3 Regulation: Reforms

The diagnosis of the crisis provide some insights into further specific reforms in order to prevent
future crisis. Policy-makers have tried to rectify the damage done to financial systems by enacting
a large set of financial reforms, both at the International and domestic level. The informal group of
regulators and central bank experts that had been meeting in Basel prior to the crisis became more
formal in April 2009 through the establishment of the Financial Stability Board (FSB). The FSB
coordinates the work of national financial authorities setting bodies at an International level. The
Dodd-Frank Act is part of a global trend to establish new banking regulations intended to make the
financial system more secure. The aim is to make banks more transparent and manageable while
containing excessive risk taking. The most relevant reforms can be summarized as follows:

Adoption of Basel III capital and liquidity requirements: Third Basel Accord is a global,
voluntary regulatory standard on bank capital adequacy, stress testing and market
liquidity risk. It was agreed upon by the members of the Basel Committee on Banking
Supervision in 201011, and was scheduled to be introduced from 2013 until 2015
Unlike Basel I and Basel II, which focus primarily on the level of bank loss reserves that
banks are required to hold, Basel III focuses primarily on the risk of a run on the bank by
requiring differing levels of reserves for different forms of bank deposits and other
borrowings. Therefore Basel III rules do not, for the most part, supersede the guidelines
known as Basel I and Basel II; rather, it will work alongside them. The main points are:
1. Capital Requirements: The original Basel III rule from 2010 was supposed to require
banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I
capital(including common equity and up from 4% in Basel II) of "risk-weighted
assets" (RWAs). Basel III introduced two additional "capital buffers"a "mandatory
capital conservation buffer" of 2.5% and a "discretionary counter-cyclical buffer" to
allow national regulators to require up to an additional 2.5% of capital during periods
of high credit growth. Basel III was supposed to strengthen bank capital
requirements by increasing bank liquidity and decreasing bank leverage.
2. Leverage Ratio: Basel III introduced a minimum "leverage ratio". The leverage ratio
was calculated by dividing Tier 1 capital by the bank's average total consolidated
assets (not risk weighted); The banks were expected to maintain a leverage ratio in
excess of 3% under Basel III. In July 2013, the U.S. Federal Reserve announced
that the minimum Basel III leverage ratio would be 6% for 8 Systemically important
financial institution (SIFI) banks and 5% for their insured bank holding companies.
3. Liquidity requirements: Basel III introduced two required liquidity ratios. The
"Liquidity Coverage Ratio" was supposed to require a bank to hold sufficient highquality liquid assets to cover its total net cash outflows over 30 days; the Net Stable
Funding Ratio was to require the available amount of stable funding to exceed the
required amount of stable funding over a one-year period of extended stress. On 24

October 2013, the Federal Reserve Board of Governors approved an interagency

proposal for the U.S. version of the Basel Committee on Banking
Supervision (BCBS)'s Liquidity Coverage Ratio (LCR). The proposal requires
financial institutions and FSOC designated nonbank financial companies to have an
adequate stock of high-quality liquid assets (HQLA) that can be quickly liquidated to
meet liquidity needs over a short period of time.

Recovery and Resolution: Strengthening banks capital ratios and liquidity coverage ratios
is only part of the aspects required to lessen the risk of bank failures. All G-SIFIs had to
draft an adequate , credible recovery and resolution plan (RRP) by June 2012. All
Domestic systemically important banks (D-SIBs) will ultimately have to follow suit. Although
the plan in theory is under the control of the banks management, the authorities regard it
as important supervisory tool to identify ways that institutions under severe stress can
regain financial strength. The information provided to the authorities is meant to enable
them to create a roadmap for achieving orderly resolution in the event that recovery
measures prove ineffective.

