An enormous effort has gone into banking and financial regulatory reform following the recent financial crisis. This presentation is an attempt to:
Describe some key open questions about the relation among stability, growth, and regulatory reform.
Raise some concerns about overemphasis on some instruments and under emphasize on others in the ongoing reform process.
4. The World’s Most 5 Devastating Financial Crises
1772 1929-39 1973 1997 2007-2008
This crisis originated
in London and
quickly spread to
the rest of Europe.
The Credit
Crisis of 1772
The worst financial
and economic
disaster of the 20th
century.
The Great
Depression of
1929–39
OPEC decided to
retaliate against the
United States in
response to its sending
arms supplies to Israel
during the Fourth Arab–
Israeli War.
The OPEC Oil Price
Shock of 1973
Originated in Thailand
in 1997 and quickly
spread to the rest of
East Asia and its
trading partners
resulted in an
overextension of credit
and too much debt
accumulation.
The Asian Crisis
of 1997
This sparked the Great
Recession, the most-
severe financial crisis
since the Great
Depression, and it
wreaked havoc in financial
markets around the world.
The Financial Crisis
of 2007–08
7. -40
DOES GREATER FINANCIAL DEPTH & DEVELOPMENT
INCREASE OR REDUCE VOLATILITY?
Question #1
COULD HIGH CAPITAL REQUIREMENTS
PROVIDE A FALSE SENSE OF SECURITY?
Question #2
HOW TO JUDGE THE COSTS & BENEFITS
OF FINANCIAL INNOVATION?
Question #3
WILL MACROPRUDENTIAL
APPROACHES BE EFFECTIVE?
Question #4
You can simply impress your audience and add a unique
zing and appeal to your Presentations.
Question #5
01
02
03
04
05
RANDALL S. KROSZNER
Professor of Economics - University of Chicago, Booth School of Business
Stability, growth and regulatory reform
8. Introduction
An enormous effort has gone into banking and
financial regulatory reform following the recent
financial crisis. This presentation is an attempt to:
• Describe some key open questions about the
relation among stability, growth, and
regulatory reform.
• Raise some concerns about overemphasis on
some instruments and underemphasize on
others in the ongoing reform process.
9. • The goal of banking and financial development and regulation is to support and
enhance sustainable economic growth, consistent with consumer protection
that maintains the integrity of the markets.
• A deep and developed financial system is a driving force behind economic
development and growth.
• The primary mechanism for the positive growth impacts appears to be through
increasing the efficiency of the allocation of capital to the highest return projects.
• Theoretically, greater financial depth and development could either increase or
decrease stability:
o On one hand, could improve risk sharing and diversification and thereby
reduce volatility.
o On the other, could allow greater concentrations of risk and generate
interconnections, thereby potentially making the entire system more fragile
and vulnerable to shocks.
1|
DOES GREATER
FINANCIAL DEPTH
AND
DEVELOPMENT
INCREASE
OR REDUCE
VOLATILITY?
Policy makers engaged in financial regulatory reform need to
consider these opposing forces in the financial system.
10. • Financial innovations are crucial in a dynamic, growing economy, but may be of
Janus-faced.
• How a market participant can determine in advance risks associated with a new
instrument?
• It’s difficult to undertake empirical testing to assess the two faces.
• Developing a framework for evaluating the costs & benefits of innovation is crucial
issue raised by the recent crisis, however remains a fundamental challenge.
2|
HOW TO JUDGE
THE COSTS AND
BENEFITS
OF FINANCIAL
INNOVATION?
Trying to assess the faces of a financial innovation is a particularly
vexing task but one that deserves much attention.
11. • Imposing higher capital requirements following the crisis is the right response.
However, is not a cure-all and in some cases seems to be relied upon as a
substitute for directly addressing fragilities in the system.
• High capital requirements, can provide a false sense of security to regulators and
to the public about the safety and soundness of the financial system and lead to
complacency in crucial areas of regulatory reform.
• It is best to address problems and vulnerabilities directly rather than indirectly in
order to reduce the likelihood of unintended consequences.
• In regulatory reform, it is important to try to avoid the false sense of
security and excessive reliance on one instrument. Capital “barriers” can
be helpful but they can also create strong incentives to find innovative
ways to evade them.
3|
COULD HIGH
CAPITAL
REQUIREMENTS
PROVIDE A FALSE
SENSE OF
SECURITY?
Capital requirements should be understood as a complement to
supervisory vigilance and not a source of complacency.
12. • Central banks are being asked to act not only in their traditional role as “fire
extinguishers” but also to act as macro-prudential “smoke detectors” before the
flames appear.
• The “fire extinguisher” role is the classic one that central banks have played as
lenders and liquidity creators in times of financial stress.
• The “smoke detector” or “macro-prudential” role emphasizes that the central bank
has a fundamental responsibility to act early to prevent the tinder from igniting into
flames.
• Being proactive in monitoring individual institutions and interconnected markets for
signs fragility is what macro-prudential policy should focus upon.
• The macro-prudential role certainly does not conflict with the more traditional “fire
extinguisher” role, but it requires a much expanded set of authorities and activities
on the part of the central bank.
4|
WILL
MACROPRUDENTIAL
APPROACHES BE
EFFECTIVE?
