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Melbourne APEC Finance Quarterly Issue 11, May 2011
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Welcome to the newsletter of the Melbourne APEC Finance Centre. In this newsletter, Melbourne University Professor Kevin Davis provides an overview of the multitude of regulatory reforms sweeping the global finance industry, while the Reserve Bank’s Mark Fabbro and Mark Hack examine the trend in bank margins and lending rates pre and post the global financial crisis. AFMA’s David Love contributes his perspective on proposed reforms to the OTC Derivatives markets and in his regular column, APEC Study Centre Director Ken Waller summarizes the issues arising out of a Regional Symposium convened recently in Melbourne on the global regulatory reform agenda. REGULATORY REFORM AFTER THE GLOBAL FINANCIAL CRISIS Kevin Davis is a Professor of Finance at The University of Melbourne and Research Director at Australian Centre for Financial Studies
The GFC prompted a wide and sweeping range of regulatory reforms The Global Financial Crisis (GFC) has resulted in a plethora of studies examining its causes, and while there is general agreement on a list of contributing factors, there is less agreement on which of these were most important and the consequent implications for desirable or needed regulatory changes. Nevertheless it has led to an attempt at harmonized global regulatory responses overseen by the G20 and prompted some changes to the structure and responsibilities of international agencies to achieve that outcome. There is a wide and sweeping range of regulatory responses in progress or under consideration, making the task of assessing the likely consequences and merits of individual measures that much more difficult. There are also questions as to whether (given differences of opinion on underlying problems) all proposed regulatory changes are well-founded, and whether regulatory changes across the broader financial sector will prove to be mutually consistent. Notably support for some proposals favored in the immediate aftermath of the GFC, such as structural separation of investment and casino banking, special taxes on big banks, or transactions (Tobin) taxes, has faded over time. And some other mooted changes, such as requiring use of Central Clearing Counterparties for over the counter derivatives, or contingent capital requirements for banks, have been shown to involve substantial complexities not fully appreciated when originally proposed. Developing countries are questioning the suitability of some of these reforms Also open to question is the suitability of regulatory changes emanating out of problems in advanced Northern Hemisphere financial sectors to emerging market (and other) financial sectors where the same scale of problems did not occur. In some ways, that is paradoxical. The regulatory responses being driven internationally, and applied individually, by nations with highly developed financial systems involve a movement away from minimalist regulation and reliance on “light touch supervision” and market discipline, towards a more interventionist approach which many emerging markets tended to favor. Examples can be seen in a willingness to consider capital controls as part of macro-prudential policy and new requirements for minimum holdings of liquid assets by banks. The GFC has shaken faith in the “free markets” paradigm The design of a new coherent regulatory framework is hampered by the failings of economic and financial theory, with the GFC shaking faith in the “free markets” paradigm which underpinned the previous deregulatory agenda. The inherent susceptibility of financial markets to crises is widely recognized, but despite significant advances in developing models to explain such characteristics, there are few clear lessons for the design of a new regulatory structure. Enhanced interest in macro-prudential policy is a good example, where agreement on its merits in principle is confounded by a lack of guidance on how it might be appropriately implemented. In the paper prepared for the Melbourne APEC Finance Centre entitled “Regulatory Reform Post the Global Financial Crisis: An Overview", a number of themes are developed as part of a review and summary of regulatory proposals which have emerged from the G20, Financial Stability Board, Basel Committee, IOSCO, and other multilateral agencies. The full report contains a number of key themes The comprehensive report located at the aforementioned web reference contains a number of key themes which are summarized as:
Credit bureaus are private, for profit entities that developed to help address the classic information asymmetry issue – borrowers have information about their ability to repay and repayment track record - which lenders do not have. In the past, the bank manager knew everyone in town, knew a borrower’s family, where they worked and their track record of financial prudence (or not). The benefits of technology mean retail lending costs are lower than in the past, but without that face to face contact, lenders need a way to assess risk. So, credit bureaus create a reputation mechanism. Other examples of formal and informal reputational mechanisms include law courts, gossip and eBay buyer and seller reviews. All of these mechanisms support the enforcement of private contracts, which in turn underpins a market based economy. In conclusion The report makes the following general conclusions:
