Marcus Buckmann, Paula Gallego Marquez, Mariana Gimpelewicz and Sujit Kapadia
Bank failures are very costly for society. Following the 2007/2008 global financial crisis, international regulators introduced a package of new banking regulations, known as Basel III. This includes a wider range of capital and liquidity requirements to protect banks from different risks. But could the additional complexity be unnecessary or even increase risks, as some have argued? In a recent staff working paper, we assess the value of multiple regulatory requirements by examining how different combinations of metrics might have helped prior to the 2007/2008 crisis in gauging banks that subsequently failed. Our results generally support the case for a small portfolio of different regulatory metrics: having belts and braces (or suspenders) can strengthen the resilience of the banking system.
Emerging markets (EMs) have become more exposed to the global financial cycle in recent years. Positive liquidity shocks – that is, a loosening of global funding market conditions – have led to exchange rate appreciations, reductions in long-term bond yields, stock market booms, and increased gross capital flows to EMs (Bhattarai et al (2018)). Negative liquidity shocks on the other hand constitute a tightening of financial conditions, reducing lending and real investment (Bruno and Shin (2015) and Avdjiev et al (2018)).
This year marks 25 years since the failure of Barings Bank. On Sunday 26 February 1995, the 200-year old merchant bank blew up thanks to derivatives trading, which it believed was both risk-free and highly profitable. It was neither of these things. The firm’s star trader was illicitly pursuing a strategy akin to ‘picking up pennies in front of a steam-roller‘. The steamroller arrived in the form the Kobe earthquake. The star trader’s losses ballooned and he doubled up on his bets, unsuccessfully. Barings went bankrupt. The episode captured the public imagination, and helped lead to the creation of a new regulator in the UK.
What was the root cause of the financial crisis? Ask any economist or banker and undoubtedly they will at some point mention leverage (see e.g. here, here and here). Yet when a capital requirement based on leverage — the leverage ratio requirement — was introduced, fierce criticism followed (see e.g. here and here). Drawing on the insights from a working paper, and thinking about the main criticism — that a leverage ratio requirement could cause excessive risk-taking — this seems not to have been the case.
Have post-crisis reforms of banking regulation made banks and lending more resilient to the shock from Covid-19 and if so by how much? This blog takes one specific example – countercyclical capital buffers (CCyBs) – and shows that policy makers in a range of countries were able to quickly release these capital requirements, enabling banks to use the cumulated buffers. This released capital may in turn potentially help banks to support lending. And it will likely benefit lending in the country releasing requirements on buffers as well as banks’ lending to other countries, leading to potential positive international spillovers (see e.g. discussion of spillovers due to macroprudential policies by the ECB and others).
Zahid Amadxarif, James Brookes, Nicola Garbarino, Rajan Patel and Eryk Walczak
The banking reforms that followed the financial crisis of 2007-08 led to an increase in UK banking regulation from almost 400,000 to over 720,000 words. Did the increase in the length of regulation lead to an increase in complexity?
Zahid Amadxarif,Paula Gallego Marquez and Nic Garbarino
“We’ve done a lot to lower prudential barriers to entry into the banking sector […] but have we done enough to lower the equivalent barriers to growth?” asked PRA CEO Sam Woods in a recent speech. To make regulation proportionate, policymakers adapt regulatory requirements to the risks posed by each firm. But regulators face a trade-off between addressing systemic risks in a proportionate way and limiting regulatory complexity. New thresholds can create complexity and cliff-edge effects that can discourage healthy firms from growing. We identify regulatory thresholds for UK banks and building societies using textual analysis on a new dataset that contains the universe of prudential rules.
Matteo Benetton, Philippe Bracke, João F Cocco and Nicola Garbarino
Academics have made the case for mortgage products with equity features, so that gains and losses due to fluctuations in house values are shared between the household and an outside investor. In theory, the equity component expands the set of affordable properties, without increasing household debt, and default risk. These products have not become mainstream, but in a recent paper, we study a large UK experiment with equity-based housing finance — the Help To Buy Equity Loan scheme. We find that equity loans are mainly used to overcome credit constraints, rather than to reduce investment risk. Unconstrained household prefer mortgage debt over equity loans, suggesting optimism about house price risk. Equity loans could still contribute to house price inflation: we don’t find evidence that houses purchased with equity loans are overpriced, but an assessment of the aggregate effects is beyond the scope of the paper.
Meteorologists and insurers talk about the “1-in-100 year storm”. Should regulators do the same for financial crises? In this post, we argue that false confidence in people’s ability to calculate probabilities of rare events might end up worsening the crises regulators are trying to prevent.
Prudential policies have grown in popularity as a tool for addressing financial stability risks since the 2007-09 global financial crisis. Yet their effects are still debated, with sanguine and more pessimistic viewpoints. In a recent Bank of England Staff Working Paper, we assess the extent to which emerging market (EM) prudential policies can partially insulate their domestic economies against the spillovers from US monetary policy. Using a database of prudential policies implemented by EMs since 2000, our estimates indicate that each additional prudential policy tightening can dampen the decline in total credit following a US monetary policy tightening by around 20%. This suggests that domestic prudential policies allow EMs to insulate themselves somewhat from global shocks.