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    Recovering from theGlobal Financial Crisis

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    Recovering from theGlobal Financial Crisis

    Achieving Financial Stabilityin Times of Uncertainty

    Marianne Ojo

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    Recovering from the Global Financial Crisis: Achieving Financial Stability

    in Times of Uncertainty

    Copyright Business Expert Press, LLC, 2013.

    All rights reserved. No part of this publication may be reproduced,

    stored in a retrieval system, or transmitted in any form or by any

    meanselectronic, mechanical, photocopy, recording, or any other

    except for brief quotations, not to exceed 400 words, without the

    prior permission of the publisher.

    First published in 2013 by

    Business Expert Press, LLC222 East 46th Street, New York, NY 10017

    www.businessexpertpress.com

    ISBN-13: 978-1-60649-700-5 (paperback)

    ISBN-13: 978-1-60649-701-2 (e-book)

    Business Expert Press Finance and Financial Management collection

    Collection ISSN: Forthcoming (print)

    Collection ISSN: Forthcoming (electronic)

    Cover and interior design by Exeter Premedia Services Private Ltd.,

    Chennai, India

    First edition: 2013

    10 9 8 7 6 5 4 3 2 1

    Printed in the United States of America.

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    AbstractWhy are some global financial crises more difficult to recover from and

    overcome than others? What steps are necessary in ensuring that finan-

    cial stability and recovery are facilitated?

    What kind of environment has the previous financial environment

    evolved to and what kind of financial products have contributed to

    greater vulnerability in the triggering of systemic risks? These are among

    some of the questions which this book attempts to address. In

    highlighting the role and importance of various actors in post-crisesreforms as well as the huge impact of certain factors and products that

    are contributing in exacerbating the magnitude and speed of transmis-

    sion of financial contagion, the book provides an insight into why

    global financial crises have become more complicated to address than

    was previously the case.

    Whilst considering and highlighting why matters related to procycli-

    cality and capital measures should not constitute the sole focus of atten-

    tion of the G20s initiatives, the book is aimed at identifying otherimportant issues such as liquidity risks and requirements which have

    constituted, to a large extent, the focus of international standard setters

    and regulators. It also aims to direct regulators, central bank officials

    and supervisors, academicians, business and legal professionals, and

    other relevant interested parties in the field toward current and previ-

    ously ignored issues such as the cartelization of capital markets. The

    need and concern for increased regulation of bond, equity markets, as

    well as other complexfi

    nancial instruments which can be traded inOver-the-Counter (OTC) derivative markets is evidenced by Basel IIIs

    focuswhich is addressed in the book. Cartelization and organized

    activities, relating to rate rigging in global capital marketsas evidenced

    recently by sophisticated Euro Interbank Offered Rate (EURIBOR) and

    London Interbank Offered Rate (LIBOR) rigging practices and occur-

    rences, are also covered.

    The aims and objectives of the book would not be complete by

    merely identifying and highlighting the general root causes of global

    financial crises and the current issues. Hence each chapter will also

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    recommend (as well as bring to the fore) measures that should be (and

    have been) put forward in order to address the issues and factors that

    contribute to the magnitude and severity of global financial crises.

    Keywords

    financial stability, procyclicality, supervisors, systemic risks, counterparty

    risks, shadow banking, Basel III, capital, liquidity standards, over-the-

    counter derivatives, central banks

    viii ABSTRACT

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    Contents

    List of Abbreviations.............................................................................. xi

    Introduction ........................................................................................ xiii

    Chapter 1 Great Expectations, Predictable Outcomes, and the G20s

    Response to the Recent Global Financial Crisis: When

    Matters Relating to Liquidity Risks Become Equally as

    Important as Measures Addressing Procyclicality...............1

    Chapter 2 Redefining a Role for Central Banks: The Increased

    Importance of Central Banks Roles in the

    Management of Liquidity Risks and Macroprudential

    Supervision in the Aftermath of the Financial Crisis ...... 9

    Chapter 3 Central Banks and Different Policies Implemented in

    Response to the Recent Financial Crisis ..........................21Chapter 4 The Role of Monetary Policy in Matters Relating to