THE EFFECTS OF FUNDING GOSTS AND RISK ON AUSTRALIAN BANKS' LENDING RATESBy Daniel Fabbro and Mark Hack; Reserve Bank of Australia, Domestic Markets Department
The following is an overview of an article published in the Reserve Bank of Australia (“RBA”), March quarterly bulletin. Summary After falling for over a decade, the major banks’ net interest margins appear to have stabilised in a relatively narrow range in recent years. In the early part of the financial crisis, margins fell to the bottom of this range, reflecting an increase in debt funding costs. Margins have since recovered a little, to around the middle of the range, as a result of some repricing of lending rates relative to these costs. In addition to the increase in the cost of debt funding, there have been other drivers of the rise in lending rates relative to the cash rate. First, the banks have increased their equity funding, which is more costly than debt finance. Second, risk margins on loans have risen to account for higher expected losses. Factors that influence bank lending rates There are a number of factors that influence the way banks set lending rates. Among these, the costs of debt and equity funding and the losses that banks expect to incur on their lending activities are particularly important. Previous Reserve Bank research has noted that the increase in the cost of debt funding – primarily due to higher costs of deposits and long-term wholesale debt – has been a key driver of the increase in banks’ lending rates relative to the cash rate in recent years. In the full article, we update this research and also discuss the influence on loan pricing of banks’ equity funding and expected losses on loans. In estimating the influence of equity funding, we have applied a model that assumes a fixed unit cost, or ‘target return’, for equity (with the cost based on average historical returns). This assumes banks’ return on equity targets have not changed over recent years. As such, changes in the contribution of equity costs in funding loans are determined solely by changes in the share of equity in funding. Although increased debt funding costs have been the most important determinant of the increase in lending rates relative to the cash rate, our estimates suggest that there has been a material effect from increases in equity capital and expected losses. This is particularly the case for lending to businesses, as both the share of equity capital used to fund business loans and banks perceptions of the risks associated with this form of lending have increased noticeably. Increases in equity capital and expected losses are estimated to have had a smaller effect on residential mortgage lending rates. A consequence of higher equity funding costs and higher expected losses is that the major banks average lending rates have risen relative to their debt funding costs over the past couple of years. This has contributed to the increase of around 15 basis points in their average net interest margin from historical lows in 2008. The current average margin of 2.35 per cent is around its average level of the past five years. The full article can be accessed from the RBA’s website via the following link. http://www.rba.gov.au/publications/bulletin/2011/mar/pdf/bu-0311-6.pdf CENTRAL CLEARING FOR OTC DERIVATIVES IS COMINGDavid Love is the Director of Policy and International Affairs at Australian Financial Markets Association (AFMA)
OTC Derivatives reforms - agreed to be in place by end 2012 Following the 2008 financial crisis, regulatory authorities around the world have sought to improve the post-trade infrastructure for over-the-counter (OTC) derivatives transactions. The Financial Stability Board (FSB) has identified the need to further enhance the safety in the OTC derivatives market. This led G-20 leaders to agree in September 2009 that all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties (“CCPs”) by the end of 2012. As a result, authorities in G-20 jurisdictions have put forward policy initiatives aimed at encouraging greater use of CCPs for OTC derivatives markets. The G-20 Pittsburgh communiqué requires OTC derivatives market reforms to take place no later than by the end of 2012. The Dodd-Frank Act reforms in the US start to come into effect from July 2011 and are having a big influence as well on derivatives trading and clearing around the world. Will CCPs reduce or intensify risk – some different contentions The underlying proposition is that a well-designed CCP can reduce the risks and uncertainties faced by market participants and contribute to the goal of financial stability. Central clearing is intended to reduce settlement risks between two parties by taking on the risk of one of the parties failing, and offsetting it against its participants. However, there