13. • The macro-prudential approach has at least three challenges:
o What metrics of financial stability or systemic risk will trigger macro-
prudential actions?
This exercise has proved difficult, and there are no generally accepted early
warning indicators to allow authorities to act early enough to avoid the next
crisis.
o Can financial economics provide a straightforward and theoretically
grounded benchmark to assess if risks are being improperly managed or
priced?
No appropriate assumptions about or shifts in risk aversion, thus Regulators
may face criticism of being arbitrary and attempting to substitute their judgment
for those of investors who are putting their own money on the line.
o Will a central bank’s independence be challenged if it engages in macro-
prudential policymaking?
The unelected body of the central bank could be accused of overruling an
elected body. Effective macro-prudential policies thus may involve risks for
central bank independence and good governance.
4|
WILL
MACROPRUDENTIAL
APPROACHES BE
EFFECTIVE?
14. • In response to the financial crisis of the early 1930s, the United States adopted a
separation between investment banking and commercial banking with the Glass-
Steag all Act.
• This Act prohibited a commercial bank or commercial bank holding company from
having any affiliates engaged in a variety of activities such as securities
underwriting.
• In response to the most recent crisis, the Dodd-Frank Act included a form of
activities restriction called the Volcker Rule. The Volcker Rule strictly limits
commercial bank activities in proprietary trading, private equity, and hedge funds.
5|
WILL RESTRICTIONS
ON BANK
ACTIVITIES,
SUCH AS THE
VOLCKER RULE,
IMPROVE
STABILITY?
15. CONCLUDING
REMARKS
The relation among stability, growth, and regulation is crucial
for assessing reform proposals and priorities.
Policy-makers should clearly articulate goals and trade-offs,
avoid overreliance on any one regulatory instrument, and be
sensitive to potential unintended consequences of regulatory
reforms.
Identifying fragilities and then addressing them as directly
as possible would be an effective way to enhance the
robustness of the financial system.
17. Economic Stability is a term used to
describe the financial system of a nation
that displays only minor fluctuations in
output growth and exhibits a consistently
low inflation rate.
It enables other macro-economic
objectives to be achieved. This is largely
because stability creates certainty and
confidence and this
encourages investment in technology and
human capital.
What is
Economic
Stability?
https://www.economicsonline.co.uk/Global_economics/Policies
_for_stability_and_growth.html
18. Why Global Economic
Stability is Important?
Promoting economic stability is partly a matter of
avoiding economic and financial crises, large swings in
economic activity, high inflation, and excessive volatility
in foreign exchange and financial markets. Instability
can increase uncertainty, discourage investment,
impede economic growth, and hurt living standards.
Economic and financial stability is both a national
and a multilateral concern. As recent financial crises
have shown, economies have become more
interconnected. Vulnerabilities can spread more easily
across sectors and national borders.
19. Stability Maps and Indicators
01
02
03
04
Assesses risk conditions in the macroeconomy
(Global – Growth – Corporate – Inflation –
Household – External – Unemployment –
Fiscal Index – Foreign Currency)
)
Macroeconomic Stability
Assesses changes in underlying conditions/risk factors
affecting the banking sector’s stability
(Liquidity – Efficiency – Profitability – Quality –
Soundness)
Banking Stability
Assesses stability of financial markets
(Banking sector – Foreign exchange market –
Equity market – Debit market )
Financial Markets Stability
Assesses overall stability conditions in the financial
system
(Macro stability – Financial market stability – Banking
stability )
Financial Stability
20. Financial
Stability
• There is no universally accepted definition of financial stability.
• There are numerous definitions of financial stability. Most of them have in
common that financial stability is about the absence of system-wide
episodes in which the financial system fails to function (crises). It is also
about resilience of financial systems to stress. A stable financial system is
capable of efficiently:
o Allocating resources
o Assessing and managing financial risks
o Maintaining employment levels close to the economy’s natural rate
o Eliminating relative price movements of real or financial assets that will
affect monetary stability or employment levels
• In stability, the system will absorb the shocks primarily via self-corrective
mechanisms, preventing adverse events from having a disruptive effect on the
real economy or on other financial systems. Financial stability is paramount for
economic growth, as most transactions in the real economy are made through
the financial system.
21. Integration of Financial Stability, Growth & Regulatory
Financial
Growth
Financial
Regulatory
Financial
Stability
Is a form of regulation or supervision, which
subjects financial institutions to certain
requirements, restrictions and
guidelines, aiming to maintain the integrity
of the financial system. This may be handled
by either a government or non-government
organization.
Is the increase in the inflation-adjusted market
value of the goods and services produced by
an economy over time. It is conventionally
measured as the percent rate of increase in
real gross domestic product, or real GDP.
Is a property of a financial system that dissipates
financial imbalances that arise endogenously in
the financial markets or as a result of significant
adverse and unforeseeable events.
23. Financial risk is an inherent
part of the investment and is
applicable to the businesses,
government, individual, and
even financial markets. It
basically represents the
chance that the parties
involved (shareholders,
investors, or other financial
stakeholders) will lose money.