Volcker Rule: Section 619 of the Dodd-Frank Act states that unless otherwise provided in
the section, a banking entity shall not engage in proprietary trading; or acquire or retain any
equity, partnership, or other ownership interest in or sponsor a hedge fund or a private
equity fund. The aim is to prohibit banks from engaging in proprietary trading for their own
gain, while not restricting market-making activities that banks take on behalf of their clients.
The Volcker Rule prohibits banks from engaging in short-term proprietary trading of
Securities, derivatives, commodity futures and options for their own account. But there are
significant exceptions. U.S. banks are permitted to conduct proprietary trading of U.S.
government agency, state and municipal obligations. It also permits, in more limited
circumstances for foreign banking organizations, proprietary trading in foreign sovereign
debt.

Consumer Financial Protection Bureau (CFPB): The Dodd Frank Act created the CFPB to
put consumer protection at the forefront of financial supervision and regulation. It is in place
to help protect consumer from unfair, deceptive or abusive acts or practices and to enforce
rules that prohibit unfair treatment in consumer finance. The CFPB has the power to
impose significant penalties on both banks and nonbanks and it has used this new authority
on a number of occasions to exact heavy fines on financial service providers.

Transparent Derivatives: The opacity of the derivatives markets exacerbated the financial
crisis due to uncertainty over the size of banks exposure after the collapse of Lehman
Brothers in 2008. In response, the U.S. is taking part in a global initiative to shift the $700
trillion over-the-country (OTC) market away from bank balance sheets and into clearing

house, which would absorb any losses if either counterparty defaults. The new rules will
force nearly all derivatives traded to be reported and sent to central counterparty clearing
houses, known in the U.S. as Derivatives Clearing Organizations.
3.1 The problem of shadow banking
Shadow banking, broadly defined as credit intermediation outside the conventional banking
system, constitutes about one-fourth of total financial intermediation worldwide. The official
financial community has (through the Financial Stability Board) been engaged since 2011 in a
global project to monitor and measure shadow banking, and to adapt the regulatory framework to
better address shadow banking risks. The United States, the euro area, and the United Kingdom
have the largest shadow banking systems according to FSB data. In the United Kingdom, shadow
banking assets as a share of GDP are more than twice those in any other area, and only in the
United States do shadow banking assets exceed those of the conventional banking system.
Shadow banking has been growing rapidly in emerging market economies and it can complement
traditional banking by expanding access to credit or by supporting market liquidity, maturity
transformation, and risk sharing. As highlighted by Gordon (2009), the shadow banking system
arose to meet: (1) the demand for collateral by firms for many purposes and, (2) the demand for a
safe way for firms to save cash in the short term. Securitization created collateral and the repo
markets provides a banking mechanism for firms and institutional investors. Shadow banking is
set to grow further in the current environment ; many indications point to the migration of
some activities, such as lending to firms, from traditional banking to the nonbank sector. That is,
some of the fastest growing shadow banking activities substitute for, rather than complement,
traditional banking It should be recognized the shadow banking as a real banking and for this
reason it needs to be protected.
Lending by shadow banking entities contributes significantly to total lending in the United States
and is rising in many countries, including in the euro area and it often enhance the efficiency of the
financial sector by enabling better risk sharing and maturity transformation and by deepening
market liquidity. However, the global financial crisis revealed that, absent adequate regulation,
shadow banking can put the stability of the financial system at risk in several ways. In advanced
economies, some shadow intermediaries (such as money market mutual funds and securitization
vehicles) were highly leveraged or had large holdings of illiquid assets during the crisis, and were
vulnerable to runs when investors withdrew large quantities of funds at short notice. This led to fire
sales of assets, which intensified the financial turmoil by reducing asset values and helped spread
the stress to traditional banks. Since then, global regulatory reforms coordinated by the FSB have
called for greater disclosure of asset valuations, improved governance, ownership reforms, and
stricter oversight and regulation of shadow banks (FSB 2013a, 2013b).

Policymakers must strike the right balance between containing systemic risks and preserving the
benefits of shadow banks. They have essentially four toolkits at their disposal to address financial
stability risks related to shadow banking:

Regulation: Policymakers can regulate shadow banks either directly, through tailored
regulatory measures, or indirectly, by extending the regulatory boundary, limiting the ability
of banks to support shadow banking activities, or by managing the implicit government
guarantees of banks (Claessens and Ratnovski 2014).