    Financial Stability: Monetary Policy Responses

    Adopted During the Most Recent Financial Crisis ..........41

    Chapter 5 Fair Value Accounting and Procyclicality: Mitigating

    Regulatory and Accounting Policy Differences

    Through Regulatory Structure Reforms and Enforced

    Self-Regulation ................................................................49

    Chapter 6 Capital, Liquidity Standards, and Macroprudential

    Policy Tools in Financial Supervision: Addressing

    Sovereign Debt Problems ................................................59

    Chapter 7 LIBOR, EURIBOR, and the Regulation of Capital

    Markets: The Impact of Euro Currency Markets on

    Monetary Setting Policies ................................................73

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    Chapter 8 Financial Stability, New Macroprudential Arrangements,

    and Shadow Banking: Regulatory Arbitrage and

    Stringent Basel III Regulations ........................................81

    Chapter 9 Volcker/Vickers Hybrid? The Liikanen Report

    and Justifications for Ring Fencing and Separate

    Legal Entities...............................................................101

    Chapter 10 Conclusions and Implications of Regulatory

    Reforms and Policy Measures......................................109

    Notes .................................................................................................113

    References........................................................................................... 143

    Index .................................................................................................157

    x CONTENTS

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    List of Abbreviations

    ABCP Asset-Backed Commercial Paper

    BBA British Bankers Association

    BIS Bank for International Settlements

    BCBS Basel Committee on Banking Supervision

    CCP Central Counter Party

    CCR Credit Counterparty RiskCDO Collateralized Debt Obligations

    CDS Credit Default Swap

    CEBS Committee of European Banking Supervisors

    EBA European Banking Authority

    ECB European Central Bank

    EFSF European Financial Stability Facility

    EIOPA European Insurance and Occupational Pensions Authority

    ESA European Supervisory AuthoritiesESFS European System of Financial Supervisors

    ESMA European Securities and Markets Authority

    ESR European Securities Regulators

    ESRB European Systemic Risk Board

    EU European Union

    EURIBOR Euro Interbank Offered Rate

    FASB Financial Accounting Standards Board

    FEE Federation des Experts Comptables Europeens

    FSA Financial Services Authority

    FSB Financial Stability Board

    FSF Financial Stability Forum

    HRE Hypo Real Estate

    IASB International Accounting Standards Board

    IRB Internal Ratings Based

    LCR Liquidity Coverage Ratio

    LIBOR London Interbank Offered Rate

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    LTRO Longer Term Refinancing Operation

    NSFR Net Stable Funding Ratio

    OTC Over-the-Counter

    SRR Special Resolution Regime

    xii LIST OF ABBREVIATIONS

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    Introduction

    Experience has shown that political institutions often do not

    maintain stable prices. They have several powerful incentives to

    expand the money supply beyond the rate of real growth in the

    economy. In non-democratic societies, the control of the money

    supply is an important instrument of economic policy that can

    address various political needs, most notoriously the financing ofgovernment needs. It is against this background that indepen-

    dent central banks find their contemporary justification: central

    bank independence is conceived as a means to achieve the goal

    of price stability. Central bank independence has been the pre-

    ferred institutional arrangement to promote monetary stability

    since the end of the 1980s and beginning of the 1990s. A num-

    ber of factors have contributed to this development.1

    Rosa Maria Lastra, Legal Foundations of InternationalFinancial Stability, 2006

    How Independent Are Highly IndependentCentral Banks?

    Theories that appear to suggest that absolute independence exists (i.e.,

    the theory that recognizes no limits on central bank independence, so

    long as the bank itself is reliably pre-committed to achieving price sta-

    bility2

    ), indeed, cannot be sustainable.A sufficient and appropriate degree of central bank independence is

    definitely necessary for the goal of achieving price stability. However,

    despite the levels of independence claimed to be enjoyed by several cen-

    tral banks, recent events indicate shifts in focus of monetary policy

    objectives by various central banks, notably, that of the Fed Reserve.