Financial Risk • Government – Failure of monetary policy & default on bonds
• Company – Unable to pay debt, loosing value on investments
• Individuals – Not able to pay debt
• Financial markets – It faces financial risk due to macroeconomic factors
Typesoffinancialrisks
Market risk Fluctuations in price of financial instruments
Credit risk One party does not fulfill its obligations
Liquidity risk Incapability to pay due to lack of funds
Operational risk Mismanagement of operations
Legal risk Lawsuits and other legal proceedings
Political risk Unstable political condition
24. Top 20 Economies in the World
1. United States
2. China
3. Japan
4. Germany
5. United Kingdom
6. France
7. India
8. Italy
9. Brazil
10. Canada
11. Russia
12. South Korea
13. Spain
14. Australia
15. Mexico
16. Indonesia
17. Netherlands
18. Saudi Arabia
19. Turkey
20. Switzerland
This list is based on the
IMF's World Economic
Outlook Database, April
2019.
26. Why CHINA?
China is the largest investor in US
government bonds, and today it is
increasingly one of the most important
industrial investors in various sectors in the
US economy, especially in the automotive
sector and accessories.
China sees itself as an “economic partner” for
America while Donald Trump sees China as a
fierce economic “enemy”, quietly and cleverly
pursuing the secrets of industry and
technology that distinguish America and make
it a leader.
The US also has a very important “position” in
the Chinese economy. It has huge
investments there in many different fields,
from iPhone to Starbucks to General Motors
among hundreds of other companies.
27. People's
Republic of
China
(PRC)
• China is largest country of east Asia.
• The population is approximately 20% of world population (population: over 1.5
billion)
• 23 provinces (including Taiwan) – 4 Municipalities: Beijing, Tianjin, Shanghai,
Chongqing
• 2 Special Administration Area: Hong Kong, Macao
• China adopted- socialist market economy (predominance of public ownership
and state-owned enterprises within a market economy).
• China had the world's second-largest economy in terms of nominal GDP,
totaling approximately US$13.5 trillion (90 trillion Yuan).
• China is the largest Exporter & second largest Importer of goods in the
world.
28. China, An Emerging Superpower
The Rise of Modern China:
• The first stage from 1950 to 1980, is what
may term the preparation for growth
stage.
• The second stage in China’s economic
development, lasting from 1980 to 2020, is
what may call the high‐speed growth
stage.
• The third stage of development, lasting
from 2020 to 2050, is what may call the
steady‐growth stage.
29. Chinese Growth and Social Stability
• Chinese rulers are dependent on high employment to keep their people
happy.
• This is a nation that has experienced double digit growth for decades and is
not cooling off.
• China has had a one couple one child policy that has reduce its growth rate
and resulted in an aging population.
• As the Chinese economy has thrived wages have risen and China has lost
some of its competitiveness.
30. Innovative China New Drivers of Growth
After nearly four decades of rapid growth, China has entered a new normal of
slower growth:
• China’s economy is growing at some 6–7 percent a year.
• Per capita gross domestic product (GDP) stands at nearly US$10,000, about
one-fourth of the average for Organization for Economic Co-operation and
Development (OECD) countries.
China’s next transformation is well under way, and a “new economy” is
emerging:
• China has a strong manufacturing base and is the leading global exporter of
manufactured goods.
• Its one of the central hubs of the global value chain.
• Its export products are becoming increasingly more sophisticated, and the
share of domestic, value-added exports has been rising steadily in the past
decade, as domestic supply chains have deepened.
World Bank Group
Development Research Center of the State
Council, the People’s Republic of China
32. The Three D’s
• China’s future growth will come from 3 D’s:
removing distortions, accelerating diffusion,
and fostering discovery.
Six Strategic Choices
• China’s authorities are facing 6 strategic
choices in furthering productivity and
innovation.
7 Areas of Structural & Institutional Reforms
• China’s authorities will need to address 7
critical areas of structural and institutional
reforms.
INNOVATIVE CHINA
World Bank Group Development Research Center of the State Council, The People’s Republic of
China
A strategic reform agenda for promoting an innovative and
productive China
33. INNOVATIVE CHINA
World Bank Group Development Research Center of the State Council, The People’s Republic of China
A strategic reform agenda for promoting an innovative and
productive China
• The first D, reducing distortions in the allocation of
resources, has been a key driver of growth in the past,
and continuing reforms would allow China to reach its
current maximum potential production frontier. it
requires land, labor, and financial resources to be
allocated competitively and efficiently to their most
productive uses in the economy.
• The second D, accelerating the diffusion of advanced
technologies and innovations, will help China to extend
its current production frontier to the global frontier.
Accelerating diffusion would allow China to take
advantage of its large remaining potential for catch-up
growth by promoting technology diffusion, upgrading the
capacity of its workers to adopt and use new
technologies, and facilitating access to global
technologies & innovations
• The third D, fostering the discovery of new innovation
and technology, will help China to create new
innovations &to push out the global technology frontier.
Fostering discovery will become more critical as China
becomes richer and edges closer to the global
technology frontier.
