Spain Introduces New Reforms to Clean Up Its Banking Sector

Sources:
Bloomberg: Spain Imposes 30 Billion Euros of Provisions on Banks
FT:  Spain in New Bid to Clear Property Assets
Guardian:  Spanish Banks to Face New Scrutiny as Fears Rise
Reuters:  Lack of New Cash Disappoints in Spain Bank Reform
WSJ:  Spain Tries a New Cleanup

On Friday May 11, 2012, the Spanish government introduced new reforms to clean up its banking sector. The Spanish government has struggled to correct its banking crisis, which occurred in 2008 with a property bubble burst—rapid increases in the value of real estate properties to the point of unsustainable levels and ultimately lead to a drastic drop in value. These new reforms mark Spain’s fourth attempt to correct its banking crisis in the past three years and come only a few days after the government part-nationalized the country’s fourth largest bank, Bankia, by claiming a 45% stake. The country’s past reform attempts were likely unsuccessful because Spain’s approach of making gradual changes to its banking sector was not enough to offset the receding economy and falling property values.

The Spanish government imposed two main reforms. First, banks must set aside an additional €30 billion in provisions to cover potential bad loans—provisions, also known as loan loss reserves, require banks to increase their capital. Banks must meet certain capital/asset ratios (also known as capital requirements). For instance, if a bank needs to write-off unpaid loans (assets), then the bank must increase its capital in order to meet the specified capital requirements. Thus, Spain increased the bank's capital requirements to ensure that the banks would have sufficient capital in the event of loan write-offs.

Spain’s provisions cover 45% of a bank’s real estate assets when added to the €54 billion provision increase mandated this past February. The Spanish government decided to allow banks one month to develop a plan to meet the extra provisions. The government also decided to offer five-year loans with a 10% interest rate to those banks struggling to find capital. If a bank fails to pay back these five-year loans, then the loan converts into shares. Therefore, if the bank fails to pay, the government becomes a part owner of the bank.

The second reform is to hire two independent auditors to value the banking sector’s assets. The Spanish government agreed to hire independent auditors after its recent takeover of Bankia. This is because past auditors refused to sign off on Bankia’s accounts when they discovered discrepancies over the value of foreclosed properties and the value of junk loans—loans with a high risk of default. Thus, Spain likely hired independent auditors in hopes that their outside perspective will reveal other discrepancies similar to those discovered in Bankia’s accounts. While the auditors have not yet been identified, Spain’s Economy Minister Luis de Guindos ensured that the auditors have “maximum international prestige.” The hiring of independent auditors with such “international prestige” ensures credibility and confidence in Spain’s banking reform efforts.

Although the International Monetary Fund (IMF) managing director Christine Lagarde welcomed and praised these reforms, others remain skeptical. Many economists, including Columbia University’s Xavier Sala-i-Martín, believe that the €30 billion increase is not enough. Instead, some economists propose that an increase of  €50 billion is necessary.  Other economists worry that the reforms and the nationalization of banks like Bankia will leave Spain with greater debt in the future. This is because the five-year loans Spain offered to banks to finance the required provisions as well as Spain’s nationalization of Bankia could leave the country without reimbursement of its loans to banks and with a large ownership share in failing banks that have little hope of turning a profit. Even investors are skeptical as shares in Spain’s top three banks, which include Banco Santander, BBVA, and Banco Popular, all fell in response to the announcement of the new reforms.

The European Commission recently forecasted that Spain would fail to meet its imposed budget deficit target next year, which is 5.3% of its gross domestic product (GDP). Instead, the European Commission projects Spain’s budget deficit to be 6.4% of its GDP. This suggests that Spain’s austerity measures—policies of drastic cuts on government spending and/or increases in taxes—are not as effective as originally thought. However, these projections do not account for Spain’s newly introduced banking reforms. The Spanish government views the banking sector as a key component to the country’s overall economic recovery and is hopeful that these reforms will help the country meet its future targets as well as restore the banking sector that has continued to struggle since 2008.

Asset Valuation: A Numbers Game?

Sources:

Reuters: Goldman, Morgan Stanley Mull Reducing Mark-to-Market Accounting

TIME: Will Mark-to-Market Fix Help Save the Banks?

WSJ: Bank Quandry-Valuing the Assets

Continuing uncertainty in the global markets has led some major financial institutions to reconsider how they account for and report certain assets. This week both Morgan Stanley and Goldman Sachs announced that they are considering whether to reduce their use of “mark-to-market” accounting in favor of “historical-cost” accounting. This process, called “asset valuation,” impacts a bank’s ability to meet capital requirements, fund operational spending, and implement lending programs.

Investment banks and commercial banks are subject to different accounting requirements for different assets. As investment banks, Goldman and Morgan were required to price most assets using “fair-value accounting,” currently defined as mark-to-market accounting which requires institutions to price assets on their balance sheets according to the price they could be sold at on the open market—not the price they paid for them. However, to receive emergency federal funds during the subprime crisis, Morgan and Goldman converted to bank-holding companies which are subject to different accounting regulations. Banks are able to record certain assets based on historical-costs which means these assets are reported at their original value or purchase price. In short, Morgan and Goldman now have more flexibility in reporting certain asset values and the use of historical costs could substantially increase asset values.

Mark-to-market accounting became problematic after the 2008 U.S. financial crisis as the market for some securities collapsed and buyers disappeared. Mark-to-market accounting requirements magnified the impact of the crisis by forcing banks to show massive losses on their balance sheets, which reduced their ability to lend since banks are only allowed to lend an amount equal to a certain percentage of the total value of their assets. As a result, many banks were left holding (and still are) billions of dollars worth of toxic assets, which they have to report at very low values ranging from zero to sixty percent of their original price. Thus, some banks argue that the accounting requirements are making an already bad situation worse.

Since 2008, the financial industry has lobbied regulators to ease the mark-to-market requirement, which it argues would bolster their bottom-line, prevent additional bank failures, and help stabilize the economy. In April of 2009, the Financial Accounting Standards Board (FASB) adopted changes to accounting rules to allow banks more discretion in the use of mark-to-market accounting for “distressed” assets. Generally, distressed assets refer to securities that can only be sold by greatly reducing the price or for which there is no market at all. Critics argue that easing mark-to-market requirements allows banks to hide losses and reduces transparency.

Morgan Stanley’s and Goldman Sachs’s decisions to move away from mark-to-market valuations could dramatically affect financial results for both firms. Under historical-cost accounting rules, assets are generally reported at their original value or purchase price, a shift that would increase asset values on the firms’ balance sheets. Given the continued market volatility and sluggish economy, such balance sheet reorganizations will likely be met with a certain degree of skepticism. The accounting shifts could be viewed as an effort to disguise significant losses that belie greater financial concerns, or they may reflect prudent management decisions enabling the banks to recapitalize internally by retaining earnings or increasing capital ratios by reducing losses, which will allow them to loan more money and potentially earn more profits.