is an alternative possibility that forcing derivatives through CCPs could intensify risk in the system, because it does not remove risk but centralises and concentrates it into a CCP which is systemically critical to the well-being of the system. Globally, authorities assume that centralised clearing reduces systemic risk by making the CCP rather than one dealer the counterparty to each transaction. The clearing house acts as a CCP when it interposes itself as a legal counterparty to both sides of a transaction. A CCP does not remove counterparty credit risk, but it manages and redistributes it by establishing rules as to who bears losses arising from a participant default. Making clearinghouse participants stand behind each cleared trade is the core justification for requiring OTC trades to be conducted through a clearinghouse. For market participants, the credit risk of the CCP is substituted for that of the other participants. Novation replaces market participants’ exposure to bilateral credit risks with a standard credit risk to the CCP. CCPs significantly reduce total potential insolvency losses by: increasing netting; requiring the segregation of accounts; having standardised two-way margin programs; establishing capital requirements for the clearinghouse and its participants; managing transfers of collateral; and generally increasing transparency, which is an important public good. The CCP’s unique position of being a common, substituted counterparty to all trades in a centrally cleared market greatly simplifies the multilateral netting of trade obligations. All of these improvements reduce externalities and, taken as a whole, may be quite important to reducing systemic risk. On the other hand, because CCPs create a single point of failure, and a concentration of risk, there is less diversification of risk flowing from errors in the system. As the CCP is counterparty to each cleared transaction, the failure of the CCP would itself pose a systemic risk; such risk will increase with the volume of trades the CCP clears. Linked CCPs – a possibility of contagion? Links between CCPs could provide the basis for a systemic crisis because of contagion risk. The weakest link in the chain could bring others down if it were involved in a default and was insufficiently capitalised to meet margin calls. Even if covered by collateral, inter-CCP exposures could give rise to liquidity risk, if a CCP could not find the necessary liquidity to cover the collateral call. Because such issues remain unresolved, access and interoperability between CCPs is not possible. Attempts to link CCPs together in the European Union have proved highly complex in the case of cash equities, and interoperability for derivatives is a much greater challenge. There is also little likelihood of a single CCP clearing derivatives across asset classes. As a result market participants have a preference for clearing through CCPs in which their counterparties are also members so they can get netting benefits. This preference favours major CCPs operating on a global basis. Asia Region; Australia & Canada are carefully examining G-20 solutions While OTC derivatives markets in the Asian region are still relatively small and therefore do not the have same level of systemic importance that they have in the US and Europe, the increasing need to manage risk through derivatives is growing in line with the big rise in demand for and trading in related underlying assets in the Asian region. Jurisdictions are all working towards the goal of meeting the G-20 commitment on central clearing. Accordingly, authorities are pushing for derivatives to be cleared centrally. Some jurisdictions, such as Singapore, Japan and Hong Kong are pursuing local solutions by requiring derivatives denominated in local currencies to be cleared through domestically regulated CCPs. Other jurisdictions, such as Australia and Canada are carefully examining the question of how to define and contain systemic risk associated derivatives in their currencies while maintaining global connectivity with the main CCPs serving the globally traded market. At a minimum, standards in forthcoming regulation requiring centralised clearing in the United States, Europe and Asia should ensure CCPs adhere to the same standards wherever they are located. Ultimately – a matter of faith? CCPs are being promoted as a cornerstone of financial market infrastructure for OTC derivatives on the policy assumption that they will reduce systemic risk. As with a number of other developments in market regulation this assumption is more a matter of faith than demonstrated fact. Centralised clearing is likely to have significant behavioural effects on the allocation of risk, the total amount of risk in the system, and the incentives of firms and individuals to take on, manage, and monitor risk. The cumulative effect of the changes is difficult to predict because of the complex nature of the interactions within the financial system. REGIONAL RESPONSES TO REGULATORY REFORMS AFTER THE GLOBAL FINANCIAL CRISISKen Waller is the Director of the Australian APEC Study Centre at RMIT.
