New paradigm of global monetary and banking regulatory policies

•  Is the world heading towards new risks?
  
   

This article highlights unconventional monetary policy easing and banking regulatory tightening being followed in the Western world to facilitate the recovery from the current global economic and financial crisis since mid-August 2007 and current concerns

By P. Samarasiri

The current global economic and financial crisis as the source of new policy paradigm



The current global economic and financial crisis that started hitting the world from mid-August 2007 is primarily attributed to largely free financial markets supported by relaxed regulatory policies. However, there is no consensus on the finding of the various post-mortem analyses of the crisis.

While market indiscipline by excessive risk-taking and leverage (excessive financing supported with low capital funds) beyond the real needs of the economies in the developed world, especially in the US and Europe, through profit frenzied business models is primarily blamed, monetary and banking regulatory policies are also blamed on grounds of fast liberalisation of markets and not handling asset bubbles.

Therefore, as usual, the crisis resolution at the very beginning started with a large number of unconventional interventions in the market mechanism by the Governments. The market participants themselves who lobbied for free markets in the recent decades not only called for state interventions but also blamed the governments for not having appropriate interventions and early warnings.

It is this background that led to the new paradigm of monetary and banking regulatory policies that have been explored and practiced in the Western/developed world during last five years seeking to recover from the crisis and economic recession.

Innovative banking business models connected with sub-prime customers, boom of the housing mortgage market supported with complex structured finance through securitisation, credit derivatives, special purpose vehicles and credit ratings, market-based risk management strategies deviated from conventional relationship banking and internal controls, risk-encouraged employee remuneration policies, universal banking through extended group/conglomerate corporate structures and poor governance at the board and senior management levels due to knowledge problem of directors and dominance of few senior executives in decision-making are the lapses from the market side.

Emergence of excessively bureaucratic integrated/single regulator model outside the central banks without conventional lender of last resort facility to avert liquidity crises, regulatory relaxations permitting banks to undertake investment banking/securities trading and business diversification for promotion of financial market integration and high interconnectedness without appropriate firewalls/Chinese walls, excessive dependence on derivatives markets, especially the over-the-counter market where risk were not known and products were not standardised, financial market deepening to trade financial products/derivatives on both financial and non-financial products (i.e., commodities, carbon), emergence of too-big-to-fail banks and financial firms, excessive build-up of shadow banking with regulatory arbitrage through innovative products and poor resource base of the regulators are the lapses on the side of the regulators/state.

A regulated market cannot fail without lapses or failures of the regulator. From the monetary policy side, after a long period of low interest rates (2001-2005) with relaxed monetary policies, monetary tightening with high interest rates to address fears of inflation was followed fuelling an asset bubble burst which created the global financial crisis.

What is the nature of new paradigm of monetary and banking regulatory policies?

The new paradigm includes a large number of new policies, some of which are unconventional, in three major areas, i.e., aggressive bailing out of banks, financial institutions and markets, monetary easing and regulatory tightening, aiming at stimulating the economic growth and rebuilding the financial stability as briefed below. Unconventional policies mean policies which are not in the standard text books or normal policy literature.

 i. Aggressive bailouts

Conventionally, bailing out means the lender of last resort facility or short-term credit/funds provided by central banks at good collaterals and interest rates to regulated banks which are solvent but confronted with unexpected temporary liquidity problems. This will covertly protect the customer confidence in such banks and contagion of liquidity crises or bank-runs.

Unlike conventional bailouts, central banks and Governments have now bailed out not only illiquid banks but also insolvent and failing banks, other financial institutions regulated or unregulated and money markets. Credit packages against bad assets/private securities, equity participation, unsecured subordinated debentures, purchase of bad assets and exchange of government securities for bad assets/securities are some of unconventional instruments of such bailing outs. In addition, nationalisation through acquisition of majority stakes also has been followed in the US and UK.

At present, a number of high street banks including Lloyd TSB and Royal Bank of Scotland in the UK are nationalised banks. The bank “northern rock” which failed at the onset of the crisis in the UK in September 2007 also was nationalised in addition to bailing out by the central bank. All big commercial banks, leading Wall Street investment banks and world insurance giant AIG (American International Group) in the US were bailed out jointly by the central bank and the US Treasury through various funding supports including TARF (Troubled Asset Relief Program).