U.S. Sues Big Banks Over $196 Billion in High-Risk Home Loans

Sources:
Fannie Mae
Federal Housing Financial Agency
FT: Banks Sued Over Mortgage Deals
Freddie Mac
NYT: Federal Regulators Sue Big Banks Over Mortgages
WSJ: U.S. Sues Big Banks Over Home Mortgages

Last Friday, the U.S. Federal Housing Finance Agency (FHFA) filed lawsuits against 17 of the world’s largest banks, alleging that they failed to disclose the high-risk nature of some of the home loans contained in $196 billion worth of mortgage-backed securities (MBS) they sold to Fannie Mae and Freddie Mac. The U.S. Congress established Fannie Mae and Freddie Mac (known as government-sponsored entities, or GSEs) to provide liquidity and stability to the U.S. housing market. As the largest source of home financing in the U.S., Fannie Mae and Freddie Mac play an integral role in ensuring that the average American can secure a home loan.

Although Fannie and Freddie do not lend money directly to homeowners, they are the largest purchasers of home loans from banks and other financial institutions that create the mortgages. Thus, they are able to influence what loans the banks issue based on what loans they (Fannie and Freddie) will purchase. The GSEs “securitize” many of the loans they purchase by bundling several loans together and selling them as one financial instrument called a mortgage-backed security or MBS. They also purchased MBSs from banks.

The FHFA lawsuits accuse the banks of making “materially false statements” about how risky the home loans were that the banks securitized and sold to the GSEs to mislead the GSEs into buying these unsafe investments. After the collapse of the U.S. mortgage market in 2008, Fannie Mae and Freddie Mac were left holding billions of dollars of home loans and MBSs that became worthless as homeowners defaulted at an unprecedented pace. Since then, the U.S. Treasury has spent $141 billion taxpayer dollars keeping the GSEs afloat as part of an ongoing effort to stimulate the U.S. housing market. Since 2008, the FHFA has been responsible for overseeing the preservation and conservation of Fannie’s and Freddie’s assets on behalf of U.S. taxpayers. The FHFA filed the lawsuit in keeping with this role.

The controversial lawsuits are the most sweeping governmental action aimed at holding the banks accountable for their role in the financial crisis. In their defense, the banks point to Fannie Mae’s and Freddie Mac’s formidable roles as “major players” in the mortgage market as they purchased, packaged and sold billions of dollars worth of mortgage securities. In July of 2008, just prior to the U.S. government taking control of Fannie and Freddie, the portfolios each GSE held were worth $758 and $798 billion respectively. The banks claim that Fannie and Freddie were, therefore, shrewd and sophisticated market participants with detailed knowledge of the home loans and securities they purchased. Because Fannie and Freddie knew so much about the home mortgage business, the banks argue, the government should not blame the banks for the GSEs’ investing mistakes.

The banks claim that, even if they are at fault, the lawsuits will do more harm than good. After spending the past three years rebalancing their business to address the massive losses they suffered during the financial crisis, the banks fear that the lawsuit creates enormous potential liabilities and uncertainty that threaten their stability. Of the seventeen banks named in the lawsuit, Deutsche Bank, Credit Suisse Holdings USA, Goldman Sachs and Morgan Stanley sold $10 billion or more each in MBSs containing questionable home loans to Fannie and Freddie. J.P. Morgan Chase and Royal Bank of Scotland Group sold over $30 billion each, and the beleaguered Bank of America’s total exceeds $57 billion due to its acquisitions of Countrywide and Merrill Lynch/First Franklin Financial. Although the lawsuit does not specify how much the government hopes to recoup in damages, prior settlements of similar lawsuits indicate that the government could recoup twenty percent (nearly $40 billion) of the total securities sold to the GSEs.

Government critics point to high U.S. unemployment rates, the declining stock market, including the rapid devaluation of bank stocks since the lawsuits were filed, and broad consumer concerns as an indication that the timing and potential consequences of the lawsuit could be bad news for the economy. Bank critics claim that the U.S. government needs to hold the banks accountable for their past reckless practices to prevent future misdeeds. Irrespective of the merits of the lawsuits, the litigation may take years and cost the banks and taxpayers millions of dollars in legal expenses. Most of the banks were in settlement negotiations with the regulators prior to the filing of the lawsuits and observers expect those negotiations to continue.

Banks Reach Deal with New York Regulators to End Controversial Mortgage Lending Practices

Sources:
Economist: A Call to Arms
IMF: "Global Risks Are Rising, But There is a Path to Recovery;" Remarks at Jackson Hole
Miami Herald: Goldman to Stop Controversial Mortgage Practices
SEC: SEC Addressing Misconduct That Led To Or Arose From the Financial Crisis
WSJ: Banks, State Reach a Deal

Last week, IMF Managing Director Christine LaGarde issued a global call to action for a “broad rebalancing of fiscal priorities.” LaGarde specifically challenged the U.S. to take aggressive action to deal with the ongoing foreclosure crisis. New York regulators and three financial institutions, including Goldman Sachs, reached a deal this week that appears to be a timely response and offers far reaching regulatory implications.

Prior to LaGarde’s call, the U.S. had already implemented various measures at the state and federal levels to address the spiraling housing market and reduce the foreclosure rate. Such programs generally focused on lowering homeowner’s interest rates, reducing the overall amount homeowners owe on their mortgages, and extending payment options. So far, none of these measures have been successful in fixing the housing market’s troubles. The New York agreement is the latest attempt at finding a solution.

Major U.S. banks, including Goldman Sachs and the five largest U.S. mortgage banks (J.P. Morgan, Bank of America, Citigroup, Wells Fargo, and Ally Financial) are facing regulatory inquiries regarding allegedly improper mortgage procedures they used prior to and after the financial crisis. This week’s agreement with Wall Street powerhouse Goldman Sachs and two smaller mortgage banks sets an example for addressing these procedures. The deal requires the financial firms involved to reduce mortgage payments for some homeowners, put an end to the so-called “robo-signing” of mortgage documents (illegally signing documents without having a qualified employee review them first), and conduct internal reviews of all previously processed loans to identify additional instances of robo-signing. The banks will have to reinstate or compensate borrowers whose property the banks improperly foreclosed through robo-signing.

The agreement promises to have far reaching implications as New York regulators are responsible for supervising nearly two-thirds of all U.S. mortgage servicing firms--many of which face allegations similar to those lodged against Goldman Sachs. The clear message of the agreement is that regulators will hold banks accountable for their actions and do what is necessary to help those who suffered as a result of the illegal mortgage practices.