1- Striking the right balance between the three
drivers of growth
2- Reshaping industrial policies
3- Adjusting the balance between the state and
markets
4- Attaining mutually beneficial international
trade and investment relations with global
partners
5- Balancing supply-side reforms with demand-
side reforms
6- Preparing for the future impact of
technological changes
1- Reshaping industrial policies and supporting
market competition
2- Promoting innovation and the digital economy
3- Building human capital
4- Allocating resources efficiently
5- Leveraging regional development and
integration
6- Promoting international competitiveness and
economic globalization
7- Governing the next transformation
The Three D’s 01 Six Strategic Choices
7 Areas of Structural &
Institutional Reforms02 03
34. China as a New Type of Superpower
What is the China dream?
• Mao Zedong said fifty years ago that in the twenty‐first century China should make a
greater contribution to mankind, and in contribution to Hu Jintao’s even greater
contribution.
• It is clear that China’s position has changed along the years.
The question remains: What will be China’s contribution to the world?
• Besides its enormous economic and trade contributions, as well as poverty
reduction contributions, China needs to contribute in four other key areas:
– Human development
– Science and technology
– Green movement
– Culture
• These four contributions would represent China’s modern renaissance, with domestic and international significance.
• Given that China has become one of the largest stakeholders in world affairs today, it is incumbent upon it not only
to follow its own interests and the interests of developing countries but also to develop in a fashion consistent with
the interests of developed countries.
36. References
• https://www.economicsonline.co.uk/Global_economics/Policies_for_stability_and_growth.html
• http://www.businessdictionary.com/definition/economic-stability.html
• https://en.wikipedia.org/wiki/Financial_stability
• https://www.imf.org/en/About/Factsheets/Sheets/2016/07/27/15/22/How-the-IMF-Promotes-Global-Economic-Stability
• https://www.investopedia.com/insights/worlds-top-economies/
• https://www.britannica.com/list/5-of-the-worlds-most-devastating-financial-crises
• https://efinancemanagement.com/?s=financial+risk
• https://www.youtube.com/watch?v=qC-U76O76X0
• https://www.youtube.com/watch?v=rgratIU1glk
• https://en.wikipedia.org/wiki/China
• https://www.skynewsarabia.com/video/1304718-%D8%A8%D9%83%D9%8A%D9%86-
%D8%AA%D9%82%D8%B1%D8%B1-%D8%A7%D8%B3%D8%AA%D8%A8%D8%AF%D8%A7%D9%84-
%D8%A7%D9%84%D8%AD%D9%88%D8%A7%D8%B3%D9%8A%D8%A8-
%D9%88%D8%A7%D9%84%D8%A8%D8%B1%D9%85%D8%AC%D9%8A%D8%A7%D8%AA-
%D8%A7%D9%84%D8%A7%D9%94%D8%AC%D9%86%D8%A8%D9%8A%D8%A9
• Stability, growth and regulatory reform, RANDALL S. KROSZNER-Professor of Economics University of Chicago, Booth
School of Business
• China 2018 Economic Report
• World Bank Group: Development Research Center of the State Council, the People’s Republic of China
• INNOVATIVE CHINA: World Bank Group Development Research Center of the State Council, The People’s Republic of China
• Doing Business 2019 Report
The Credit Crisis of 1772
This crisis originated in London and quickly spread to the rest of Europe. In the mid-1760s the British Empire had accumulated an enormous amount of wealth through its colonial possessions and trade. This created an aura of overoptimism and a period of rapid credit expansion by many British banks. The hype came to an abrupt end on June 8, 1772, when Alexander Fordyce—one of the partners of the British banking house Neal, James, Fordyce, and Down—fled to France to escape his debt repayments. The news quickly spread and triggered a banking panic in England, as creditors began to form long lines in front of British banks to demand instant cash withdrawals. The ensuing crisis rapidly spread to Scotland, the Netherlands, other parts of Europe, and the British American colonies. Historians have claimed that the economic repercussions of this crisis were one of the major contributing factors to the Boston Tea Party protests and the American Revolution.
The Great Depression of 1929–39
This was the worst financial and economic disaster of the 20th century. Many believe that the Great Depression was triggered by the Wall Street crash of 1929 and later exacerbated by the poor policy decisions of the U.S. government. The Depression lasted almost 10 years and resulted in massive loss of income, record unemployment rates, and output loss, especially in industrialized nations. In the United States the unemployment rate hit almost 25 percent at the peak of the crisis in 1933.
The OPEC Oil Price Shock of 1973
This crisis began when OPEC (Organization of the Petroleum Exporting Countries) member countries—primarily consisting of Arab nations—decided to retaliate against the United States in response to its sending arms supplies to Israel during the Fourth Arab–Israeli War. OPEC countries declared an oil embargo, abruptly halting oil exports to the United States and its allies. This caused major oil shortages and a severe spike in oil prices and led to an economic crisis in the U.S. and many other developed countries. What was unique about the ensuing crisis was the simultaneous occurrence of very high inflation (triggered by the spike in energy prices) and economic stagnation (due to the economic crisis). As a result, economists named the era a period of “stagflation” (stagnation plus inflation), and it took several years for output to recover and inflation to fall to its precrisis levels.