Regional Symposium convened to discuss impact of regulatory reforms In the opening article to this newsletter, Professor Kevin Davis outlines a range of reforms proposed in response to the global financial crisis. He describes a number of key themes included in a report which he prepared for this Centre and which was the centre-piece of a symposium convened by the Centre in Melbourne on 8/9th March attended by regional policy makers, regulators, businesses, academics, international standard setting bodies and professional groups. The report of the symposium together with the commissioned paper by Professor Davis are both available on the centre website. While the symposium noted that many complex issues arising from proposed regulatory reforms do remain to be resolved and that the timing of implementing some of them will be phased-in, a global consensus has been reached on financial reforms aimed at increasing capital adequacy, improving liquidity and containing leverage in banking systems. Implementing the necessary reforms will involve an intense commitment of resources - by banks and by supervisors. Not surprisingly, this support reflects backing for the work of the G20 and the Finance Stability Board in salvaging the international financial system after the havoc caused by the crisis, and in creating a degree of confidence about the continued functioning of global finance. Regulatory responses essentially reflect Developed Markets’ concerns The analysis by Professor Davis and others focused attention on the regulation and supervision of a network of structure of finance rather than the focus, manifest in the era of deregulation, on the efficient market hypothesis. Participants in the symposium discussed the inter-relationships between banking and capital markets and institutions outside the formal regulatory perimeter, noting that the diffusion of risk and the complex nature of instruments that facilitate diffusion in a sense outstripped regulatory capacities and contributed to the global financial crisis. Regulatory responses to the crisis, essentially reflect the way developed markets have been forced to rethink approaches to the degree and form of regulation and increased regulatory intervention. Even though the proposed reforms reflect developed country concerns, the higher costs in terms of capital charges that will be incurred by banks generally, have been broadly accepted by developing economies of the Asia Pacific so long as there is a reasonable phase-in period. Reforms need to fully reflect the interests of Developing Countries What is of concern to developing economies is that reforms proposed by the Financial Stability Board and the Basel Group of Bank Supervisors need to be formulated, taking fully into account the interests of developing economies. The IMF and G20 intend implementing out-reach programs to ensure a consultative process to respond to these concerns. If there is to be an effective globally integrated regulatory process, it is vital that effective and comprehensive outreach program be implemented. As the symposium report notes, if local issues are not taken into account in framing international standards, national implementation of those standards is likely to become much more difficult. Regional economies face major challenges arising from the proposed regulatory reforms. They include implementing Basel lll, enhancing macro-prudential frameworks, enhancing regional liquidity support measures, broadening market infrastructure, expanding financial inclusion and improving consumer protection measures. In contrast to the proposals to strengthen banking systems, the symposium noted serious questions about reforms proposed for Over the Counter Trading and derivatives. The reforms proposed by the Dodd-Frank Act in the US of June 2010 legislated requirements in the US for standardized OTC derivative products to be traded on regulated exchanges and for the central clearing of trades. Europe has proposed similar reforms. While the value of derivatives as a risk management tool is not in question, the relevance of a central clearing requirement of OTC derivatives as a measure to mitigate risk – underlying the proposed reforms – is in question. The symposium noted that the implications of US and European proposals for matters such as the depth and liquidity of local-currency derivative markets and the vital role they play in hedging, need to be seriously considered before changes are contemplated to existing market infrastructures. Credit Rating Agencies – misgivings about the Dodd- Frank approach The symposium also noted misgivings about the approach to Credit Rating Agencies under the Dodd-Frank Act. Since the crisis, major agencies have revised their codes of conduct to focus on the quality and integrity of the rating process and to reduce conflicts of interest. The symposium recognized that despite internal changes introduced by CRAs, there remains a potential for unmanaged conflict of interest in the user-pays business model, the predominant model of major agencies. Despite these concerns, CRAs are likely to continue to serve an important function in the foreseeable future for funds managers and for rating corporates, and for banking supervisors. The proposed reforms to place the onus on financial institutions to undertake ratings was seen as impractical. Building regional capacity to handle reforms – a key challenge ahead While the major focus on the symposium was on regulatory reforms in response to the crisis, other important matters were also discussed. The region is vulnerable to volatile capital flows, the limited capacity of local capital markets, the need to broaden the investor base across the region and to improve access to finance by SMEs. There is a need to strengthen regional policy dialogue on macro-economic and financial conditions impacting on the region and in forging greater regional policy coordination. These matters need to be raised to a higher level in the Asian region The global financial crisis points to the need to build on arrangements created after the Asian financial crisis a decade earlier, and to respond to the proposal by the Asian Development Bank for an Asian Financial Stability Dialogue. Building regional capacities to handle the reforms discussed above will be covered in a training program being convened by the Centre in coordination with the Asian Development Bank Institute in late August/early September in Melbourne.
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