Fax: 44 (0)20 7183 8820Email: [email protected]: www.cepr.orgBritish Library Cataloguing in Publication DataA catalogue record for this book is available from the British LibraryISBN: 978-0-9557009-7-2

Geneva11 latest.qxp07/05/200916:48Page iiiThe Fundamental Principles ofFinancial RegulationGeneva Reports on the World Economy 11Markus BrunnermeierPrinceton University and CEPRAndrew CrocketJPMorgan ChaseCharles GoodhartLondon School of EconomicsAvinash D. PersaudChairman. Intelligence Capital LimitedHyun ShinPrinceton University and CEPRICMB INTERNATIONAL CENTERFOR MONETARYAND BANKING STUDIESCIMB CENTRE INTERNATIONALD’ETUDES MONETAIRESET BANCAIRES

Geneva11 latest.qxp07/05/200916:48Page ivInternational Center for Monetary and Banking Studies (ICMB)The International Center for Monetary and Banking Studies was created in 1973 as an independent, non-profit foundation. It is associated with Geneva’s Graduate Institute ofInternational Studies. Its aim is to foster exchange of views between the financial sector, central banks and academics on issues of common interest. It is financed through grants frombanks, financial institutions and central banks.The Center sponsors international conferences, public lectures, original research and publications. It has earned a solid reputation in the Swiss and international banking communitywhere it is known for its contribution to bridging the gap between theory and practice inthe field of international banking and finance.In association with CEPR, the Center launched a new series of Geneva Reports on the WorldEconomy in 1999. The eight subsequent volumes have attracted considerable interest amongpractitioners, policy-makers and scholars working on the reform of international financialarchitecture.The ICMB is non-partisan and does not take any view on policy. Its publications, includingthe present report, reflect the opinions of the authors, not of ICMB or of any of its sponsoring institutions.President of the Foundation BoardDirectorTommaso Padoa-SchioppaCharles WyploszCentre for Economic Policy Research (CEPR)The Centre for Economic Policy Research is a network of over 700 Research Fellows andAffiliates, based primarily in European universities. The Centre coordinates the researchactivities of its Fellows and Affiliates and communicates the results to the public and privatesectors. CEPR is an entrepreneur, developing research initiatives with the producers, consumers and sponsors of research. Established in 1983, CEPR is a European economicsresearch organization with uniquely wide-ranging scope and activities.CEPR is a registered educational charity. Institutional (core) finance for the Centre is provided by the European Central Bank, the Bank of England, 33 other national central banks,36 companies and the European Commission. None of these organizations gives priorreview to the Centre’s publications, nor do they necessarily endorse the views expressedtherein.The Centre is pluralist and non-partisan, bringing economic research to bear on the analysis of medium- and long-run policy questions. CEPR research may include views on policy,but the Executive Committee of the Centre does not give prior review to its publications,and the Centre takes no institutional policy positions. The opinions expressed in this reportare those of the authors and not those of the Centre for Economic Policy Research.Chair of the BoardPresidentChief Executive OfficerResearch DirectorPolicy DirectorGuillermo de la DehesaRichard PortesStephen YeoMathias DewatripontRichard Baldwin