Some banks such as Citi Group, Bank of America and JP Morgan Chase which became state banks have now settled their dues to the US Treasury and secured the private ownership while AIG is still a state insurer. Central banks openly made credit available to any banks and to activate the inter-bank market. In addition, central banks purchased money market securities such as commercial papers in the market to bail out corporates and markets.

 ii. Monetary easing

Conventionally, the monetary policy is conducted through standard text book instruments, i.e., adjustments of central bank interest rate (policy rates), statutory reserve ratio (the percentage of deposit liabilities the banks should keep in cash in the central bank) and open market operations (buying and selling government securities in the market to manage the market liquidity for the purpose of maintaining interest rate targets).

The immediate economic impact of the crisis was the global credit crunch which led to almost collapse of financial and property markets and world-wide economic recession due to non-availability of credit (world GDP growth declined from 5.4% in 2007 to –0.6% in 2009). Therefore, relaxed monetary policies were necessary to boost the market liquidity and credit. In this regard, the conventional objective of the monetary policy as the price stability or low and stable inflation had to be compromised for the objectives of economic growth, employment and financial stability as long as inflation does not exceed 2.5% and unemployment rate declines to 6.5% level.

Starting with cutting down the policy interest rates gradually and opening liquidity support to banks in the open market at conventional terms, central banks moved to a host of unconventional policy instruments as conventional monetary policy instruments were hardly effective to support the economic recovery and financial stability as highlighted below.

nReduction of policy interest rates close to zero: From 2007 to-date, the fed fund rate of the US Fed has been reduced to 0-0.25% (from 5.25% in 2007) and the Bank Rate of the Bank of England (from 6% in 2007) and refinance rate of the European Central Bank (from 4.25% in 2007) to 0.5% which are historically low levels questioning the concept of liquidity trap in economics (view that interest rates cannot decline below a certain low level). Call money rate target of Bank of Japan has been virtually zero (0-0.15%) in the last decade.

nCentral banks providing liquidity/money (printing of money or helicopter drop of money) at a large scale to economies through purchase of financial assets: This is known as quantitative easing (QE) which is an instrument defined to be used when the interest rates have reached a very low level without room to ease the monetary policy further. Assets purchased under QE include government securities as well as private securities such as commercial papers and various asset-backed securities without regard to credit risk and marketability. The volume of such assets to be purchased is announced to the market well in advance. At present, under QE3 stage, the US Fed buys US$ 85 b of such assets monthly to print money. The Bank of England’s QE asset purchase program is open for £ 375 b. The Bank of Japan announced in April 2013 a policy of doubling the monetary base through purchase of Japanese government bonds (JGBs) and exchange-traded funds (ETFs) over a period of two years with an annual increase of monetary base by about 60-70 trillion yen (Bank of Japan started QE far back 2000 due to prolonged deflation problem which is still being addressed through QE). This measure appears to support financing the government borrowing through money printing which a conventional central bank would not normally do. Both Bank of England and the US Fed followed securities swap programmes where they exchanged government securities for illiquid private bonds held by banks to facilitate the banks to raise liquidity from the market using government securities. Meanwhile, the Fed increased the interest rate paid on statutory reserves of banks to encourage parking excess funds/liquidity of banks until credit demand picks up favourably.

nBilateral currency swap arrangements among the leading central banks: These currency swaps enable the central banks to provide the liquidity to the market in foreign currencies under swaps. Accordingly, these central banks undertook coordinated interventions to address liquidity shortages in leading foreign currencies in their countries.

n The US Fed adopting a policy known as “operation twist” to reduce long-term market interest rates to encourage long-term investments for growth. Under this policy, the US Fed sold short-term government bonds and simultaneously bought the long-term government bonds using proceeds of short-term bonds. As a result, the long-term yield rates were expected to decline and short-term yield rates to increase.

nUnconventional monetary policies supported by the Governments to facilitate fiscal policy operations. For example, British Parliament gave a new remit to the Bank of England in March 2013 to adopt unconventional monetary policy instruments to support the economy despite the Bank of England being one of the world’s most conventional central banks. The monetary easing facilitates financing budget deficits at low interest rates and money printing.

nCentral banks looking for new monetary policy targets in place of conventional explicit or implicit inflation target. Targeting an index value of a consumer price index rather than a rate of increase (%) of consumer price index and nominal GDP are two such unconventional targets being proposed or explored. The nominal GDP target gives the policy flexibility for adjustment of monetary policy for both price stability and economic stability objectives as the nominal GDP contains both price (inflation) and production volume (growth). The price index value target gives a price level target understood by the general public unlike rate of change of the index which is biased towards the base or denominator (base effect) when computing the rate of change. Meanwhile, inclusion of asset price inflation is also being debated as the conduct of the monetary policy being a macro-demand management policy may not be technically appropriate to based on a consumer price index whose movements are largely dependent on few basic consumer goods or food items, prices of which may not be immediately affected by the monetary policy actions, but by other seasonal factors.

