Basel III: ‘The only game in town’

Hyun Song Shin interviewed by Viv Davies, 25 March 2011

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<p><em>Viv Davies interviews </em>Hyun Song Shin<em> for Vox</em></p>
<p><em>March 2011</em></p>
<p><em>Transcription of a VoxEU audio interview [http://www.voxeu.org/index.php?q=node/6280]</em></p>
<p><strong>Viv Davies</strong>: Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from the Center for Economic Policy Research. It's the 8th of March 2011, and I'm in Washington D.C. attending a conference hosted by the IMF on Macro and Growth Policies in the Wake of the Crisis. I'm talking to Hyun Song Shin, Professor of Economics at Princeton University. Professor Shin discusses the main points of the presentation he gave at the conference on capital flows between advanced and emerging economies. He also discusses his views on Basel III, capital ratios, and macro prudential policies. I began the interview by asking Professor Shin to briefly outline the main points of his earlier presentation on global liquidity.</p>
<p><strong>Hyun Song Shin</strong>: The low interest rate policy and the expanse of monetary policy pursued by the advanced countries in the aftermath of the crisis has set off a fierce debate about capital inflows to emerging markets, and about carry trades, and the difficulties that that creates for the monetary policy of the capital recipient country, and so on. And this raises some fundamental issues about the role of the U.S. dollar. I think we are fairly familiar with the role of the U.S. dollar, as for example, the currency that's used for invoicing, and therefore, the currency that's used to settle real transactions. And also, we're relatively familiar with the role of the dollar as an international reserve currency. It's a currency that's used as a store of value.</p>
<p>But the dollar is also the currency that underpins the global banking system, in the sense that it's the funding currency of choice by the global banks. And what I mean by that is if we look at the cross border flows of dollar funding that's raised in the U.S. capital markets, a lot of that goes via the U.S. branches of the foreign banks back to the head office. One way we can gauge that is through the inter office accounts of the foreign banks in the U.S.</p>
<p>What we see is that from the mid 80s onwards, we see a very rapid growth in the amount of funds that's channeled out of the U.S. by the foreign banks. And a lot of these banks would be European banks. And one way we can gauge who these actors are is to look through the list of those banks that received liquidity support during the recent financial crisis, so the banks that received the Federal Reserve Term Auction Facility, for instance.</p>
<p>The big U.S. banks are represented there, many of the banks are actually European banks too. And because these global banks will have portfolio decisions as to how to deploy the funds that they've raised, they, in effect, act as the carrier of liquidity conditions across borders.</p>
<p>So you have something of a paradox really that the U.S. is, in a way, the biggest debtor country, vis-a-vis, the rest of the world. But in the banking sector, they are the biggest net creditors, in the sense that the amount that foreign banks take out of the U.S. is much larger than the amount that the foreign banks bring into the U.S. from their head office. So the U.S. is a net creditor in the banking sector even though it is a very large debtor overall. So in effect, the U.S. borrows long and lends short through the banking sector.</p>
<p>So one of the effects of this will be that through the portfolio decisions...so when a European bank borrows dollars in the U.S. capital markets and then decides how to deploy those funds, at the margin they'll have to earn a similar rate of return wherever they deploy the funds. So if there's very ample liquidity conditions and funding is very cheap in the U.S., through the actions of the global banking system that liquidity condition will be transmitted through that portfolio decision.</p>
<p>On the other side, as it were, the portfolio decisions of the global banks will manifest themselves in the form of capital inflows, through increases in the banking sector loans to emerging market banks, for example. So emerging market banks who borrow in dollars would be borrowing from other banks, in particular, global banks. And capital inflows through the banking sector which build up the vulnerability to future deleveraging would be very much one of the consequences of the liquidity flow.</p>
<p><strong>Viv</strong>: Some of these ideas came from a short paper you wrote recently titled &quot;Macro Prudential Policies Beyond Basel III.&quot; You begin that paper by stating that &ldquo;in its current form, Basel III is almost exclusively micro prudential in its focus, concerned with the solvency of individual banks, rather than being macro prudential and concerned with the resilience of the financial system as a whole&rdquo;. What did you mean by that?</p>