Geneva11 latest.qxp07/05/200916:48Page vAbout the AuthorsMarkus K. Brunnermeier is the Edwards S. Sanford Professor at PrincetonUniversity. He is a faculty member of the Department of Economics and affiliatedwith Princeton’s Bendheim Center for Finance and the International EconomicsSection. He is also a research associate at CEPR, NBER and CESifo, and an academicconsultant to the Federal Reserve Bank of New York. He was awarded his Ph.D. bythe London School of Economics (LSE), where he was also affiliated with itsFinancial Markets Group. He is a Sloan Research Fellow, and recipient of theGerman Bernácer Prize granted for outstanding contributions in the fields ofmacroeconomics and finance.He is primarily interested in studying financial crises, bubbles and significantmispricings due to institutional frictions, strategic considerations, and behavioraltrading. His research also explains why liquidity dries up when it is needed mostand has important implications for risk management and financial regulation. Heis also an associate editor of the American Economic Review, Journal of EuropeanEconomic Association, Journal of Finance, Journal of Financial Intermediation and waspreviously on the editorial board of the Review of Financial Studies.Charles Goodhart, CBE, FBA is a member of the Financial Markets Group at theLondon School of Economics, having previously, 1987-2005, been its DeputyDirector. Until his retirement in 2002, he had been the Norman Sosnow Professorof Banking and Finance at LSE since 1985. Before then, he had worked at the Bankof England for seventeen years as a monetary adviser, becoming a Chief Adviser in1980. In 1997 he was appointed one of the outside independent members of theBank of England's new Monetary Policy Committee until May 2000. Earlier hehad taught at Cambridge and LSE.Besides numerous articles, he has written a couple of books on monetary history; a graduate monetary textbook, Money, Information and Uncertainty (2nd Ed.1989); two collections of papers on monetary policy, Monetary Theory and Practice(1984) and The Central Bank and The Financial System (1995); and a number ofbooks and articles on Financial Stability, on which subject he was Adviser to theGovernor of the Bank of England, 2002-2004, and numerous other studies relating to financial markets and to monetary policy and history.Andrew Crockett is President of JPMorgan Chase International, and a member ofthe Executive Committee of JPMorgan Chase & Co. Before joining JPMorganChase, Mr. Crockett had been General Manager (CEO) of the Bank forv

Geneva11 latest.qxp07/05/200916:48Page vivi The Fundamental Principles of Financial RegulationInternational Settlements ("The Central Banks' Bank"), serving two five-year terms.At the request of the G-7 Finance Ministers, he also served from 1999-2003 as thefirst Chairman of the Financial Stability Forum, a group of senior financial officials from the major economies that monitors the health of the InternationalFinancial System. Earlier in his career, Mr. Crockett had held senior positions atthe Bank of England and the International Monetary Fund.Mr. Crockett has also served in the past as Chairman of Working Party 3 of theOECD, as Alternate Governor of the IMF for the United Kingdom, as a member ofthe Monetary Committee of the European Union; and as a Trustee of theInternational Accounting Standards Committee Foundation. He is currently amember of the Group of 30, Chairman of the Per Jacobsson Foundation, memberof the International Council of the China Banking Regulatory Commission, member of the International Council of the China Development Bank, Director of theInternational Centre for Leadership in Finance (Malaysia), and a trustee of theAmerican University of Beirut.Among honours received by Mr. Crockett are Honorary LLD (University ofBirmingham) European Banker of the year (2000), and Knight Bachelor (UnitedKingdom, 2003). He is the author of several books on economic and financial subjects, as well as numerous articles in scholarly publications.Avinash Persaud’s career spans finance, academia and policy advice. He was a topranked sell-side analyst for 15 years and a senior executive at State Street, J. P.Morgan and UBS GAM before becoming Chairman of Intelligence Capital Limitedin 2005, a financial advisory boutique. He won the Jacques de Larosiere Prize fromthe IIF in 2000 for his essay ‘Sending the herd off the cliff edge’ on how trends inrisk management and regulation were leading to systemic risks.He is an Emeritus Professor of Gresham College and Visiting Fellow at CFAP,Judge Institute, Cambridge. He was elected a Member of Council of the RoyalEconomics Society (2007), is a Governor and former Member of Council of theLondon School of Economics. Persaud is known for his work on ‘liquidity blackholes’ and investors' shifting risk appetite.Persaud is a Member of the UN Commission of Experts on InternationalFinancial Reform, Chairman of the Second Warwick Commission, Co-Chair of theOECD EmNet, Deputy Chair of the Overseas Development Institute and one ofthe founding directors of the Global Association of Risk Professionals (2002-2009).He was formerly a Visiting Scholar at the IMF (2001) and the European CentralBank (2006).Hyun Song Shin is the Hughes-Rogers Professor of Economics at PrincetonUniversity, affiliated with the Department of Economics and the Bendheim Centerfor Finance. Prior to coming to Princeton, he was Professor of Finance at theLondon School of Economics. Professor Shin's current research is on financial economics and economic theory with particular reference to financial crises, disclosures, risk and financial stability issues, topics on which he has published widelyboth in academic and practitioner outlets. He has served as editor or editorialboard member of several scholarly journals, and has served in an advisory capacity to central banks and policy organizations on financial stability issues. He is afellow of the Econometric Society and of the British Academy.