    The impact of political and government influences on central banks

    monetary policies has been evidenced from the recent financial crisis

    and in several jurisdictions. Many central banks have adjusted monetarypolicies having been influenced by political pressures that have built up

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    as a result of recent financial and sovereign debt crises. However, such

    lack of absolute independence (from political spheres) could prove

    symbiotic, in the sense that, despite the need for a certain degree of

    independence from political interference, certain events which are

    capable of devastating consequences, namely, a drastic disruption of the

    systems financial stability, need to be responded to as quickly and

    promptly as possible. Is it possible for a central bank with absolute

    independence to operate effectively, particularly, given the close links

    between many central banks and their Treasury in several countries?

    It may be inferred that central banks crucial roles in establishing a

    macroprudential framework provide the key to bridging the gap

    between macroeconomic policy and the regulation of individual finan-

    cial institutions. This however, on its own, is insufficientclose collab-

    oration and effective information sharing between central banks and

    regulatory authorities is paramount.

    Consequences of lack of close collaboration, coordination, and

    timely exchange of information between tripartite authorities, such as

    the relationship which exists between the United Kingdoms Financial

    Services Authority (FSA), the Bank of England, and the Treasury, werewitnessed during the Northern Rock Crisis. The Bank of England could

    not effectively perform its traditional role as lender of last resort for a

    limited time without such a role being made public.

    The need for the establishment of bridge banks and special

    resolution regimes (SRRs) has also been acknowledged in various

    jurisdictions. Hence, whilst a certain degree of independence from polit-

    ical interference is necessary, as well as an affirmation of the

    commitment to monetary policy objectives, absolute independencecould also result in a process whereby the necessary coordination

    required between regulatory and government authorities exacerbate pro-

    blems which they (the authorities) were designed to solve.

    Here, Rosa M. Lastras observation does appear to be manifesting

    itself ever increasingly:

    Perhaps in the twenty-first century we shall witness the emer-

    gence of a rebalanced framework of macroeconomic policy (withfiscal policy regaining part of its earlier role) that may lead to a

    xiv INTRODUCTION

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    realignment of the goals to be pursued by the monetary authori-

    ties, which in turn will lead to a new wave of legal reforms.

    Other consequences of the recent financial crisis include increased

    implementation of fiscal policy measuresin respect of taxing and

    spending activities [which are distinguished from proposals relating to

    quantitative easing measures (an inflationary policy measure)in

    respect of the need to address the Eurozone sovereign debt crises].

    As regards the implementation of fiscal policy measures, caution is

    to be had to the implementation offiscal measures which are such that

    whilst they generate corrective effects, they do not impede the prospects

    of growth and development of the economy.

    Even though the Fed Reserve is not involved in determining fiscal

    policy measures (the Congress and the Administration being responsible

    for this), fiscal policy measures impact the Feds monetary policy deci-

    sions. The indirect effect of fiscal policy on the conduct of monetary

    policy through its influence on the aggregate economy and the eco-

    nomic outlook and the impact of federal tax and spending programs on

    the Fed Reserves key macroeconomic objectivesmaximum employ-ment and price stability and in making appropriate adjustments to its

    monetary policy toolsis notable in several situations and instances.

    Hence, how independent is the Fed really from government andfis-

    cal policy influences? Could it not be said that the government really

    has a dual role in fiscal and monetary policy setting? As indicated ini-

    tially, an appropriately and sufficiently independent central bank has a

    crucial role in ensuring price stability objectives.

    The following remark highlights the level of impact as well as theinfluence of political pressures on the Feds monetary policy objectives:

    for several decades, a generally healthy monetary policy balance

    produced good results. The Feds focus has shifted dramatically to

    the short-run objective of lowering unemployment and recently

    the willingness to (temporarily?) set aside its inflation target.3

    In view of such political interference, would it be wise to thrustmore powers into the hands of the Fed Reserve, namely, through a

    INTRODUCTION xv

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    widening of its scope of powers since the executive (Government), as

    well as Congress, have a degree of influence over the decision-making

    capacities of the Fed Reserve. Further, and addressing the issue indepen-

    dently of political influences on the Fed Reserve, would it really be in

    the interest of accountability to delegate more powers to an already rela-

    tively powerful Fed Reserve?