<p><strong>Hyun</strong>: I was being somewhat provocative with that statement. I think some of the people involved with Basel III would probably disagree with that statement. But what I was trying to highlight was the fact that the core elements that have now already been agreed, - and have now an agreed set of standards - are almost exclusively micro prudential, in the sense that they pertain to individual bank capital ratios. So the core of Basel III is a requirement that banks hold common equity of seven percent of risk rated assets.</p>
<p>And there are associated liquidity rules, and there are associated rules on leverage, on liquidity, and so on, which will be phased in over a long period. So they are micro prudential, in the sense that they pertain to the loss absorbency of bank capital. If the bank's loans go bad, then the bank has enough equity to absorb the losses.</p>
<p>I think one of the problems in focusing on the loss of absorbency of capital and capital ratios is that it diverts attention from the total size of assets, and in particular, how fast assets are growing in a boom. So when you have the banking sector whose loan book is increasing at, let's say, 20 25% a year, this is a speed which far outstrips the growth of the real economy. And so, the financial sector is becoming very large.</p>
<p>And even during such an expansion, we would see the capital ratios of the banks looking very, very healthy, because during a boom, the profitability of banks is very high. And measured risks, when you look at market prices, or look at market indicators of risk, they indicate very benign market environments. So that when you calculate the risk rated assets which is the capital over the risk rated assets of the bank a bank can look very, very healthy. But that still masks the underlying vulnerability to a downturn.</p>
<p><strong>Viv</strong>: Basel I and Basel II succeeded one another and took around 10 years each, I think, to implement. Would you expect Basel III to be any different from that? If not, it'll be around 2018 by the time the recommendations are fully implemented, by which time, I would think that many of the recommendations and proposals would be irrelevant. Do you think that's a problem?</p>
<p><strong>Hyun</strong>: Well actually, Basel III has already been agreed. And I think one of the good things about Basel III is how rapidly the agreement was reached. And the basic building blocks were all agreed in September of last year. There are one or two loose ends to do with systemically important financial institutions, and some of the details with the liquidity rules and so on, but Basel III has already been agreed. This is one of the differences between Basel III and its two predecessors. In the sense that, the sense of crisis concentrated minds into coming to a very rapid agreement. My point, rather, is that the elements that were most easily agreed were the ones that, in a way, were least controversial. And what's least controversial may not be what may be most effective going forward. I think it's that contrast that I wanted to point to in this memo.</p>
<p><strong>Viv</strong>: To what extent, if at all, are the ideas and suggestions on risk and capital requirements and so on reflected in the Dodd Frank Act?</p>
<p><strong>Hyun</strong>: The Dodd Frank Act tends to focus much more on the legal structure and on the processes, rather than on the substance. I think what the Dodd Frank Act is, in some ways, complementary, or in some ways it's also tangential to the debate about capital and about these other quantitative restrictions. So, it's something that has been driven by U.S. agenda. It has to do with the reform of the regulatory structure and about setting up of new institutions, such as the Financial Stability Oversight Council, and about the new consumer protection regulator, and so on. Whereas, the discussion in Basel III have focused much more on the detailed capital rules that will be imposed to the internationally active banks.</p>
<p><strong>Viv</strong>: Would you say that the U.S. has been making more progress in these areas than Europe?</p>
<p><strong>Hyun</strong>: In some respects the U.S. has been making some progress, but I think the ultimate success or failure will have to be seen in terms of how effective some of the institutional reforms will have been, given time.</p>
<p><strong>Viv</strong>: I'd like to talk a little about developing countries. Developing countries account for almost half of global growth, and one in every three banks is also located in those countries. A potential issue is, perhaps, that developing economies&rsquo; markets may not be deep enough to raise the capital requirement of the banks, and borrowing internationally may not be an option. So, given the one size fits all nature of the Basel III proposals, could this perhaps undermine efforts to establish a more stable global financial system?</p>
<p><strong>Hyun</strong>: No. On the contrary, I think for developing countries, their banking regulation was already much more stringent than for the advanced countries, and capital ratios will not be a problem for most of the emerging market countries. In fact, in those countries that went through the emerging market financial crises of the 1990s, they already have very, very stringent financial regulations rules and much higher capital ratios than even the numbers that are mentioned in Basel III. There is a more general point about the effect of financial regulation on financial intermediation activity. So, one argument you frequently hear is that excessive regulation will choke off funding to borrowers, and, in fact, it's actually the eventual borrowers who will be suffering from excessive regulation.</p>