Geneva11 latest.qxp07/05/200916:48Page viiContentsAbout the AuthorsAcknowledgementsForewordExecutive Summary123456viiAnalytical BackgroundNature of Systemic Risk1112.12.22.32.42.52.6111416192021Solvency, Liquidity and Maturity MismatchLoss Spiral-Asset Price EffectMargin/Haircut SpiralProcyclicality and Margin SpiralsExternalities-Rationale for RegulationAggregate Liquidity Expansions and ContractionsWho Should be Regulated (by Whom)233.1 Classification of Financial Institutions based onObjective Risk Spillover Measures3.2 Rules for Individually Systemic Institutions3.3 Rules for Institutions that are "Systemic in a Herd"3.4 International Considerations for International Entities23252526Counter-cyclical Regulation294.14.24.34.44.54.64.74.8Focus on Systemic Risk SpilloverWhen to look Out for Systemic Risk?How to modify CAR?More on Bank Capital : Two NotionsLadder of ResponsesClear Incentives for Regulators : Rules versus DiscretionCross-country ConsiderationsContrast to Spanish Dynamic Provision Mechanism2930303133333434Regulation of Liquidity and Maturity Mismatches355.15.25.35.436363638Focussing solely on AssetsFunding Liquidity and Maturity MismatchMark to Funding-A New Accounting RuleCapital Charges against IlliquidityOther Regulatory RemunerationLoan to Value Ratios in MortgagesCredit Rating AgenciesCentralized Clearing House Arrangements vs. OTC MarketsYear-end Spikes

Geneva11 latest.qxp07/05/200916:48Page viiiviii The Fundamental Principles of Financial Regulation78The Structure of al Conclusions and RecommendationsCapital RequirementsLiquidityOther ConsiderationsAppendix : The Boundary Problem in Financial Regulation59Endnotes66

Geneva11 latest.qxp07/05/200916:48Page ixAcknowledgementsThe authors thank Rafael Repullo, Charles Wyplosz, Anil Shamdasani, RichardPortes, John Williamson, John Pattison, Richard Johnson, Philipp Hartmann,Jean-Pierre Landau, Michael Foot, John Walsh, Maria Nieto, Geoffrey Gardiner,Steve Thieke, Brian Quinn and Enrico Perotti.Each author has contributed on a personal basis, and no responsibility should beattached to any institution to which that author either is or has been attached.ix

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Geneva11 latest.qxp07/05/200916:48Page xiForewordThe authors of this Geneva Report on the World Economy are predominantly macroand finance economists. In our view such economic analysis and insight has, inthe past, been insufficiently applied to the design of financial regulation. The purpose of this paper is to help rectify that lacuna.The crisis which began in the US sub-prime mortgage market in early 2007 andthen spread broadly and deeply was not the first banking crisis. It was closer to the100th. We can draw a few important implications from this observation. If anevent with widespread and severe economic and social consequences keeps onrepeating itself, the onus is surely on the authorities to change something.Chiding bankers is satisfying; but insufficient. When a regulatory mechanism hasfailed to mitigate boom/bust cycles, simply reinforcing its basic structure is notlikely to be a successful strategy. Moreover, a type of crisis that repeats itself cannot easily be put down to new, complex, instruments. In this report, we set oursights on moderating the recurring cycle of financial crises, cycles that in our vieware not wedded to particular instruments, institutions, individuals or information.The prevention of crises in the banking system is more important than in thecase of other industries. As outlined in Chapter 1, the externalities from an individual bank failure both to other banks and thence to the wider economy are justso much greater. One