The Asian Crisis of 1997
This crisis originated in Thailand in 1997 and quickly spread to the rest of East Asia and its trading partners. Speculative capital flows from developed countries to the East Asian economies of Thailand, Indonesia, Malaysia, Singapore, Hong Kong, and South Korea (known then as the “Asian tigers”) had triggered an era of optimism that resulted in an overextension of credit and too much debt accumulation in those economies. In July 1997 the Thai government had to abandon its fixed exchange rate against the U.S. dollar that it had maintained for so long, citing a lack of foreign currency resources. That started a wave of panic across Asian financial markets and quickly led to the widespread reversal of billions of dollars of foreign investment. As the panic unfurled in the markets and investors grew wary of possible bankruptcies of East Asian governments, fears of a worldwide financial meltdown began to spread. It took years for things to return to normal. The International Monetary Fund had to step in to create bailout packages for the most-affected economies to help those countries avoid default.
The Financial Crisis of 2007–08
This sparked the Great Recession, the most-severe financial crisis since the Great Depression, and it wreaked havoc in financial markets around the world. Triggered by the collapse of the housing bubble in the U.S., the crisis resulted in the collapse of Lehman Brothers (one of the biggest investment banks in the world), brought many key financial institutions and businesses to the brink of collapse, and required government bailouts of unprecedented proportions. It took almost a decade for things to return to normal, wiping away millions of jobs and billions of dollars of income along the way.
As with any time of reform, it is crucial to clearly articulate the goals or objectives of banking and financial regulatory reform, including both public and private forms of regulation. I believe that the goal of banking and financial development and regulation should be to support and enhance sustainable economic growth, consistent with consumer protection that maintains the integrity of the markets. A large body of research suggests that a deep and developed financial system is a driving force behind economic development and growth (see, e.g., the summary in Levine forthcoming that I draw on here). Cross-country evidence suggests that such systems can be particularly helpful for those at the lower end of the income distribution. The primary mechanism for the positive growth impacts appears to be through increasing the efficiency of the allocation of capital to the highest return projects and giving the less affluent access to capital that they would not have in a less developed system.
This line of research, however, generally does not address a fundamental issue: Might there be a trade-off with volatility? (See Kroszner and Strahan, 2011.) That is, to obtain a higher growth “return” through financial development, is there a cost in terms of greater “risk” in the system? Following the crisis, this is a critical issue to investigate. For this reason, I included “sustainable growth” rather than simply “growth” as part of the goal of regulatory reform. This issue raises a further and much more vexing question: If there is such a trade-off, then how would we determine the “optimal” size of the financial sector in an economy?
Theoretically, greater financial depth and development could either increase or decrease stability. On the one hand, a larger and more developed financial sector could improve risk sharing and diversification and thereby reduce volatility. On the other, a larger and more developed financial sector could allow greater concentrations of risk and generate interconnections, thereby potentially making the entire system more fragile and vulnerable to shocks. Policy makers engaged in financial regulatory reform need to consider these opposing forces in the financial system.
Unfortunately, little research exists to help guide policy makers. In earlier work with Luc Laeven and Daniela Klingebiel on banking crises (2007), for example, we indirectly addressed this by looking at whether firms that relied more on sources of external finance were hit harder during banking/financial crises than firms that relied more on internally generated cash flows. Not only did we find this generally across countries, we found that this affect was most pronounced in countries with the deepest financial systems. (See also Kroszner, 2007.) This evidence thus hints at the possibility of a trade-off. The deeper financial system might create more connections between the real and the financial sectors that could make the firms that rely most heavily on the financial system more vulnerable in a banking crisis. Our analysis, however, did not allow us to address in detail the welfare question of whether these types of firms or the economy as a whole was better off in the long run. The data from branching deregulation across US states, however, suggests that there is no trade-off but that deepening of the financial sector is a “win-win.” The evidence suggests that state growth rates tend to increase following branching deregulation. Examining the quarter century during which states removed barriers that had prevented banks from branching across states, Morgan, Rime, and Strahan (2004) and Kroszner and Strahan (forthcoming) find that measures of state economic
volatility fell as the banking system integrated across state lines. The variability of state employment growth and the growth of gross state product, for example, decreased after interstate branching was permitted. Interestingly, both growth shocks and trend growth rates become more alike across states as the degree of commonality of the ownership of banks in those states increased.1The relationship between the financial sector and volatility, thus, is an open question that more work on the most recent financial crisis may help to shed light upon.
Although I believe that financial innovations are crucial in a dynamic, growing economy, in some cases these innovations may be Janus-faced. The “good” face of credit default swaps (CDS), for example, is that they are brilliant innovations that permit market participants to hedge default risk and give supervisors one metric to measure market perceptions of a firm’s or a sovereign’s risk in real time. The “bad” face of CDS, however, is that they can permit astonishing risk concentrations (e.g., AIG) that can generate fragile interconnections and systemic risk when such contracts are traded over-the-counter and not centrally cleared (see Kroszner and Shiller, 2011). The possible two-faced nature of innovation raises the question of how a supervisor (or market participant) can determine in advance the risks associated with a new instrument or the market structures that would be necessary to reduce those risks. Obviously, with a new instrument, it is diffi cult – if not impossible – to undertake the empirical testing to assess the two faces that such an innovation may have. The cost of stopping all types of financial innovation
due to insufficient data, however, seems too great. Developing a framework for evaluating the costs and benefits of innovation is another crucial issue raised by the recent crisis. How to do this, however, remains a fundamental challenge. Even in cases where we do have relatively long data sets, it is possible that the innovation itself
can change the historical correlations and risks – that is, they may be endogenous to the innovation. (See Kroszner, 2010a.) For most of the 20th century, for example, the mortgage market in the United States was relatively fragmented geographically, so geographic diversification of a mortgage portfolio could reduce risk. Interstate banking as well as geographically diversified pools of mortgage-backed securities (MBS) helped to provide a national source of financing. In principle, banks could then diversify away from local housing risk concentrations and individual home owners could tap a national rather than localised market for financing their mortgages.
