Economics 1490

THE WORLD ECONOMY:

GROWTH OR STAGNATION?
with
Professor Dale W. Jorgenson

Lecture 8. FINANCIAL REGULATION

September 26, 2017

Harvard University Department of Economics

Fall 2017
 THE WORLD ECONOMY:
GROWTH OR STAGNATION?
A. Comparing Economies
B. U.S. Crisis and Recovery
C. European Slowdown
D. Asian Economic Miracles
E. Sustainability of Economic Growth
F. World Economic Outlook
 B. U.S. CRISIS AND RECOVERY

6. U.S. Financial Crisis

7. Monetary Policy
8. Financial Regulation
9. Fiscal Policy
10. Secular Stagnation
 SUPPLEMENTARY READINGS ON FINANCIAL
REGULATION: The Official Documents
Basel Committee on Banking Supervision (2011, 2013), International
Regulatory Framework for Banks (Basel III), Basel, Switzerland, Bank of
International Settlements. See: http://www.bis.org/bcbs/basel3.htm

Board of Governors, Federal Reserve System (2013), “Federal Reserve Board

Approves Final Rule to Help Insure Banks Maintain Strong Capital Positions,“
Washington, DC, Board of Governors, Federal Reserve System, Press Release,” July
2. See: https://
www.federalreserve.gov/newsevents/pressreleases/bcreg20130702a.htm

Janet Yellen (2017), “Financial Stability a Decade after the Onset of the Crisis,” Federal
Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 25. See: https://
www.federalreserve.gov/newsevents/speech/yellen20170825a.htm
DODD-FRANK WALL STREET REFORM AND
CONSUMER PROTECTION ACT OF 2010
• Re-organized Regulatory Agencies to Elimination
Overlapping Jurisdictions

• Undertook Comprehensive Regulation of

Financial Markets

• Provided a Resolution Mechanism for Insolvent

Financial Institutions

• Greatly Extended Consumer Protection

 WHAT IS BASEL III?

“Basel III” is a comprehensive set of reform measures,

developed by the Basel Committee on Banking Supervision,
to strengthen the regulation, supervision and risk
management of the banking sector. These measures aim to:
improve the banking sector's ability to absorb shocks arising
from financial and economic stress, whatever the source;
improve risk management and governance; strengthen
banks’ transparency and disclosures.
 WHAT IS THE PURPOSE OF BASEL III?

The reforms target bank-level, or microprudential,

regulation, which will help raise the resilience of individual
banking institutions to periods of stress, and
macroprudential, system wide risks that can build up across
the banking sector as well as the procyclical amplification of
these risks over time. These two approaches to supervision
are complementary as greater resilience at the individual
bank level reduces the risk of system wide shocks.
 PILLAR 1: CAPITAL