Results of the 2011 EU Stress Test Released

Sources:
FT: EU Stress Test Pass Rate Under Fire
WSJ: Few Banks Fail EU Exams
Economist: Europe’s Stress Test: Disease and Cure

The European Banking Authority (EBA) recently released the results of the 2011 EU-wide stress test. While analysts expected that fifteen to twenty banks would fail the test, only eight banks out of ninety banks from twenty-one countries failed to meet a minimum standard—a core Tier-1 capital ratio (a measure of a bank's strength to absorb losses) of 5 percent—after enduring the test’s worst-case scenarios. A German bank, Helaba, also failed the test, but the bank did not allow the EBA to release its test results. ATE, a Greek bank, was the worst performing bank with a core Tier-1 capital ratio of minus 0.8 percent.

Investors and analysts claim that the test was not tough enough and failed to restore confidence in Europe’s financial markets. In particular, the test’s worst-case scenario did not include the chance of a Greek default. EBA officials also agree that the test was not rigorous enough in part due to “conflicting political pressures” from banks and governments. However, the EBA officials defend the test, saying that the test is still valuable because investors and analysts now have access to data about banks’ exposures to sovereign assets, including Greek debt. Also, Andrea Enria, chairman of the EBA, said that that the test had been “a catalyst for pressure to raise capital.” Over the four months from the end of December to the end of April, banks raised around €100 billion of additional capital.

The EBA formally recommended that national regulators should require eight banks that failed the test to raise fresh capital (€2.5 billion) by the end of this year. Also, sixteen additional banks that barely passed the test with the ratios of between 5 and 6 percent need to improve their capital position by April 2012. Spain was the worst performing nation. Among those twenty-four failing or nearly failing banks, twelve are Spanish, including Caja de Ahorros del Mediterraneo, which will be required to raise additional capital of €947 million. If these banks cannot raise the capital, their national governments may have to provide assistance to them. The EBA will publish two reports on the progress those banks make in February and July next year.

Bank of Moscow to Receive the Largest Bailout in Russia

Sources:
FT: Bank of Moscow Rescued With $14bn State Bail-out
WSJ: Russia Gives Bank $14 Billion Bailout
NYT: Regulators Provide $14 Billion Bailout for Bank of Moscow

Bank of Moscow, the fifth largest bank in Russia, will receive the largest bank bailout ($14.5 billion) in Russia’s history. The bailout was necessary due to the problem loans extended to the bank's former management. VTB, another Russian bank that acquired a 46.5 percent stake in Bank of Moscow last February, recently found that the size of the problem loans amounted to 250 billion rubles ($9 billion), representing almost 30 percent of the bank’s assets. Sixty percent of the problem loans were “very bad” and were made without any collateral. According to Russia’s central bank, Bank of Moscow will receive 295 billion rubles from the Deposit Insurance Agency at 0.5 percent. Additionally, VTB will provide 100 billion rubles as well.

This bailout raises questions about the quality of regulation and supervision in Russian banking. Indeed, banks in Russia have not been considered transparent, and problem loans have been rising after the recent financial crisis as regulators have not actively responded to regulate such problems. Still, the huge size of bailout (almost 50 percent of the bank’s total assets) for a quasi-sovereign bank surprised investors. “If this kind of thing happens at such an important institution, it’s an amber light that the entire Russian banking system has to be finally cleaned up,” said Tim Ash, emerging markets economist at Royal Bank of Scotland.

Finance Minister Alexei Kudrin asked for criminal investigations, accusing the bank’s former chief executive Andrei Borodin, closely connected to an ousted mayor Yury Luzhkov, of practicing “fraudulent lending.” Investors question why VTB was not able to find the bank’s problem loans prior to its purchase of such a large share of the bank. VTB’s chief executive Andrei Kostin said that the bank’s management had not provided the bank’s actual loan book and former mayor Luzhkov “prevented anyone from asking unwelcome questions.”

Banks in Hong Kong Told To Conduct Stress Tests

Sources:
Bloomberg: Hong Kong Banks Told To Hold Stress Tests Assuming $89 Billion In Outflows
ChinaDaily: HKAB: Banks May Slow Credit Growth
FT: Hong Kong Tests Banks’ Ability To Survive Outflows
Market Watch: Hong Kong Banks Asked to Conduct Stress Tests

Hong Kong banks will conduct another stress test to see whether they could withstand capital outflows of HK$650 billion ($83.52 billion) in customer deposits. Since late 2008, the amount of deposits in Hong Kong banks has grown rapidly by HK$1.38 trillion ($177 billion). As liquidity is tightening and the United States may soon raise interest rates, the Hong Kong Monetary Authority (HKMA), the de facto central bank, requested banks to test whether they could survive if customers withdrew half of such new deposits in six to twelve months. “When the US ends its quantitative easing, monetary policy and global liquidity will tighten, and this may cause more fund outflows in Hong Kong,” said Paul Lee, an analyst at Haitong International Group.

The request for stress tests reflects the HKMA’s concerns about the health of Hong Kong banks as banks have rapidly expanded lending. Loans have grown by 30 percent from January to March this year. The loan growth has also driven the loan-to-deposit ratio up from 71 percent to 81.7 percent in a year since early 2010. In the case of smaller banks, the loan-to-deposit ratio has grown up to 90 to 100 percent. High interest rates in mainland China has contributed to the loan growth in Hong Kong banks as more Chinese firms have borrowed loans from Hong Kong banks at lower interest rates. The central bank in China has increased interest rates four times since last October in an attempt to control inflation and reduce loan growth. It also has raised reserve requirements eight times during the same period.

It is notable that recently, the portions of renminbi deposits and loans in US dollars in Hong Kong banks have surged, reflecting the expectation that the value of the renminbi will likely go up against the US dollar in the future. During the last two quarters, renminbi deposits have increased three times up to 452 billion yuan ($69 billion). Loans in foreign currency, mostly in US dollars, have increased by 54 percent during the first quarter this year.

The HKMA will receive the test results from banks in a month. While some predict that banks that fail the test will reduce lending, others say that the test results will not immediately change banks’ lending policy as the bank’s “risk management policy, regulatory requirements and the cost of capital of different banks” determines the banks' lending criteria.

IMF Warns Europe’s Sovereign Debt Crisis Could Spread to Other Parts of Europe

Sources:
Guardian: Fix Banks to Avoid Eurozone Meltdown, IMF Warns
IMF: IMF Calls for Strengthened Policy Response, Stronger Financial Integration to Bolster Europe’s Recovery
WSJ: IMF Weighs Extending Greek Repayments

Last week, the International Monetary Fund (IMF) published the latest Regional Economic Outlook for Europe. The IMF expects that economic growth in Europe will not be fast “but still solid and sustainable.” It estimates that economic growth for Europe will be 2.4 percent and 2.6 percent in 2011 and 2012, respectively. In the case of emerging market economies, they are expected to grow at 4.3 percent both in 2011 and 2012. However, the IMF also warns that sovereign debt problems in Greece, Ireland and Portugal could spread to “the core euro area, and then onwards to emerging Europe,” calling for comprehensive and strong policy actions to restore confidence and fix vulnerabilities in the financial sector and accelerate reform efforts.