This monetary easing is clearly shown by huge increases in central banks’ assets. For example, increases of total assets from the end of 2006 to the end of 2012 are US$ 2 trillion or 236% (from US$ 0.85 trillion to 2.86 trillion) in the US Fed, £ 291 b or 1,177% (from £ 24.7 b to £ 315.5 b) in the Bank of England and Euro 101.6 b or 96% (from Euro 105.7 b to Euro 207.3 b) in the European Central Bank. Such unconventional monetary policies are likely to continue at least for the next two to five years as the global economic recovery is still at low level even after last five years of such policies.

 iii. Tightening banking regulations

The post-crisis banking regulatory framework is the return of a form of conventional rule-based regulation. The Volcker Rule in the US in January 2010, The Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010 in the US, Report of the Independent Commission on Banking in September 2011 in the UK and Basel III Capital Accord in December 2010 are the key drivers of this new regulatory framework. It covers several new regulatory areas as highlighted below to protect conventional banking business and rebuild the customer confidence. As a result, regulators world-over are now busy with compilation and issue of lengthy documents of rules. For example, on average, nearly 60 new rules/rule changes are introduced a working day world-over.

(a) Prohibiting banks from proprietary trading which involves in securities trading on own account. However, proprietary trading for market-making (arbitraging) and hedging purposes is permitted while speculative trading is prohibited. This is to prevent banks from gambling on prices of securities through bank funds/depositors’ funds.

(b) Separating retail banking from investment banking. Retail banking is the conventional deposit-taking and lending business based on customer relationship. Banks may be permitted to undertake investment banking through separate corporate entities such as subsidiaries where the retail bank will be ring-fenced from investment banking.

(c) Big banks to be broken into small banks and dispose various non-core financial business units. This is to prevent the problem of too-big-to-fail connected moral hazard problem (customers and banks taking undue risks expecting the state to bail out them in the event of crisis). Accordingly, this new policy is expected to prevent bank mergers/consolidation and to promote a system of too-small-to-save banks where public funds will not be at risk.

(d) Banks to follow utility company business model in the area of retail banking and fund transfers.

Basel Capital Adequacy ratio to include minimum amount of equity capital and an additional component for systemic risk: Minimum equity capital ratio as 4.5% in the proposed total ratio of 10.5% to make shareholders responsible for absorption of risks to some extent and a new counter-cyclical capital buffer up to 2.5% to cover systemic/macro-prudential risks in addition to normal minimum 8% capital adequacy ratio which covers credit, market and operational risks of individual banks (micro-prudential).

(f) Re-introduction of leverage ratio (capital funds as a % of total assets) as a simple capital ratio in addition to complex Basel risk-based capital ratio. A minimum ratio of 4% is proposed.

(g) Introduction of liquidity ratio. This is a ratio of liquid assets to liabilities of banks to ensure that banks have adequate funds to meet short-term liabilities.

(h) Expanding regulation to cover shadow banking. Shadow banks are the financial intermediaries such as investment banks and fund management companies which create credit in the financial system without being subject to bank-type regulation. The current financial crisis originated from the shadow banking industry to which banks were exposed through warehouse credit lines, ownership, management, etc.

(i) Introduction of macro-prudential/systemic regulation to promote financial system stability. In this regard, a set of regulations linked to asset bubbles, business cycles and indicators of banking system’s risks will be implemented. Financial system oversight councils/committees consisting of all financial sector regulators have been created for this purpose. Study on net working, i.e., inter-connectedness among banks and customers to identify risky concentrations, has become a key element of financial stability assessment framework.

(j) Big banks to have resolution plans/living wills approved by regulators to resolve adverse impact of future failures/crises by absorbing losses by shareholders, creditors and depositors (known as bailing-in) or early liquidating the banks without a burden to public funds or bailing-out.

(k) Banks to conduct stress testing periodically to identify and address possible vulnerabilities and risk concentrations.

(l) Introducing consumer protection rules: In this regard, credit cards, rescheduling of bad loans and educating the customers on risks of over-the-counter products sold to them are some of the prime areas.

(m) Specific regulations on systemically important financial institutions (SIFIs).

(n) Central banks taking-over banking regulation and supervision for both micro-prudential and macro-prudential risk management leading to multiple objectives such as price stability, economic stability and financial system stability for central banks.