• Quality and Level of Capital

• Capital Loss Absorption at the Point of Non-Viability

• Capital Conservation Buffer

• Countercyclical Buffer
 PILLAR 1: RISK COVERAGE

• Securitizations

• Trading Book

• Counterparty Credit Risk

• Bank Exposures to Central Counterparties

 PILLAR 1: CONTAINING LEVERAGE

• Non-Risk-Based Leverage Ratio

• Backstop to Risk-Based Capital

Requirement

• Contains Build-Up of System-Wide Leverage

PILLAR 2: RISK MANAGEMENT AND SUPERVISION

• Firm-Wide Governance and Risk Management

• Includes Off-Balance Sheet and Securitization

• Managing Risk Concentration

PILLAR 3: DISCLOSURE REQUIREMENTS

• Market Discipline

• Requirements for Securitization and Off-Balance

Sheet Vehicles

• Disclosures on Components of Regulatory

Capital Requirements
 LIQUIDITY

• Liquidity Coverage Ratio

• Net Stable Funding Ratio

• Liquidity Risk Management and Supervision

• Supervisory Monitoring
SYSTEMICALLY IMPORTANT FINANCIAL
INSTITUTIONS

• Identify Global SIFI’s

• Higher Loss Absorbency Capacity

• Progressive Common Equity Tier

• Additional Loss Absorbency

 BASEL III PHASE-IN ARRANGEMENTS

• Leverage Ratio: 2013-2017

• Minimum Common Equity Capital Ratio: 2013-2019

• Minimum Total Capital Ratio: 2013

• Liquidity Coverage Ratio: 2015-2019

 U.S. IMPLEMENTATION

July 2, 2013: The Federal Reserve Board approved a final

rule to help ensure banks maintain strong capital positions
that will enable them to continue lending to creditworthy
households and businesses even after unforeseen losses
and during severe economic downturns. The rule will
implement in the United States the Basel III regulatory
capital reforms from the Basel Committee on Banking
Supervision and certain changes required by the Dodd-
Frank Wall Street Reform and Consumer Protection Act.
 THE VOLCKER RULE

“Volcker Rule” requirements of section 619 (of the Dodd-Frank Wall

Street Reform and Consumer Protection Act) generally contains two
prohibitions. First, it prohibits insured depository institutions, bank
holding companies, and their subsidiaries or affiliates (banking entities)
from engaging in short-term proprietary trading of any security,
derivative, and certain other financial instruments for a banking entity's
own account, subject to certain exemptions. Second, it prohibits
owning, sponsoring, or having certain relationships with, a hedge fund
or private equity fund, subject to certain exemptions.
 NEW FORMS OF FINANCIAL INTERMEDIATION

• The greatest change to intermediation in the history of

finance has been spurred by advances in information
technology (IT) that have enabled, among other things,
better and faster processing of information and trading in
a wider range of financial instruments.

• Over the past 10 years, these changes have allowed

more financial intermediation to take place in markets
instead of through bilateral negotiations .
 RISING SYSTEMIC RISKS

• Size and Complexity of Financial Institutions

• Concentration, Interconnectedness, and Procyclicality

• Wholesale Funding and Market Discipline

• Nonbanks and New Financial Products

 SIZE OF THE GLOBAL FINANCIAL SYSTEM

Sources: Bank for International Settlements; Bankscope; Bloomberg L.P.; and World Federation of Exchanges.
RELATIVE SIZE OF TRADITIONAL TO TOTAL BANKING ACTIVITIES
SHARE OF TOTAL LOANS AND BONDS BY NON-BANK INSTITUTIONS
GLOBAL SECURITIZATION
OUTSTANDING OVER-THE-COUNTER CREDIT DERIVATIVES
 OTC DERIVATIVES

• Counterparty Risk: The AIG Rescue

• Central Clearing Mandates

• Minimum Margin Requirements

• Data Reporting Requirements

HAS THE STRUCTURE OF THE FINANCIAL SYSTEM
BECOME SAFER?
• Market-Based Financial Intermediation Remains
Important

• Financial Systems Remain Dependent on Wholesale

Funding

• Globalization Has Not Been Much Affected

• Official Interventions Have Made “Bail-In’s” Less Credible

 RESOLUTION OF GLOBAL SIFI’S

• Core Elements of a Resolution Framework

• Statutory Authority to Convert Claims into Equity

• Recovery and Resolution Plans

• Crisis Management Groups

 GLOBAL POLICY RESPONSE

• Capital Requirements for Global SIB’s

• Counter-Cyclical Capital Buffers

• Liquidity Rules

• Multiple Channels for Reform

 FINANCIAL REGULATION: SUMMARY

• Macro-Prudential versus Micro-Prudential Regulation

• Basel III

• U.S. Implementation

• Resolution of GSIFI’s
 CONCLUSION

The recent crisis showed that some financial innovations,

over time, increased the system's vulnerability to financial
shocks that could be transmitted throughout the entire
economy with immediate and sustained consequences that
we are still working through today. Some of these
vulnerabilities were a consequence of innovations that
increased the complexity and interconnectedness of aspects
of the financial system. In response to the crisis and the
weaknesses it revealed, governments around the globe are
acting to improve financial stability and reduce the risks
posed by a highly interconnected financial system.