As banks in other countries in Europe hold substantial amounts of bonds of the governments with sovereign debt problems, “a shock to confidence” could spread to other European countries, said the IMF. According to Morgan Stanley, BNP Paribas in France holding around €5billion of such bonds would be hit the hardest. In order to contain contagion risk, the IMF emphasized a need to strengthen the banking system in Europe and it also said that the 2011 EU-wide bank stress test will be a great opportunity to identify and fix weaknesses in the banking sector. Antonio Borges, Director of the European Department said that while systemic risk in the European banking sector had been reduced, banks in Europe would have to raise additional capital and accelerate their efforts to consolidate. Also, the IMF called for more financial integration, arguing that the incomplete financial integration as well as the lack of effective institutions to handle cross-border problems at the regional level had contributed to the worsening of the financial crisis in Europe.

As for Greece, the IMF showed optimism, saying that there would be no possibility of a default and that any type of debt restructuring would be necessary at this point. Mr. Borges said, he did not think that restructuring would provide a “miraculous” solution. Instead, Mr. Borges pointed out that the Greek government “has an extraordinary portfolio of assets” and it can raise additional cash through privatizing such assets. Currently, the Greek government is in the process of privatizing its assets amounting to €50 billion. Also, the IMF said that Greece will likely meet it deficit target of 6.2 percent of gross domestic product in 2012.

Many Banks in Europe Face Funding Difficulties

Sources:
Economist: Cutting It Fine
Bloomberg: European Bank Funding Threatened as Basel III Meets Solvency II
FT: Banks Endorse Option of Creditor ‘Bail-in’; Brussels to Target Bondholders on Bail-outs

In many European countries, the maturities of bank debt have shortened dramatically in 2011 compared to 2006, according to data provided by Dealogic. In particular, in countries having sovereign-debt problems such as Greece and Portugal, the maturities of bank debt have fallen more sharply. In other countries such as Spain and Italy, banks also face funding difficulties and have been issuing more short-term bonds or paying higher yields. In the case of Italy, banks pay higher yields on their bonds by 1-1.5 percentage points than banks in France and Germany. Having more short-term funding is worrying because it makes banks vulnerable to a sudden liquidity dry-up in short-term funding markets as it happened during the recent global financial crisis.

On the other hand, banks in some countries including France and Germany have been able to improve their funding situations, issuing more long-term bonds during the same time period. In France, for instance, banks’ weighted-average debt maturity in 2011 increased over eight years from around six years in 2006.

However, most banks in euro-zone countries will likely continue to suffer from funding difficulties in the near future as new regulations pose additional challenges. The new Basel III rules require banks to hold more capital. McKinsey & Co. estimates that banks in euro-zone countries will have to raise additional €2.3 trillion ($3.4 trillion) in long-term funding. However, other two regulations imposed by European regulators may make it even harder for banks to sell long-term bonds. First, under the Solvency II rules, insurance companies are required to hold more capital against corporate bonds when they purchase longer-term bonds. Insurance companies are the biggest purchasers of bank bonds in Europe, holding about 60 percent of banks’ debt. The Solvency II rules may discourage them to hold longer-term bonds. Second, European regulators have proposed a regulation which requires bondholders to share the losses of failing banks. Under the proposed rules, bondholders will be first asked to reduce the value of their bonds before taxpayers bail them out.

Vickers’ Reform Plans to Make UK Banks Safe and Competitive

Sources:
FT: Lloyds Lashes Out at Vickers Report; Ringfenced But Game’s Far From Up; Vickers to Propose More Competition for Banks
Economist: Commission Accomplished
Telegraph: Sir John Vickers Unveils Radical Shake-up of Banking Industry Regulation; The Quiet Revolution for British Banking

Last summer, the UK government established the Independent Commission on Banking (ICB) and asked the ICB to provide banking reform plans to enhance stability of the UK financial system and improve competition. The ICB, chaired by Sir John Vickers, a former chief economist at the Bank of England, published its interim report on April 11th. After the release of the report, bank shares rose since its recommendations were less radical than expected. Notably, the report did not recommend an option of requiring banks to completely separate their retail banking units from investment banking units.

Mainly, the ICB’s report suggests three measures. First, the report recommends that banks’ retail banking units be ring-fenced from other units so that retail units can keep functioning in a financial crisis. Second, as a measure to increase banks’ ability to absorb losses, the report recommends that banks hold a core Tier 1 capital ratio of at least 10 percent, higher than the minimum requirement of 7 percent set by Basel III. Lastly, in order to enhance competition in the retail banking market, the report recommends that Lloyds Banking Group reduce its market share of current accounts by selling more branches. Lloyds’ market share rose up to almost 30 percent after the purchase of HBOS during the financial crisis. As a condition for receiving state aid, Lloyds has already begun selling its 600 branches, but the report did not specify how many additional branches Lloyds would be required to sell.

Critics say that the ICB “bottled it” and its recommendations were timid. They point out that the ICB rejected options of formally separating banks’ retail and investment banking units and unwinding of the merger between Lloyds and HBOS. Also, the ICB did not provide any recommendations regarding caps on bankers’ bonuses. However, Sir Vickers claims that the report’s reform options are “very far-reaching” and would “make a world of difference to UK retail banking.”

The ICB’s final report is due in September. In the meantime, the ICB will receive comments on their recommendations from the public.

Systemically Important Financial Institutions

Sources:
FT: Financial Groups Seek to Avoid ‘Important’ List; US Regulators Divided on Systemic Risk List; HSBC Chairman Calls for ‘Systemic’ List of Banks Reuters
Reuters: No Deal Yet on Which Banks Face Extra Cap Rules-FSB; Over 80 Banks Should Be Systemically Important-HSBC

Under the Dodd-Frank Act (DFA), the Financial Stability Oversight Council (FSOC), a group of US financial regulators, has the authority to designate a financial institution as systemically important. If designated, such institutions will be subject to tighter liquidity and capital standards as well as closer supervision pursuant to Title VIII of the DFA so that they would not increase liquidity or credit risks enough to threaten the stability of the entire financial system. Financial institutions have been desperately lobbying to avoid being designated as systemically important since the designation would likely to be a “scarlet letter,” a sign that their profits would be reduced due to higher capital and liquidity requirements.

Currently, there is a split among regulators over which financial institutions should be on the list. The Federal Reserve and the Treasury want to designate only a few (less than 10) as systemically important. Federal Reserve Governor Daniel Tarullo said the “initial list…should not be a lengthy one…in part it’s because some of the obvious pre-crisis candidates – the large freestanding investment banks – have either become bank holding companies, been absorbed by [them], or gone out of existence.” On the other hand, the Federal Deposit Insurance Corporation (FDIC), in charge of winding down systemically important financial institutions, prefers to designate about 30 to 40 financial institutions systemically important including hedge funds and insurance companies.