These innovations, however, changed the historical correlations and risks by helping to increase the integration, hence correlation, of housing markets across the country. Thus, the benefits of geographical diversification waned precisely as instruments such as MBS rose to provide that diversification. As this example shows, trying to assess the faces of a financial innovation is a particularly vexing task but one that deserves much attention.
The crisis revealed that both the quantity and quality of capital held by banking and financial institutions were clearly inadequate to deal with shocks to the system. I want to state unambiguously that I believe that imposing higher capital requirements following the crisis is the right response. My concern, however, is that raising capital requirements is not a cure-all and in some cases seems to be relied upon as a substitute for directly addressing fragilities in the system. High capital requirements, I worry, can provide a false sense of security to regulators and to the public about the safety and soundness of the financial system and lead to complacency in crucial areas of regulatory reform. (See also Tucker, 2012.) A high capital requirement, for instance, is not a substitute for developing orderly resolution procedures, both domestically and cross-border, or for improving market infrastructure, such as central-clearing of over-the-counter derivatives (see Kroszner and Shiller, 2011). I believe that it is best to address problems and vulnerabilities directly rather than indirectly in order to reduce the likelihood of unintended consequences.
Relying too heavily on any one instrument, such as capital requirements, may not be a prudent approach for regulators and supervisors – much as we would not want banks to put too many of their eggs in one basket! Very high capital requirements can generate incentives to the owners of the financial institution to try to take on more risk in order to reach return on equity goals (see Levine forthcoming). More generally, the higher the requirement, the more incentive there is to find ways around it. These incentives can lead to a number of unintended consequences.
A very high capital requirement, for example, can lead to more off-balance-sheet activity and risk exposures by a regulated institutions that may be harder for supervisors and the public to detect. Second, it can push activities off into the “shadows,” to markets and institutions that are not directly regulated but that may be closely interconnected to the regulated institutions, e.g., borrowers, funders, and counterparties. Third, it can channel efforts in financial innovation to create instruments that may evade particular capital requirements but not reduce risks to an individual institution or to the system as a whole. It is quite difficult for the Basel Committee as well as national regulators to get the risk pricing “right” in a dynamic market. Thus, rather than conserving supervisory resources and providing greater cushions against shocks, very high capital requirements could paradoxically require greater vigilance by supervisors, generate more fragile interconnections, and thereby potentially reduce the overall safety and soundness of the system.
I will draw an analogy with the Maginot Line: the more heavily you rely on any one instrument, the more incentive there is to evade it and the fewer resources may be allocated to other instruments of defense (or offense). Following the large losses of life in Word War I, the French debated the most effective way to prevent a repeat of that tragedy.
Charles de Gaulle argued that France should invest in new types of armored mobile vehicles, airpower, and the training of large standing army to deter a German invasion and allow a rapid and flexible response if one did occur. André Maginot countered that resources would be more effectively used to build a heavily fortified barrier to deter and slow a German invasion. If an invasion were to begin, he argued, this defense would give sufficient time for
France to mobilise and call up reserves, thereby substituting for a large standing army and investment in new means of rapid response.2 Maginot of course won the argument, and France built what came to be known as the Maginot Line along its eastern border in the 1930s.
In response, the Germans naturally tried to find ways around the fortification and invested heavily in innovative armored mobile vehicles (Panzer Divisions) and airpower (Luftwaffe). The Germans made a lightning fast strike (Blitzkrieg) through the Ardennes forest, the weakest point of the Maginot Line. Given the denseness of the forest and their fortifications, however, the French military did not believe that a quick invasion through the Ardennes
was possible.3 Obviously, they were wrong and soon the Maginot Line was surrounded, and France fell to Germany two months after the initial invasion.
In regulatory reform, it is important to try to avoid the false sense of security and excessive reliance on one instrument. Capital “barriers” can be helpful but they can also create strong incentives to find innovative ways to evade them. As the crisis demonstrated, what may have been seen as a well-capitalized institution can have this “fortification” erode extremely quickly in tumultuous market conditions. “Prompt corrective action” relied on capital layers above the regulatory minimum to provide sufficient time for remedial action, but the rapid decline of Washington Mutual’s capital ratios, for instance, demonstrates that the capital “fortification” may not give supervisors have the potential to reduce, rather than enhance, stability of the system.
Capital requirements should be understood as a complement to supervisory vigilance and not a source of complacency. I am concerned that so much emphasis in the supervisory community has been put on capital that other reforms, such as cross border resolution and moving OTC derivatives onto centrally cleared platforms, have not been receiving the priority they deserve. sufficient time to act. In addition, activities that were thought to be relatively low risk, such as housing (as evidenced by low Basel I risk weights), could actually be the places of greatest vulnerability, much like the Ardennes.