Addressing the underlying causes: Supply-side and demand-side measures are a more
indirect but potentially powerful way of addressing shadow banking stability risks. Applying
such measures would require intensive coordination with authorities in charge of monetary,
fiscal, and structural policies. Demand-side measures contain the factors stimulating the
growth of shadow banking. For example, according to Pozsar(2011), the demand for
shadow banking assets that arises from safety considerations (such as by institutional cash
pools) could be redirected by ensuring a sufficient supply of publicly generated safe assets,
however this may entail moral hazard risks. Measures on the supply side include imposing
restrictions on new instruments.

Access to central bank facilities: In principle, it is conceivable to extend the lender-of-lastresort function to certain kinds of systemically important shadow banks to protect the
financial system against liquidity shocks. However, extending access to central bank
funding entails substantial moral hazard risks. Therefore, explicit public backstops should
be considered only if appropriate regulatory oversight mechanisms are in place, including
for collateral and governance.

Recovery and resolution: Ordinary insolvency law may not provide for the specific recovery
and resolution tools needed to manage systemic failures of shadow banking entities or
activities. Setting up tailored recovery and resolution frameworks would increase the
authorities ability to mitigate systemic risk in crisis situations.

However, FSB has recognized that policymakers will have to better integrate the entity and activity
dimensions of shadow banking regulation. Monitoring and risk identification should focus primarily
on economic functions and activities, but regulation and supervision have so far mostly focused on
entities.
The Financial Stability Board, in cooperation with other international regulatory bodies, carried out
work in five areas:

Mitigating banks interactions with shadow banks: To appropriately capture banks

interactions with the shadow banking sector, the Basel Committee on Banking Supervision
(BCBS) has improved its frameworks for (1) measuring and controlling banks large

exposures, and (2) capital requirements on banks equity investments in funds, and is
working toward developing guidance on the scope of regulatory consolidation.

Reducing the susceptibility of money market mutual funds (MMFs) to runs: The FSB
endorsed recommendations of the International Organization of Securities Commissions
(IOSCO), including the conversion of constant net asset value (NAV) MMFs into floating
NAV MMFs where workable. IOSCO recommends that constant NAV MMFs be protected
against investor runs through redemption gates, redemption fees, or side pockets( Side
pockets are special accounts that allow fund managers to separate parts of an investment
portfolio from other assets until market conditions allow for proper valuation and
liquidation). IOSCO is conducting peer review of the progress of national regulation.

Oversight and regulation of other shadow banking entities: The FSB issued a policy
framework consisting of an assessment of economic functions and activities of shadow
banking, adoption of policy tools, and an information-sharing process between authorities,
complemented by peer review. Recommended policy tools included primarily prudential
measures, such as capital requirements, leverage limits, liquidity buffers, and restrictions
on maturity and liquidity transformation.

Securitization: The FSB endorsed IOSCO recommendations to better align the incentives
of securitization markets, including issuer risk retention and improved transparency and
disclosure. IOSCO is conducting peer review in this area as well. The BCBS and IOSCO
are jointly reviewing developments in securitization markets and discussing criteria to
identify simple and transparent securitizations.

Dampening procyclicality in repurchase agreement(repo) and securities lending: The FSB

policy recommendations seek to enhance transparency, regulation, and improvements to
the structure of repo and securities lending markets and to address risks associated with
rehypothecation (reuse of funds in other repo transactions), collateral valuation, and
haircuts (reduction in the principal paid to creditors)

In addition, the FSB is developing methodologies to identify systemically important nonbank, noninsurer financial institutions. Its first consultation paper on the topic, released in January 2014,
proposed separate methodologies for finance companies, market intermediaries, and investment
funds.
Concrete policy measures will be developed once the methodologies are finalized. However, in
contrast to the progress on the international level, the national implementation of policies on
several issues is still at an early stage. Only a few national regulators have acted in response to
the international policy developments, although in specific markets some reform proposals were
implemented.