While the FSOC has yet to finalize the list, every bank holding company with over $50 billion in assets will be automatically included in the list. Those institutions include Bank of America, MetLife, AIG, Prudential, and Hartford Financial Services. Insurance companies argue that they do not deserve to be designated as systemically important since they have stable funding and are not subject to “bank-type runs.” They also argue that their businesses are not dangerously related to other financial institutions. However, Viral Acharya, a professor at New York University, says that insurance companies as big buyers of corporate bonds may be systemically important. If they stop buying corporate bonds during a crisis, it would affect banks’ funds as corporations have to rely on banks.

Globally, the Group of 20 countries (G20) has agreed to require systemically important global financial institutions to hold more capital. The Financial Stability Board has been working on proposals regarding how many financial institutions would be required to hold how much additional capital. The proposals will be available during the G20 summit in November.

Goldman Sachs Expands in India

Sources:
WSJ: Goldman Sachs to Bolster India Business
The Hindu Business Line: Goldman Sachs Gets RBI Nod for Primary Dealership
Bloomberg: Goldman Sachs Gets Approval for Indian Primary Dealer Permit
Businessweek: Goldman Sachs Finds It Slow Going in India

Goldman Sachs is bolstering it equity and debt capital market business in India. Anshul Kriskhan, managing direct of Goldman Sachs (India) said, “All the core businesses Goldman Sachs operates around the world are represented on the ground in India.” Mr. Kriskhan also said that Goldman Sachs will further augment is capital markets activity, including debt. The bank operates of out Bangalore and Mumbai, and conducts investment banking, global investment research, and operations and technology practices.

Goldman Sachs has applied for a banking license in India, and it expects to receive the license in the next three to six months. The license allows Goldman Sachs to trade currencies and trade derivates. Goldman Sachs trails its competitors, Morgan Stanley and Citigroup, in getting a license. On Friday, the Reserve Bank of India gave Goldman Sachs approval for a primary dealership that would allow it to underwrite government bonds starting April 18, 2011. Primary dealers are banks, brokers, dealers, or other financial institutions that deal in government securities. The permit for the primary dealership will let Goldman Sachs compete to help the Indian financing ministry raise 4.17 trillion rupees, which is $94 billion.

Indian economic expansion drove mergers and stock offerings to records last year, and India is among the emerging markets that Goldman Sachs is targeting as the firm faces more restrictive rules in the U.S. and Europe on how it can manage and deploy its capital. The bank’s annual revenue in India from all of its businesses is about $100million, which is a 0.25% of the bank’s $39.2 billion in worldwide revenue last year. Indian investment banking fees, although growing, are still a fifth of China’s at $1 billion, and Indian customers are price sensitive compared to other global markets, so Goldman’s expensive, but high quality services, may be a hard sell in India.

Goldman Sachs has invested $2 billion in India, almost all of it since 2005, by buying shares of companies like Benchmark Asset Management Co., which is based in Mumbai. The purchase gave Goldman Sachs access to a market where assets managed by mutual funds tripled to 6.8 trillion rupees over the last five years.

WikiLeaks Founder Says To Expect Major Leak Concerning Big U.S. Bank

Sources:
Forbes: An Interview with Julian Assuage
CNN: Which Bank is WikiLeaks’ Target?
FDIC’s Bair: ‘Ignore’ WikiLeaks Bank Release
CNN Money: Wacky Wiki Won’t Wreck Bank Stocks

The news the last few weeks has been filled with mentions of WikiLeaks, the website that releases confidential and nonpublic documents. Most of that news has been filled with discussion concerning the website’s recent release of thousands of the United States’ State Department’s diplomatic cables. However, there is also some curiosity over information the website may have that could affect the United State’s private sector.

Julian Assuage, the founder of WikiLeaks, sparked this curiosity in a recent interview with Forbes. While discussing the massive nature of the cables leak, Assuage mentioned that the website had enough information for another major leak, and this one would be the website’s first leak concerning the private sector. Assuage stated that about half of the website’s documents concerned the private sector and hinted that the website’s next major release, scheduled for early next year, would target one of the biggest banks in the United States. Assuage said that the information was of such a nature that it would “take down” the bank.

Although evasive on the actual contents of the documents that the website will release, Assuage mentioned that the leaks would detail the inner workings of the bank and likely spark even more investigation and reform within the financial sector. Assuage likened the bank’s atmosphere to “an ecosystem of corruption.” Assuage alluded that there were definite ethical violations occurring within the bank, as well as possible criminal actions, and he predicted that it will cause a scandal of Enron-like proportions.

Assuage’s comments have ignited wide speculation regarding on which bank the WikiLeaks’ has such condemning information. Most commentators think the likely candidates are Wells Fargo, Wachovia, Citibank, JPMorgan Chase, and Bank of America. However, the media has speculated that one bank in particular is the likely subject of the controversy, because of Assuage’s previous comments. Last year, Assuage mentioned to an interviewer from Computerworld that WikiLeaks had five gigabytes of information from a Bank of America executive’s computer. Bank of America’s stock is already suffering from Assuage’s comments. On Tuesday, shares fell more than 3% and ended pennies above their lowest price of the past year.

The head of the FDIC, Sheila Bair, downplayed Assuage’s comments. She suggested consumers simply ignore his remarks and rumors of an upcoming leak. Bair stated that since the financial crisis the transparency of the banking industry has increased. Bair was also skeptical that Wikileaks could have any major information about the financial sector and banking industry that has not already been previously released. Time will tell what kind of impact these WikiLeaks could have on the private sector. If Assuage is to be believed, there will be at least some impact, and we probably won’t have to wait long.

Discussion:
1. Do you think Assuage has the kind of information that could cause another Enron-like scandal or is Bair’s statement that there isn’t any further and unknown information more accurate?
2. If WikiLeaks does have such information, what kinds of reform would you expect?

"Swiss Finish" to New Global Capital Rules

Sources:
Economist: First Mover
Financial Times: Swiss urge capital boost for banks
NYTimes: 2 Swiss Banks Facing Higher Capital Standards
WSJ: UBS, Credit Suisse Face Tough New Capital Rules

Last month, global regulators reached an agreement on new capital rules for banks. Under the new Basel III rules, banks are required to hold core capital of minimum 7 percent of risk-weighted assets. The Basel Committee on Banking Supervision also recommended that the top 30 global banks should hold more capital in addition to the minimum requirement. On October 4th, Switzerland made the first move. The proposals by the Commission of Expert (Commission) require the two "systemically important" banks, Credit Suisse and UBS, to hold 19 percent of risk-weighted assets (10 percent in the form of common equity plus 9 percent of contingent convertible bonds (CoCos)). CoCos are similar to bonds but convert to equity if core capital ratios falls below a predefined level. The Commission, appointed by the government, was comprised of representatives from the central bank, industry, etc. If the Parliament approves the proposals, the two banks must comply with the new rules by 2019.