The lesson for supervisors and regulators is not to rely on very high capital as a substitute for dealing with fragilities and vulnerabilities throughout the system. The unintended consequences of doing so have the potential to reduce, rather than enhance, stability of the system. Capital requirements should be understood as a complement to supervisory vigilance and not a source of complacency. I am concerned that so much emphasis in the supervisory
community has been put on capital that other reforms, such as cross border resolution and moving OTC derivatives onto centrally cleared platforms, have not been receiving the priority they deserve.
Supervisors and central banks around the world are being asked to do more, and being given more authority, to engage in “macroprudential” policy. In particular, central banks are being asked to act not only in their traditional role as “fi re extinguishers” as the flames of a financial crisis have begun to burn but also to act as macroprudential “smoke detectors” before the fl ames appear. (The following draws on Kroszner, 2010b and 2011, and Kroszner
and Strahan, 2011.) The “fi re extinguisher” role is the classic one that central banks have played as lenders of last resort and liquidity creators in times of financial stress andtumult. Once the flames of the crisis appear, the central bank can then douse them with liquidity to prevent the fi re spreading from one institution or market to another in order to avoid a system-wide confl agration. By moving beyond institution-specific regulations, this macroprudential approach” may lead to less regulatory arbitrage.
The “smoke detector” or “macroprudential” role emphasises that the central bank has a fundamental responsibility to act early to prevent the tinder from igniting into flames. Being proactive in monitoring individual institutions and interconnected markets for signs of froth and fragility is what macroprudential policy should focus upon. In some cases, it make involve effective credit allocation but raising the costs of funding in some sectors relative to others.
The macroprudential role certainly does not conflict with the more traditional “fi re extinguisher” role, but it requires a much expanded set of authorities and activities on the part of the central bank.
The macroprudential approach, however, has at least three challenges. First, what metrics of financial stability or systemic risk will trigger macroprudential actions? Following the financial and currency crises in the 1980s and 1990s, academics and researchers at the International Monetary Fund and World Bank tried to develop “early warning” systems to anticipate where a crisis might occur. This exercise has proved difficult, and there are no generally accepted early warning indicators to allow authorities to act early enough to avoid the next crisis.
In addition, can financial economics provide a straightforward and theoretically grounded benchmark to assess if risks are being improperly managed or priced? Reasonable people could disagree about appropriate assumptions about or shifts in risk aversion, discount rates, “tail risks,” and other factors in asset pricing. Regulators thus may face criticism of being arbitrary and attempting to substitute their judgment for those of investors who are putting
their own money on the line. Such assessments are particularly difficult in new and innovative areas where data histories are short. Finally, will a central bank’s independence be challenged if it engages in macroprudential policymaking?4 In the case of housing in the United States, many programs subsidise home ownership, by lowering down payments or subsidizing securitisation. The large costs of these subsidies have become clear as losses at Fannie Mae and Freddie Mac mount. Yet neither the 2010 Dodd-Frank Act nor any subsequent acts have been taken to address these issues. If a central bank again becomes concerned about “frothiness” in housing, policies to reduce loan-to-value ratios, restrict securitization, or raise capital might run into political headwinds. The unelected body of the central bank could be accused of overruling an elected body. This certainly could put the central bank in the political cross hairs and lead to questions about its judgments and demands for greater political oversight. Effective macroprudential policies thus may involve risks for central bank independence and good governance.
In response to the financial crisis of the early 1930s, the United States adopted a separation between investment banking and commercial banking with the Glass-Steag all Act. This Act prohibited a commercial bank or commercial bank holding company from having any affiliates engaged in a variety of activities such as securities underwriting. The 1999 Gramm-Leach-Bliley Act relaxed parts of the Glass-Steag all Act to allow bank holding companies to have separately incorporated and capitalized subsidiaries engage in investment and merchant banking activities, even though the commercial bank itself is still prohibited from doing so directly or through
its own subsidiary. During the last decade, a few large US banks have become significant global players in, for example, market making and securities underwriting through their investment banking subsidiaries. In response to the most recent crisis, the Dodd-Frank Act included a form of activities restriction called the Volcker Rule. The Volcker Rule strictly limits commercial bank activities in proprietary trading, private equity, and hedge funds. The prohibitions on private equity and hedge funds have not created much controversy because these activities are relatively easy to define and had not become an important part of commercial bank operations. Propriety trading, however, involves much greater challenges to define and implement. The recent notice of proposed rulemaking from the US regulatory agencies ran more than two hundred pages and asked for comments on 383 questions! Depending upon what the regulators choose to define as “proprietary” (the Dodd-Frank legislation provided little concrete guidance and, hence, the long list of questions), the Volcker Rule has the potential to reduce rather than increase risk at the banks in the markets. First, natural hedging activities of banks could be curtailed. Second, the role that banks play as market makers in key global markets, such as those for government securities, could be reduced or eliminated. The unintended consequence could be to reduce liquidity and increase bid-ask spreads. A number of international regulators, in addition to the banks, have raised the concern that the Rule may make important markets less liquid and less stable. In addition, it is difficult to find systematic evidence from the recent crisis that involvement in proprietary trading increased the risk of failure.5 In the United States, the major banks that collapsed did so primarily because of high exposure to mortgages, not due to proprietary trading. Internationally, “universal” banks did not fare worse than their more “traditional” brethren and in many cases benefit ted from the diversification of income sources that are associated with engagement in a wide variety of activities (Kroszner and Melick, 2011). As we have experienced from earlier episodes of regulatory arbitrage, restrictions that apply to one set of institutions may just move risks to other institutions or markets and may, at the same time, increase inter-linkages and market opaqueness. Depending upon what constitutes “proprietary” trading, pushing risk-taking activities just outside of the commercial banking system could have the unintended consequence of making the entire system more, rather than less, fragile. Making markets more, not less, robust is crucial for the stability of the financial system and must be an important factor taken into account in the debate over activity restrictions on banks (see Kroszner, 2010c and Kroszner and Strahan, 2011).