Opportunities and risks of the new policy paradigm

Monetary and prudential regulatory policies will normally have both costs and benefits to banks and public in numerous ways as they are directly involved in business of banks and public. Some of risks/costs and benefits/opportunities of the new policy paradigm are highlighted below.

(The writer is currently an Assistant Governor and Secretary to the Monetary Board and a former Director of Bank Supervision of the Central Bank and the Chairman of the Sri Lanka Accounting and Auditing Standards Monitoring Board. The views stated above are his personal views.)



(a) New business opportunities: The low interest rates and high market liquidity are expected to encourage economic activities, i.e., demand (investment and consumption) through easy credit. Therefore, banks will have new opportunities of business and customers. As the world is to come out of recession, banks will have to fund new technology, innovations and products. Therefore, banking business models have to be redefined to leverage on new business opportunities.

(b) Safety and stability: Business discipline and improved risk management resulting from enhanced regulation will promote safety and stability of banks. The new regulatory framework which will encompass both micro-prudential and macro-prudential risk management will improve the safety net mechanism for banks, provided that the regulatory authorities perform as envisaged from the new regulatory framework. Financial stability promotes investments and businesses.

(c) Regulatory cost: New regulations always add costs (compliance cost) to banks and public as banks have to have new systems and staff to comply with such regulations and some costs are passed on to public while they find difficult to deal with banks due to business limitations under new regulations.

(d) Risks of asset bubbles: As seen from the past, implementation of the monetary policy has a cyclical behaviour with opposite cycles of inflation and asset prices with time lags depending on the duration of the monetary policy transmission mechanism in commodity and asset markets. High volume of liquidity, credit and money will raise consumer spending and business investments which will raise the economic growth and employment first and inflation later. Meanwhile, the demand for financial assets and properties will also increase due to new credit. As a result of very low interest rates, banks and public will tend to look for high yielding investments/assets which are riskier. The increased demand for assts will raise asset prices or asset bubbles. Therefore, a long period of monetary easing should end up in inflation and asset price bubbles. As a result, the next round of tight monetary policies to address such inflation and asset bubbles will limit credit and burst the asset bubbles creating losses to banks and public. Such asset bubble bursts were the sources of financial/banking crises in the past and it is very difficult to prick asset bubbles or predict the time of asset bubbles burst.



Therefore, banks and public have to have a longer-term view on the monetary policy actions in order to manage cyclical impacts of the monetary policy on their businesses.

(e) Conflict between monetary easing and regulatory tightening: Although monetary easing is to encourage credit, investments and spending, regulatory tightening would raise prudential limitations/standards on credit and other business operations of banks which will limit the usage of liquidity generated by central banks through monetary easing. This could be a reason why the economic recovery expected from unconventional monetary policies is still below the expectations. With monetary easing, stock markets have recovered to pre-crisis level covering the value/wealth loss at the crisis. However, mortgage markets and commodity markets, i.e., consumer spending and business investments, have not recovered yet and, as a result, inflation, employment and growth remain sluggish despite such a high rate of monetary easing during last five years. Therefore, issues remain as to why there is a long delay in monetary transmission mechanism, where is the new money printed by the central banks, how long will it take for the global economy to recover from the recession and when will inflation pick up and unemployment drop due to monetary easing and financial safety net.

(f) Government debt hike: In order to fight the crisis, the governments have been increasing government spending through large budget deficits funded through borrowing for the implementation of various stimulus packages. Due to risk-averse behaviour of banks and investors, the monetary easing has helped government securities market and financing of budget deficits at low interest rates and easy credit and money. Therefore, in the developed world, the government debt volume has reached alarming levels. For example, government debt to GDP ratio between 2007 and 2013 increased from 66% to 108% in the US, 43% to 93% in the UK and 183% to 245% in Japan. Some European countries (e.g., Greece and Cyprus) have faced a debt crisis as the latest wave of the crisis. As a result, several packages of bailing out of governments by European Union and IMF have been implemented. Increased government debt will have adverse repercussions on economic growth by way of crowding out of private investments and tax hikes for loan repayments.

Therefore, the current world appears to be vulnerable to a new round of risks due to the current new policy regime. Further, policymakers and the market participants of emerging economies can draw good lessons from the journey of banking and financial industry and monetary and regulatory policy regimes in the Europe and the US during the last two decades. Therefore, to aim at innovations and business/market expansion, they should not attempt to follow the business and policy models failed in the West in the recent past, but it will be useful to pay attention to new models now being followed in the West as such models may dominate the world soon.