The proposed rules will "significantly mitigate the too big to fail problem in Switzerland and thus reduce the risk for the Swiss economy," said Philipp M. Hildebrand, Chairman of the Swiss National Bank (SNB) Governing Board. According to the Commission, the total capital requirement of 19 percent makes sense given the size of Credit Suisse and UBS and their potential impact on the economy. The balance sheets of the two banks amount to around six times the nation's gross domestic product. Also, during the financial crisis (from the last quarter of 2007 to the first quarter of 2009), UBS incurred losses of 13 percent of risk-weighted assets.

Both Credit Suisse and UBS confidently say that they can meet the heightened requirement by 2019. However, experts disagree over the practicalities of CoCos. John Cryan, UBS's financial director doubts whether a CoCo market would emerge or whether banks can use it. Only two banks, Lloyds and Rabobank, have used CoCos so far, issuing around $16.4 billion last year. Credit rating agencies have not been willing to rate CoCos. On the other hand, Thomas Jordan, director of the SNB, is confident that investors will buy CoCos. According to the Economist, CoCos can be viewed as "a kind of catastrophe insurance for which a premium is received in return for a small chance of a big loss," and banks will be able to use CoCos. The Commission estimates that if Credit Suisse and UBS use CoCos to raise 9 percent of their risk-weighted assets, the amount would be approximately SFr 72 billion.

Discussion:
1. Jose-Maria Roldan, head of banking regulation for the Bank of Spain, said that CoCos are "brilliant ideas but... preferred shares and subordinated debt also looked great before the crisis and they were totally useless. Why do we think financial innovation will work this time around?” What are the benefits and disadvantages (or risks) when banks use CoCos to raise capital?

2. The Commission heightened the capital requirement, but did not propose to break up the two biggest banks or limit their size or activities (e.g., proprietary trading) Should the Commission have suggested breaking up the two banks or limiting their size or activities in order to address the too-big-to-fail problem?

China Allows Banks to Trade Loans on the Interbank Market

Sources:
People’s Daily Online: Small banks get the upper hand from new policy
Istockanalyst.com: China initiates loan transfer system on Interbank market
Bloomburg.com: China Allows Banks to Sell Loans on Interbank Market
WSJ.com: China Launches Secondary Loan Market

Last week, the People’s Bank of China (PBC) established a loan trading system, officially allowing banks to trade loans on the Shanghai interbank market. By trading loans on the interbank market, banks can meet a reserve requirement (the minimum amount that deposit-taking institutions should hold against deposit liabilities) and manage liquidity. For example, banks without enough reserves can meet the requirement by purchasing funds from banks with excess reserves.

Allowing loan transactions on the interbank market in China is expected to help Chinese banks strengthen their capital and better manage financial risk. "Given the rapid lending growth in the recent past and continuously growing pressure on bank asset quality, the launch of a national interbank loan transfer trading will be significant," said PBC Governor Zhou Xiaochuan. Following the government’s economic stimulus program, the amount of new loans reached a record level of 9.6 trillion yuan ($1.43 trillion) in 2009. In an effort to prevent worsening of loan quality and asset bubbles, the government aims to limit new lending to 7.5 trillion yuan ($1.12 trillion) this year. In addition, the government requires banks to maintain a loan-deposit ratio of 75 percent. By selling existing loans, large banks will have more rooms to make more profitable loans without violating the regulatory requirement.

The National Association of Financial Market Institutional Investors (NAFMII), a self-regulatory organization in China, published rules to provide the standard procedures for loan transactions on the interbank market, how to deal with loan defaults, etc. Twenty-one banks including Industrial & Commercial Bank of China Ltd. and HSBC Holding Plc agreed to sell loans on the interbank market. One of the first transactions was executed by China’s two largest banks, Industrial and Commercial Bank of China and Bank of Communications.

Currently, only commercial banks can trade loans on the interbank market. However, the government will eventually allow institutional investors to trade loans as well, said Zhou. Also, experts say that allowing loan transactions is a preliminary move towards securitization of bank loans.

Discussion:
Will the NAFMII’s rules effectively regulate the interbank loan transfer market?

EU Reached a Consensus on Financial Reform

Sources:
Europa: Political consensus on supervisory package - remarks from Commissioner Michel Barnier
Financial Times: Deal paves way for pan-EU financial watchdogs; London fears power shift to Brussels; EU go-ahead for regulatory shake-up
WSJ: Europe's 4-Regulator Solution

In an effort to prevent a future financial crisis, the European Union (EU) agreed to create a European financial supervisory framework. "Financial companies and markets operate mostly at a European level, and we'll now have four solid authorities to monitor macroeconomic financial risks and to supervise financial markets, banks, and insurance companies," said Michel Barnier, the European Union Internal Market Commissioner.

The EU plans to establish four pan-EU financial supervisors: the European Systemic Risk Board (ESRB) and three European Supervision Authorities (ESAs). The ESRB will evaluate risks to financial stability across the EU and provide early warnings. Each of three ESAs will be responsible for overseeing banking, insurance and securities markets. The ESAs will develop common technical rules and standards. Although the ESAs will not directly supervise financial institutions, they will be able to investigate risky financial products and financial activities. And in "emergency situations," they will have power to ban or restrict risky products and activities.

Although this "European radar screen" is expected to provide better oversight of cross-border financial activities in Europe, some countries including the UK fear that national authorities may have less regulatory or supervisory power. The ESRB and ESAs will be operational by January 2011 after obtaining approvals from the European parliament and the member states. For the initial five years, the president of the European Central Bank will chair the ESRB.

Discussion:
1. One of the controversial issues is the chairmanship of the ESRB. The European parliament wants the ECB president to be the chairman while the member countries want to make the decision by themselves. Initially, the ECB president will chair the ESRB, but this issue will be reviewed in three years. What are the pros and cons of designating the ECB president as the chairman of the ESRB?
2. The status of financial market development is different for each member state. How can the new EU-level watchdogs develop common rules and standards while balancing different interests of each country?

Impact of Requiring More Bank Capital

Sources:
Economist: Super model
WSJ: Basel: Bank Rules Won't Hurt Growth; Studies Question Bank Capital Fears
Financial Times: Banks rebound on Basel concessions; Studies refute risk of higher bank capital
Financial Stability Board: An Assessment of the long-term economic impact of stronger capital and liquidity requirements; Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements

In June, the Group of 20 nations (G20) promised to implement new international rules that would require banks to increase the amount and quality of their capital. The rules are intended as measures to prevent another financial crisis and to strengthen the resilience of the banking sector. However, the banking industry has voiced concerns, arguing that raising capital requirements would increase cost of capital, cut lending, and negatively affect the global economic recovery. According to the Institute of International Finance, the new rules would reduce the gross domestic product (GDP) by three percentage points in the U.S., the euro zone, and Japan by 2015.

