Graeme Douglas, Nicholas Vause and Joseph Noss
Risky asset prices plummeted following the collapse of Lehman Brothers in 2008. Whilst driven partly by deteriorations in fundamental news, these falls were amplified by ‘flighty’ investors that sold at the first signs of trouble. Conventional wisdom dictates that life insurers, with their long-term investment horizons, are better placed than most to ‘lean against the wind’ by looking through short-term fluctuations in asset prices. They could thereby stabilise prices when others are selling. But the structure of regulations can greatly influence insurers’ investment incentives. Using our model of insurers’ asset allocations, we find that new ‘Solvency II’ regulations reduce UK life insurers’ willingness to act as the white knights of financial markets, particularly in the face of falling interest rates.
(Northern Rock image – Lee Jordan – Flickr, reproduced from wikimedia commons under CCA licence)
Ten years ago this month, queues of people started to form early in the morning outside Northern Rock branches across the UK, to withdraw their money out of fear that their bank would soon collapse. As the day wore on panic spread, and the run continued until when the government stepped in to guarantee all Northern Rock deposits. It was the UK’s first retail bank run since the 19th century and one of the first symptoms of the global financial crisis. This anniversary is an appropriate time to reflect on those events, but also to look forward and assess how things have moved on in the last decade, and whether something similar could ever happen again.
Joseph Noss and David Murphy
For some years, financial regulations have been becoming more complex. This has led some prominent commentators, regulators and regulatory bodies, to set out the case for simplicity, including Adrian Blundell–Wignall, Andy Haldane, Basel Committee and Dan Tarullo. In his contribution, Haldane illustrates how simple rules can achieve complex tasks: by simply adjusting its speed to keep its angle of gaze fixed, a dog can manage the complex task of catching a Frisbee. In this post, however, we argue that some financial risks are hard to catch with simple rules – they are more like a boomerang’s flight path than that of a Frisbee. Complex rules can sometimes do a better job at catching risk; and simple rules can be less prudent.
Angus Foulis and Jon Bridges
Macropru is new. Although many countries have now used macroprudential tools, there is no well-established guidebook to help policymakers develop their reaction functions. The principles behind macroprudential strategy are still being explored, with recent speeches by Alex Brazier, Vitor Constancio, and a review by the IMF,FSB & BIS. This post illustrates how the balancing act at the heart of the macroprudential debate can be formalised – it is a call to arms for further research, rather than the definitive guide.
Mounir Kenaissi and Mariana Gimpelewicz.
A key feature of the post-crisis regulatory reform agenda has been the introduction of a leverage ratio to complement the risk-weighted framework. The FPC designed the UK leverage ratio to mirror risk-weighted capital requirements so the two frameworks move in lock-step over time and across firms. For the sake of simplicity however, the FPC did not reflect Pillar 2 capital charges, which aim to capture risks that cannot be modelled adequately in the risk-weighted framework, in the leverage ratio framework. In this post we explore what happens to leverage and risk-weighted requirements once Pillar 2 are taken into account. We find that in keeping the leverage ratio simple, the perfect lock-step interaction with risk-weighted requirements no longer holds, which could prompt riskier banks to take on more risk.
Sebastian J A de-Ramon, William Francis and Qun Harris
Shakespeare first coined the term ‘sea change’ in The Tempest to describe King Alonso’s lasting transformation after his mystical death by drowning. Resting five fathoms deep, Alonso suffers a sea change into something rich and strange, with coral for bones and pearls for eyes. In a recent working paper, we explore for evidence of a possible sea change in UK banks’ balance sheets using data spanning the 2007-09 crisis. Our initial dive into the still murky, post-crisis waters shows signs of something strange and unrecognizable, with UK banks, in response to higher capital requirements, increasing the level and in particular the quality of capital more after the crisis. This post describes our dive and its findings.
Matteo Benetton, Peter Eckley, Nicola Garbarino, Liam Kirwin and Georgia Latsi.
Do financial regulations change bank behaviour? Does this create new risks? Under Basel II, some banks set capital requirements based on their internal risk models; others use an off-the-shelf standardised approach. These two methodologies can produce very different capital requirements for similar assets. See Figure 1, which displays a snapshot of recent risk weights for UK mortgages. In a new working paper we show empirically that this discrepancy causes lenders to adjust their interest rates and to specialise in which borrowers they target.
Jon Frost and Julia Giese.
A seismic shift is occurring in the European financial system. Since 2008, the aggregate size of bank balance sheets in the EU is essentially flat, while market-based financing has nearly doubled. This shift presents challenges for macroprudential policy, which has a mandate for the stability of the financial system as a whole, but is still focused mostly on banks. As such, macroprudential policymakers are focusing increasing attention on potential systemic risks beyond the banking sector. Drawing from a European Systemic Risk Board (ESRB) strategy paper which we helped write along with five others, we take a step back and set out a policy strategy to address risks to financial stability wherever they arise in the financial system.
Glenn Hoggarth, Carsten Jung and Dennis Reinhardt.
Supporters of financial globalisation argue that global finance allows investors to diversify risks, it increases efficiency and fosters technology transfer. The critics point to the history of financial crises which were associated with booms and busts in capital inflows. In our recent paper ‘Capital inflows – the good, the bad and the bubbly’, we argue that the risks depend on the type of capital inflow, the type of lender and also the currency denomination of the inflows. We find that equity inflows are more stable than debt, foreign banks are more flighty than non-bank creditors, and flows denominated in local currency are more stable than in foreign currency. We also find evidence that macroprudential policies can make capital inflows more stable.
Ian Webb, David Baumslag and Rupert Read.
One September morning, the Lord Mayor of London was called to inspect a fire that had recently started in the City. Believing that it posed little threat, he refused to permit the demolition of nearby houses, probably due to the expense of compensating the owners. The fire spread and ultimately destroyed most of the city. The Great Fire of London had begun. Only when the fire became too extensive to be readily halted did the full extent of the danger become evident. Financial regulators today face a similar challenge preventing financial crises- action causes significant costs to some but the consequences of inaction are much more uncertain. To combat this, we argue they should apply the precautionary principle.