Compliance with risk targets – will the Volcker Rule be effective?
Jussi Keppo, Josef Korte 07 September 2014
Four years ago, the Volcker Rule was codified as part of the Dodd–Frank Act in an attempt to separate allegedly risky trading activities from commercial banking. This column presents new evidence finding that those banks most affected by the Volcker Rule have indeed reduced their trading books much more than others. However, there are no corresponding effects on risk-taking – if anything, affected banks take more risks and use their trading accounts less for hedging.
The Volcker Rule, passed as part of the Dodd–Frank Act in July 2010, has been appraised as one of the most important changes to banking regulation since the global financial crisis. By restricting banks’ business models and prohibiting allegedly risky activities, the rule ultimately aims at increasing resolvability and reducing imprudent risk-taking by banks, and therefore at increasing financial stability. This is done by banning banks from proprietary trading and limiting their investments in hedge funds and private equity.
Financial markets Microeconomic regulation
banking, regulation, Volcker rule, Dodd–Frank, banking regulation, proprietary trading, risk, hedging, financial stability
Shadow banking and the global financial ecosystem
Zoltan Pozsar 07 November 2013
Modern banks operate in a complex global financial ecosystem. This column argues that proper regulation requires an updating of our ideas about how they operate. Modern banks finance bond portfolios with uninsured money market instruments, and thus link cash portfolio managers and risk portfolio managers. Gone are the days when banks linked ultimate borrowers with ultimate savers via loans and deposits. The Flow of Funds should be updated to reflect the new realities.
Regulatory reform has focused on banks and how much liquidity and capital they should hold, rather than on the evolution of the broader financial ecosystem that banks are only a part of. However, understanding this ecosystem is imperative, as it can influence the types of activities banks engage in and the types of liabilities they issue.
Financial markets Microeconomic regulation
risk, banking, shadow banking, intermediation
Towards a more procyclical financial system
Jon Danielsson 06 March 2013
Is the fact that different banks have different risk models problematic? Contrary to the Basel Committee and the European Banking Authority, this column argues that heterogeneity is a good thing. It leads to countercyclicality, and thereby reduces instances of procyclical price movements. Both the Basel Committee and the European Banking Authority have indicated that they are troubled by heterogeneity and are seeking to rectify the problem. Their conclusion is plainly wrong.
The Basel Committee and the European Banking Authority1 have recently noted that banks' risk models do not give the same risk assessments for the same assets. In other words, banks’ risk models are not the same, making use of different estimation horizons and model assumptions, whilst reflecting different preferences and specific institutional situations. Both authorities find this problematic and have expressed a desire to move towards the harmonisation of models across the industry.
risk, risk models
Systemic risks in global banking: What available data can tell us and what more data are needed?
Eugenio Cerutti, Stijn Claessens, Patrick McGuire 17 December 2012
The current global crisis highlights how interconnected the financial world has become. This interconnectedness is a challenge for global systemic risks analysis. This column argues that much of the data needed for tracking systemic risk are not available and that, in fact, world decision makers are leading in the dark. Recent initiatives that aim to improve aggregate banking statistics and gather better institution-level data are welcome, but the complexity of the system means that we won’t have the data we need for some time yet.
The starting point for systemic risk analysis for a single-country is typically the banking system1. A systemic risk analysis involves the use of disaggregated national bank data, including information on the composition of banks’ asset and liabilities, maturity and currency mismatches, and other balance sheet and income metrics.
Global crisis International finance
risk, global crisis, banking
Don't expect too much from EZ fiscal union – and complete the unfinished integration of European capital markets!
Mathias Hoffmann, Bent E. Sørensen 09 November 2012
How do members of existing monetary unions share risk? Drawing on a decade of research, this column argues that fiscal transfers in fact make a limited contribution to economic coherence. In the context of Europe’s current crisis, the evidence suggests that unfinished capital market integration must be completed if we wish to see adequate and effective risk sharing.
The sovereign debt crisis apparently suggests that Eurozone economies should now move substantially closer towards fiscal union. Current policy discussions revolve much more around how such a fiscal union should be designed than whether fiscal union can solve Europe’s underlying problems of economic coherence. What can we expect from a fiscal union? Aren't private capital markets better suited to economic coherence?