In contrast, recent studies published by the Financial Stability Board (FSB) and Basel Committee on Banking Supervision (BCBS) demonstrate that the long-term benefits of raising more capital are "substantial" despite "manageable" short-term costs. According to the studies, when banks are required to raise their capital by three percentage points within four years, the absolute level of GDP would decrease by 0.6 percentage points. However, the global economy would ultimately benefit as more bank capital would lower the frequency and severity of bank crises. The net increase in absolute GDP is estimated to be around 1.7 percentage points.

Mr. Mario Draghi, Chairman of the FSB and Governor of the Bank of Italy, emphasized the importance of "appropriate phase-in arrangements" for the new rules. If banks have time to adjust to the new rules, they can reduce the short-term costs (e.g., increased loan cost or loan reduction) by using other "adjustment mechanisms" such as reducing costs, issuing equity, retaining profits, etc. In July, the BCBS postponed the implementation date-- the rules will not take full effect until 2018. The FSB and the BCBS are expected to finalize the rules before the next G20 meeting in Korea in November.

Discussion Questions: Will banks be able to survive another financial crisis without using taxpayers’ money if they increase the level and quality of capital according to the new rules? Will the new rules harm banks?

Three Major Points of the U.S. Financial Reform Bill

Sources:
Restoring American Financial Stability Act of 2010
Wall St. J.: Senate Passes Sweeping Financial Overhaul
NY Times: 3 Auto Dealer Tactics the Overhaul Missed
Financial Times: A New Era: Key Points of the Senate Bill
CNN: Wall Street Reform: What’s in the Bill?
The Boston Globe: Agency has Teeth, Panelist Says

On Thursday July 15, 2010, the Senate voted 60 to 39 to approve the 2,300 page financial reform bill. The bill marks the most drastic revision of financial regulation since the Great Depression. So, how will the bill affect the financial sector? The bill changed many aspects of financial regulation­­­ ­ (far too many to discuss all of them here), but below are three major points of the bill.

Consumer Financial Protection Agency (CFPA)

The financial reform bill created the CFPA to do exactly what its name implies—protect consumers from abuses of the financial industry. Among these abuses are predatory subprime mortgage lending (a major catalyst of the financial crisis) and mis-selling of credit cards. However, the CFPA will not have power over automobile dealers writing car loans. The CFPA is responsible for writing the rules to protect consumers from abuses, but the bill does not require the CFPA to implement any specific laws.

The CFPA will be housed within the Federal Reserve and will be funded by fees paid by banks. It will operate completely independently from the Fed and have a protected funding stream that will shield the CFPA from congressional and corporate interference.

The rationale for creating the agency is that abuses by some financial institutions helped lead to the financial crisis. Of course, commentators have criticized the CFPA on numerous grounds.

One criticism of the CFPA is that automobile dealers and the loans that they arrange for consumers are not subject to CFPA oversight. Proponents of the automobile dealer exemption believe that “auto dealers are part of Main Street, not Wall Street” and that automobile loans played no part in the financial crisis. In response, those that challenge the exemption are quick to point out “that Wall Street firms bundle into bonds many of the loans that dealers help originate and conveniently forget that lots of dealers are actually owned by publicly traded companies.” Thus, according to the critics of the exemption, auto dealers are actually part of Wall Street.

Another criticism is that the strength of the CFPA is unknown. The bill merely created the CFPA, but does not require the CFPA to implement any specific laws. As a result, these critics believe that the CFPA will be weak if those who write the rules implement weak, loophole-laden laws.

Derivatives

The bill requires that derivatives that trade in over-the-counter (OTC) deals now be traded on exchanges or similar systems and routed through a clearinghouse. A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to something else such as stocks, bonds, interest rates, or commodities. Customized swaps can still be traded OTC, but they would have to be reported to central repositories so regulators have a better idea of what is taking place in the market. Put simply, a swap is a simultaneous buying and selling of the same security—such as a bond—to hedge risk, speculate, or reduce funding costs. There will also be new capital, margin, reporting, record keeping, and business conduct rules for derivative dealers.

Before the bill was passed into law, the OTC derivatives market was largely unregulated, disclosure requirements were minimal, and it was made up of highly sophisticated parties (banks and hedge funds). An example of an OTC derivative is a credit default swap, which many believe was a cause of the global financial crisis (and here). A credit default swap is similar to an insurance contract that pays out if, for example, a party defaults on its home mortgage. Previously, counterparties in OTC derivative transaction executed their transactions directly with each other rather than through a clearinghouse. As a result, the counterparties had no assurance that the other would perform. By requiring trades to be executed through a clearinghouse, counterparty risk is minimized—if a counterparty cannot meet its obligations the clearinghouse will cover the loss of the defaulting party. The use of a clearinghouse will decrease counterparty risk and increase transparency.

The bill provides exemptions for non-financial companies using contracts to hedge risk. A company hedges risk to attempt to eliminate the volatility of an underlying asset. Speculation is different than hedging in that the main purpose of speculation is to profit from betting on the direction an asset will move. For example, an airline will buy options in oil to reduce the volatility (hedge) of the price of fuel. On the other hand, a speculator will buy a call option if it believes that the price of oil will increase solely to make a profit.

Volcker Rule

The Volcker rule prevents deposit-taking banks from buying and selling financial products for their “trading account”. The law then defines the trading account as an account meant to profit in the “near term” from “short term” movements in prices. Additionally, it prevents these banks from owning more than a small piece of hedge funds and private equity firms. The bill does provide an exception (government bond exemption) which allows banks to trade in Treasuries, government backed bonds, and municipal bonds.

The Volcker rule attempts to reduce moral hazard for the largest banks which came as a result of the government bank bailouts of 2008-2009. Moral hazard is the idea that when governments bail out financial institutions that have engaged in risky behavior—e.g., risky trades—that threatens the financial system, they send signals to other financial institutions that they too can engage in similarly risky behavior with the expectation that they will be bailed out if they get into trouble. Essentially, the Volcker rule bans banks from using their own funds, which were backed by taxpayer cash, to speculate in the financial markets. For example, in the fourth quarter of 2007, Morgan Stanley took a $7 billion dollar trading loss. Eventually Morgan Stanley took bailout money from the government. Furthermore, Citigroup had significant holdings of mortgage-backed securities and collateralized debt obligations of which it took significant losses. Following these losses, Citigroup received $45 billion in government money and guarantees. Thus, the financial reform bill introduced the Volcker rule to help reduce the number of risky bets that banks make on their own behalf.

