New York (Thomson Reuters Regulatory Intelligence) - Banking regulators around the world should remain vigilant against a growing threat of regulatory rollback to avoid potential regulatory fragmentation, said Vítor Constancio, Vice-President of the European Central Bank speaking at an international financial regulation conference.
Constancio highlighted the leverage ratio and liquidity ratio metrics –- the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) -- as the most important enhanced prudential standards initiatives of the post-crisis regulatory for improving risk weighting and reducing a heavy reliance on wholesale funding.
Any weakening of these standards could lead to the collapse of the international regulatory regime, Constancio warned. He spoke in Rome at the Financial Regulatory Outlook Conference(here), sponsored by the think tank Centre for International Governance Innovation and by the Oliver Wyman consultancy.
The U.S. Treasury department, for example, has recommended changes in the way leverage ratios are calculated, with effect of reducing the amount of equity banks need to meet leverage standards.
“It is still premature to assess the strength of the current regulatory pushback but not soon enough to try to prevent its success. We should not allow the memory of the financial crisis we went through to be dissipated in the fog of vested interests,” Constancio said.
THE LEVERAGE RATIO
Regulators have typically used the leverage ratio --the amount of readily available, “Tier I,” capital by total consolidated assets-- to complement risk-weighted capital ratios in their efforts to assess whether financial institutions can meet their obligations.
Despite its simple format –it treats all asset classes as equally risky-- the leverage ratio is considered more effective than capital adequacy ratios in capturing fragilities in the banking sector, as it cannot be gamed through subjective assignments of risk weights.
While risk-weighing is not considered a bad idea in principle, banks nonetheless face a conflict of interest in designing their own models -– as is allowed in the United States under the current Dodd-Frank framework. This can leave them vulnerable to understating risk, thereby reducing their required level of capital. This idea is supported by the research of William Cline of the Peterson Institute think tank(here). He found that among U.S. banks the ratio between stated risk-weighted assets and total assets declined from 70 percent in 1993 to 40 percent in 2011 without any apparent change in credit portfolio composition.
“There are pressures to exclude repos, sovereign bonds, and export credits from the leverage ratio. This weakening of the standard should be avoided, as it increases the probability of crises and output losses,” Constancio said.
REDUCING RELIANCE ON WHOLESALE FUNDING
Constancio also warned that measures adopted to reduce reliance on short-term wholesale funding of bank activities may have adverse effects in increasing systemic risk, due to their procyclical nature.
In the wake of the financial crisis, regulators have taken measures to reduce excessive reliance on short-term wholesale funding that inevitably resulted from the maturity transformation role that banks and bank-like institutions perform.
Through higher capital charges in the form of higher margins --or haircutting-- and central clearing -- where most derivatives trading are now transacted-- they have forced financial institutions to decrease their reliance on relatively unstable wholesale funding sources such as repurchase agreements and securitizations, and favored secured, long-term funding instruments instead.
Haircutting is the application of an adjustment to the initially quoted market value of a collateral security in order to account for any future unexpected loss.
These measures, however, have also exacerbated the procyclical nature of these instruments, Costancio said, by mutually reinforcing interactions between the financial and real sectors of the economy and amplifying business cycle fluctuations and aggravate financial instability.
Indeed, infrequent collateral valuations and a lack of qualitative or quantitative information on secured financing terms and collateral requirements may not adequately capture the current market risk. Credit triggers may lead to destabilizing collateral margin calls, or sudden and significant changes in the supply of secured financing caused by a market disruption may deepen a potential crisis rather than dampen its effect.
Constancio cited as potentially useful enhancements(here) recommended by a committee of the global Bank for International Settlements aimed at building up leverage in good times and softening system-wide effects in bad times. These include placing quantitative limits on leverage, steps that to support better measurement and pricing of risk through the cycle (in particular funding liquidity risk), and measures to mitigate procyclical effects of mark-to-market valuation.
The European Central Bank has shown that such steps are likely to gain increased support. Such support is shown in its response to the European Commission's review(here) of the European Market Infrastructure Regulation (EMIR) which included macroprudential intervention tools such as time-varying minimum buffers, and permanent minimum requirements.
“Without an effective macroprudential policy, advanced economies will not be able to safeguard financial stability. It is therefore an important endeavour to keep fighting for the appropriate tools and policies to smooth the financial cycle and to sufficiently tame finance in order to avoid crises that may threaten the future of our economies,” he said.
(Bora Yagiz, FRM is a New York-based Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence, specializing in risk. He is a certified Financial Risk Manager. Mr. Yagiz has held positions as a bank examiner for the Federal Reserve Bank of New York, as senior consultant with Ernst & Young and vice president at Morgan Stanley. Follow Bora on Twitter @Bora_Yagiz. Email Bora at email@example.com)