EU policies International finance Monetary policy
capital markets, risk, Risk sharing, Eurozone crisis, fiscal union, banking union
Why supervisors should continue measuring financial risks – the fallacy of simple rules
Lars Frisell 07 November 2012
Measuring financial risk is difficult. But what lessons, if any, have we learnt from the current crisis? This column argues against a move to leverage ratios and instead proposes continuing to measure financial risk (despite the difficulties), but with higher capital charges for banks. Focusing on the basics can only bolster central banks’ ability to fulfil their duties – looking for imbalances, and promptly tackling them with informed decisions.
Measuring financial risk is notoriously difficult. But no more difficult than measuring any other risk. Take, for example, the risk of flooding. In order to calculate the optimal height of a seawall one must take into account the regular variation of the sea level caused by the moon’s gravity, the shape of the shoreline, the probability of extreme events such as hurricanes and tsunamis, alongside myriad other factors. Such deliberations – and experience - have resulted in very different structures of seawalls, from high-rising concrete walls to porous mounds.
Financial markets Global crisis Institutions and economics International finance
risk, global crisis, global crisis debate, leverage ratios, capital charges
Bankers’ bonuses and the financial crisis
Ian Tonks 08 January 2012
Ever since the fall of Lehman Brothers, it has been a popular view – and one increasingly held by officials – that banker bonuses are at least partly to blame. This column compares executive pay in banks with other companies and finds, contrary to the growing consensus, that the financial sector differs not so much in its reward for taking risks, but in its reward for expansion.
In the fallout from the financial crisis of 2007-8, a number of official policy documents have reported on its causes and have identified executive pay packets and bonuses in banks and financial institutions as being partly to blame.
Global crisis International finance
risk, incentives, banker bonuses
Fiscal policy in developing countries: Escape from procyclicality
Jeffrey Frankel, Carlos A. Vegh , Guillermo Vuletin 23 June 2011
With the ongoing financial turmoil in Europe, many emerging market countries are now deemed less risky than so-called “advanced” countries. This column examines why this is the case and finds that the cyclicality of a country’s fiscal policy – a sign of its riskiness – is inversely correlated with the quality of the country’s institutions.
Fiscal policy is taking centre stage. Among advanced countries, the news is bad; Europe’s periphery teeters, the UK slashes, the US deadlocks, Japan muddles. But in the rest of the world there is good news. In an historic reversal, many emerging market and developing countries have over the last decade achieved a countercyclical fiscal policy.
Global crisis Institutions and economics Macroeconomic policy
risk, fiscal policy, spreads
CoCo design as a risk preventive tool
Enrico Perotti, Mark Flannery 09 February 2011
Contingent Convertible (CoCo) bonds have been suggested as a way to ensure that banks keep aside enough capital to help them through financial crises. This column proposes a market-triggered CoCo buffer to maintain risk incentives during periods of high leverage. It argues that this will also activate risk information discovery through the market prices of bank securities and increase activism by outside shareholders.
The financial crisis saw local credit losses spread widely because bank capital was insufficient to cope with the accumulated credit risk, maturity mismatch, and contingent liquidity risk. Ultimately, short-term liability holders lost faith in some large banks’ ability to repay them. The resulting runs forced supervisors to step in with government support.
financial crises, risk, Contingent convertible bonds, capital buffer
The “limits of arbitrage” agenda
Dimitri Vayanos, Denis Gromb 10 April 2010
Why do financial market anomalies arise and persist? This column summarises a new thread in financial economics – the "limits of arbitrage" literature – explaining how financial institutions sometimes lack the capital needed to arbitrage away anomolies. This new approach has far-reaching implications for our understanding of how financial markets work and how they should be regulated.
Each financial crisis reminds us that governments are vital to the functioning of financial markets – with the current crisis being a particularly painful reminder (see for example Boone and Johnson 2010, Dewatripont et al. 2009).
Financial markets International finance
risk, law of one price, limits of arbitrage