The relation among stability, growth, and regulation is crucial for assessing reform proposals and priorities. I have sketched a framework for thinking about
these issues and touched on a few specific reforms. Policy-makers should clearly articulate goals and trade-offs, avoid overreliance on any one regulatory
instrument, and be sensitive to potential unintended consequences of regulatory reforms. Identifying fragilities and then addressing them as directly as
possible would be an effective way to enhance the robustness of the financial system.
Supplementary Indicators to assess vulnerabilities emanating from
Systemic Liquidity conditions
Fiscal situation
External Sector
Housing Prices
There is no universally accepted definition of financial stability. Definitions by various experts abound but most definitions are not amenable to quantification.
Financial system functioning without disruption and return to steady state after periods of volatility/vulnerability without significant impairment to longer term prospects, is generally considered an indicator of stability.
Volatilities within an acceptable/tolerable range can represent a state of financial stability.
Government – Failure of monetary policy & default on bonds
Company – Unable to pay debt, loosing value on investments
Individuals – Not able to pay debt
Financial markets – It faces financial risk due to macroeconomic factors
When the state has such a strong hand in the economy, fundamental analysis requires that you understand the basic goals of the rulers of the country. The people of any nation support the government when times are good.
When there is a valid external threat, and when they are controlled by fear. Increasingly, Chinese rulers are dependent on high employment to keep their people happy. This is a nation that has experienced double digit growth for decades and is not cooling off.
China has had a one couple one child policy that has reduce its growth rate and resulted in an aging population. As the Chinese economy has thrived wages have risen and China has lost some of its competitiveness.
The three D’s the three D’s: removing distortions, accelerating diffusion, and fostering discovery (figure ES.1). The first D, reducing distortions in the allocation of resources, has been a key driver of growth in the past, and continuing reforms would allow China to reach its current maximum potential production frontier. The first D requires land, labor, and financial resources to be allocated competitively and efficiently to their most productive uses in the economy.
The second D, accelerating the diffusion of advanced technologies and innovations, will help China to extend its current production frontier to the global frontier. Accelerating diffusion would allow China to take advantage of its large remaining potential for catch-up growth by promoting technology diffusion, upgrading the capacity of its workers to adopt and use new technologies, and facilitating access to global technologies and innovations
The third and last D, fostering the discovery of new innovation and technology, will help China to create new innovations and to push out the global technology frontier. Fostering discovery will become more critical as China becomes richer and edges closer to the global technology frontier.
Six strategic choices
1- Striking the right balance between the three drivers of growth
2- Reshaping industrial policies
3- Adjusting the balance between the state and markets
4- Attaining mutually beneficial international trade and investment relations with global partners
5- Balancing supply-side reforms with demand-side reforms
6- Preparing for the future impact of technological changes
Seven areas of structural and institutional reforms
1- Reshaping industrial policies and supporting market competition
2- Promoting innovation and the digital economy
3- Building human capital
4- Allocating resources efficiently
5- Leveraging regional development and integration
6- Promoting international competitiveness and economic globalization
7- Governing the next transformation
The three D’s the three D’s: removing distortions, accelerating diffusion, and fostering discovery (figure ES.1). The first D, reducing distortions in the allocation of resources, has been a key driver of growth in the past, and continuing reforms would allow China to reach its current maximum potential production frontier. The first D requires land, labor, and financial resources to be allocated competitively and efficiently to their most productive uses in the economy.
The second D, accelerating the diffusion of advanced technologies and innovations, will help China to extend its current production frontier to the global frontier. Accelerating diffusion would allow China to take advantage of its large remaining potential for catch-up growth by promoting technology diffusion, upgrading the capacity of its workers to adopt and use new technologies, and facilitating access to global technologies and innovations
The third and last D, fostering the discovery of new innovation and technology, will help China to create new innovations and to push out the global technology frontier. Fostering discovery will become more critical as China becomes richer and edges closer to the global technology frontier.
Six strategic choices
1- Striking the right balance between the three drivers of growth
2- Reshaping industrial policies
3- Adjusting the balance between the state and markets
4- Attaining mutually beneficial international trade and investment relations with global partners
5- Balancing supply-side reforms with demand-side reforms
6- Preparing for the future impact of technological changes
Seven areas of structural and institutional reforms
1- Reshaping industrial policies and supporting market competition
2- Promoting innovation and the digital economy
3- Building human capital
4- Allocating resources efficiently
5- Leveraging regional development and integration
6- Promoting international competitiveness and economic globalization
7- Governing the next transformation