The government bond exemption has come under fire. Critics of the government bond exemption believe that there is still a risk of loss in government bonds. Critics point to the European sovereign debt crisis and the poor financial state of some local U.S. governments as evidence that government bonds are in fact risky. Critics argue that using leverage, it is possible for banks to make large speculative bets in exempt bonds which could lead to major losses and therefore, more bailouts.

Proponents of the exception argue that, because banks hold many of these bonds on their balance sheets, disallowing trading in these bonds would cause banks significant hardship. They believe that government bonds are safer than corporate bonds, and therefore should not be treated the same as corporate bonds. Regardless of the risk in government bonds, deposit-taking banks may invest in government bonds for their own benefit.

Discussion:
1) Did the financial reform bill go too far or not far enough?
2) Will the CFPA be effective? What will it take for it to be effective? What is the most important issue that the CFPA needs to tackle?
3) Are government bonds safer than corporate bonds? Should they be exempt from the Volcker rule?

Is Basel III “Doomsday” for Banks and Economic Growth?

Sources:
Financial Times: Bankers Warn of Basel III hit to GDP
Financial Times: Bankers’ ‘doomsday scenarios’ under fire
Financial Times: Basel Chief hits back at growth curb claim
Financial Times: Digesting the Basel Reforms
Bloomberg Businessweek: Geithner Meeting Barnier on Basel III Presses Banks
Wall St. J.: G-20 is Nearing Accord on New Capital Rules
Bank for International Settlements: History of the Basel Committee and its Membership

The Basel Committee on Banking Supervision (Basel Committee) sets global banking standards, which national regulators then implement. In 1988, the Basel Committee introduced a measure of capital called the Basel Capital Accord (Basel I) requiring a minimum capital of 8%. In 2004, the Basel Committee issued a revised framework, commonly referred to as Basel II, which refined the standardized rules set forth in the Basel I.
Among other things, Basel II lowered capital requirements and allowed the largest and most sophisticated banks to use internal models to calculate risk of their assets in determining the capital charges against them. Basel II is the minimum standard for international banks and many countries have adopted it in some form.

While Basel II sought to improve on Basel I by aligning regulatory capital requirements more closely to banks’ underlying risk, many have criticized it. In the wake of the global financial crisis, criticism of Basel II has not waned, but has actually increased. In fact, many critics such as Charles Goodhart, a former Bank of England policy maker and professor at the London School of Economics, have gone as far as saying “that Basel II failed.” Therefore, regulators are trying to fix Basel II through a financial reform dubbed “Basel III.”

Basel III will still rely on the banks’ risk models, but will call for tighter control of what goes into the calculations. There will be a narrower definition of what counts as capital and higher capital charges against riskier holdings such as derivatives. Basel III may also impose a cap on the amount of assets a bank can have in relation to its equity. Put simply, Basel III would require banks to keep enough money in reserve to insulate them against future crises. Not surprisingly, these proposed changes have not been without criticism.

As you may surmise, the loudest criticism of Basel III comes from the banking industry. Banks are claiming that the increased capital requirements will significantly reduce their profitability. Moreover, the world’s leading banking industry group has warned that economic growth in the eurozone, the U.S., and Japan will be cut by three percentage points between now and 2015 if the proposed changes come into force. Another group warns that this would lead to 9.7 million fewer jobs in those countries. Thus, according to the banking industry, the combined effects of Basel III will have a disastrous effect on the worldwide economic recovery.

Proponents of Basel III believe that these worries are unwarranted. Banks are assuming the “maximum impact of the maximum change with the minimum behavioral change.” Banks’ business models are not static and can be changed to deal with the new regulations. Furthermore, if Basel III is applied with equal force to all banks, there is no reason why banks could not maintain their profitability by passing the costs of increased capital to their customers without adverse impact on business. However, it is not clear that they would necessarily do so.

Due to the differing views regarding the effects of Basel III, the Basel Committee and the Financial Stability Board have given a mandate to the Bank for International Settlements to assess the economic effects of the Basel III reform. The estimates are still in progress, but the study shows that the costs “aren’t huge” and the “improvements to the resilience of the financial system will not permanently affect growth—except for possibly making it higher.” However, even if the reforms do slow economic growth, many proponents believe that it is a price worth paying for a stable financial system worldwide.

Even though the banking industry contends that the effects of Basel III will be disastrous, it is debatable whether Basel III truly is doomsday for banks and economic growth. Indeed, if there are costs, they may be a small price to pay for global financial stability going forward.

Discussion:
1) If Basel III does reduce banks' profitability, how do you think banks will deal with it (pass it on to customers, find a loophole, more innovation, etc.)?
2) Even if Basel III slows economic growth, do you think it is a price worth paying for a stable financial system?

Does India need a super-regulator for financial stability?

Sources:
The Hindu: A super regulator for financial stability
Business Standard: RBI ideally placed to address financial stability issues; FSDC not a super regulator: Pranab; Paper on FSDC soon: Pranab
RBI: Financial Stability Report
Livemint.com: Regulating financial stability

In an effort to enhance the stability of the financial sector, the Indian government plans to establish an "apex-level" Financial Stability and Development Council ("FSDC") which will "monitor macro prudential supervision of the economy." In the Budget speech last month, the Finance Minister Pranab Mukherjee explained that the FSDC would monitor large financial conglomerates and coordinate inter-regulatory issues. In addition, the FSDC will deal with the matters relating to financial literacy and financial inclusion.

Currently, there are four major regulators in India - the Reserve Bank of India ("RBI"), the Securities and Exchange Board of India ("SEBI"), the Insurance Regulatory and Development Authority ("IRDA") and the Pension Fund Regulatory and Development Authority ("PFRDA"). Since 1992, the High Level Coordination Committee on Financial Markets ("HLCC") has attempted to coordinate inter-regulatory issues among them. The Governor of the RBI is the chair for the committee. The RBI, in its first issue of the Financial Stability Report said that the FSDC answered "a felt need for an institutional mechanism in the post-crisis scenario to pre-empt build-up of systemic risks with potentially huge costs." It also said that it would be important to define the relationship between the FSDC and the existing HLCC.

Those who oppose the establishment of the FSDC argue that the RBI has been already implementing similar roles of the proposed FSDC. The RBI has been quite successful in protecting the Indian economy from the impact of the global financial crisis. Although the Finance Minister emphasizes that the FSDC is not a super regulator, they worry that it may eventually act like one. Also, they point out that the super regulator approach under the Financial Services Authority in the U.K. has not been effective during the global financial crisis.

Last week, the Finance Minister emphasized that the FSDC would not impair the autonomy and independence of existing regulators and only focus on what the existing regulators have not done so far. He also said that the government would publish a paper which would provide information about how the FSDC would work.

Discussion Questions:
1. How could the FSDC effectively achieve its objective of coordinating inter-regulatory issues among regulators without undermining the autonomy of existing regulators?
2. Does India need a super regulator?
3. What should be the relationship between the FSDC and the HLCC?