<p>I think we have to be clear as to what the arguments are. I think if we announced today that every bank has to double their capital ratios, then the likely consequence of that is that this would generate a very large incentive for the bank to meet those capital ratios, not by raising new equity, but by shrinking assets.</p>
<p>And, if that's the case, then clearly, that will lead to scarcer credit and have an impact on the economy. But if the additional capital is raised by retention of profits or by raising of new equity, then I the effect is much more benign.</p>
<p>And we saw during the U.S. bank stress test results, for example, in 2009, that when push comes to shove, and when some of the stigma attached to the bank's raising of new equity is removed by this coordinated move to raise new equity of the banking sector as a whole, then the banks are able to raise new equity.</p>
<p>And, if the banks raise equity, that's money that can be lent out. And not only can it be lent out, the increased equity is going to increase the ratio of capital to the total assets of the bank. Therefore, it actually generates very good incentives and actually gives resilience to the banking system, as well.</p>
<p>The idea that somehow equity is expensive has really come about very recently, in the sense that banks are targeting, or used to target, 20 percent return on equity. But we should take a very long run view of this, in that it wasn't forever that the banks have been targeting 20 percent return in equity. The banks used to have much higher capital ratios, if we look back 50, 100 years.</p>
<p>What this means is that if a bank has a large amount of equity, this is money that can be lent out. It's not that the equity has to stay in some inert form, as in cash, that is not lent out. The equity can be lent out. It's just that of the money that's lent out, a lot of it is in the form of the owner's stake, rather than money that is borrowed from either depositors or from the capital market.</p>
<p><strong>Viv</strong>: I see, and how important, do you think, is international coordination in banking regulation and financial reform? Or are there fundamental differences, for example, between the U.S. and Europe, in terms of what's required going forward?</p>
<p><strong>Hyun</strong>: International coordination is very important, in the sense that banking regulation always has these two aspects. On the one hand, the domestic regulator will want to impose regulations to insure stability of its own banking system and financial system. But, on the other hand, the regulator, wearing the hat of the champion of the national banking industry, or the national financial industry, will not want to handicap its own domestic institutions unnecessarily in the global marketplace. So, really, pretty much as soon as you have global competition in the banking industry or in the financial industry generally, the regulators and the financial policymakers will always confront this dilemma. Do you come down hard on your own institutions to preserve stability, or do you actually give them a competitive edge in order to pursue the national interest?</p>
<p>And by having international coordination, one can mitigate that dilemma somewhat by insuring that whatever is agreed is applied uniformly. So, that the standards are applied in a fair way, so that there's a level competitive playing field. But that competitive playing field should have sufficient prudential safeguards so that it's not only your banks, but also, the global financial system that's safeguarded.</p>
<p><strong>Viv</strong>: Are you optimistic about the future for regulatory reform and global financial recovery?</p>
<p><strong>Hyun</strong>: I think what we've seen with the Basel III process is that as the crisis abates, the urgency with which you pursue financial reform is somewhat dulled in the process. So, the actual form, the agreed form of Basel III certainly would be far less comprehensive than some of the initial aspirations may have been. But, nevertheless, what the Basel III process has shown, and what the G20 process has shown, in general, is that this really is the only game in town. And that we have to persuade sovereign countries, whose interests are very closely interlinked, to coordinate their policies. There will inevitably be give and take, but this is the best that we have, and we have to make the best of it.</p>
<p>And, so far, it's worked pretty well. I think last year's G20 in Korea, I think, is a good example. I think The Economist magazine called it &quot;urgent incrementalism,&quot; in that the changes are pretty incremental, but it's probably a lot faster than the pace at which many of these international negotiations follow.</p>
<p><strong>Viv</strong>: Hyun Song Shin. Thanks very much for speaking with us today.</p>
<p><strong>Hyun</strong>: Thank you very much. <br />
&nbsp;</p>

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Topics:  Global governance

Tags:  BASEL III, global liquidity, bank capital ratios

Princeton University and CEPR