    Recent changes in the delegation of supervisory responsibilities in

    the United Kingdom, namely the transfer of bank supervision from

    the FSA back to the Bank of England, and the resulting increased

    scope of the Bank of Englands powers, would appear to suggest that

    in certain cases, regulatory bodies as well as central banks should

    assume greater functions in certain capacities. Accordingly, jurisdiction

    specific cases have to be viewed individually and based on prevailing

    circumstances.

    Hence, ensuring that absolute independence is achieved, in respect

    of central bankfinancial independence, constitutes a difficult task. Is it

    possible for a central bank to operate effectivelygiven the presence of

    absolute independence? Close collaboration and exchange of informa-

    tion between the tripartite authorities in the United Kingdom (the FSA,the Treasury, and the Bank of England), as highlighted by the Northern

    Rock Crisis, if effective as it should have been, could have helped, not

    only in identifying the problems which existed at Northern Rock, but

    more importantly, facilitated timely intervention which would have

    averted the scale of the crisis.

    Crisis faced by IKB, Landesbanken, and Hypo Real Estates not only

    revealed an absence of an SRR for banks, but also raised the issue of

    optimal measures which could be implemented to control (in part) pri-vately owned but publicly sponsored or (in part) publicly owned finan-

    cial enterprises.4

    Jurisdictional Approaches to Central Bank

    Independence and Monetary Policy

    Mervyn Kings reference5 to central bank independence in the United

    Kingdom highlights the importance being accredited to the ever increas-ing and significant role of monetary policy. He adds: How much

    xvi INTRODUCTION

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    discretion to give to the Monetary Policy Committee and how much

    should remain with the Chancellor is an interesting question that was

    raised, but not fully resolved, in 1997, referring to the date when the

    bank gained operational independence.6

    However, despite the growing importance of and emphasis on

    central bank independence as highlighted previously, lack of absolute

    independence (from political spheres) could prove symbiotic in the

    sense that, despite the need for a certain degree of independence from

    political interference, certain events which are capable of devastating

    consequences, namely, a drastic disruption of the systems financial sta-

    bility, need to be responded to as quickly and promptly as possible.

    Further, subjecting actions and decisions of the central bank to other

    authorities could actually incorporate greater accountability and trans-

    parency into the supervisory and regulatory framework.

    In relation to legislative reforms that result in a reduction in central

    bank autonomy, it has been noted by several commentators generally,

    that a reduction in central bank autonomy by subjecting its actions and

    decisions to legislative procedures and approvals could result in more

    serious problems which would aggravate the stability of the economyandfinancial system.

    However, it needs to be added that the issue does not necessarily

    relate to a subjection of actions and decisions for approvals, but how

    well the authorities involved are able to communicate and coordinate

    information between them effectively.

    Central Bank Independence: Its Relevance in Developed

    and Less Developed Economies and Political Systems

    Even though a sufficient and appropriate degree of central bank inde-

    pendence is widely acknowledged to be necessary for the goal of achiev-

    ing price stability, it has also been concluded by Hayo and Hefeker that

    central bank independence is neither necessary nor sufficient for mone-

    tary stability.7 Maliszweski8 further, concludes:

    statistical signifi

    cance of central bank independence at the highlevel of liberalisation, as well as the timing of stabilisation

    INTRODUCTION xvii

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    attempts and reforms of central bank laws, suggest that the inde-

    pendence is a powerful device for protecting price stability, but

    not for stabilising the price level.

    Central bank independenceimpact and significance on the econ-

    omy, financial system, and the goal of achieving price stabilityrequires

    a consideration of historical, legal, jurisdictional, political, and other

    economic factors. As regards jurisdictional factors and with respect to

    less developed countries (and not so well developed economies), the

    need for central bank independence (and in particular operational and

    financial independence from political institutions), it appears, assumes

    greater importance.

    According to the Memorandum Submitted to the National Assembly

    in Respect of the Proposed Amendments to the Central Bank of Nigeria

    (CBN) Act, 2007:9

    Financial independence for a central bank has four ingredients

    namely:

    The right to determine its own budget;

    The application of central bank-specific accounting rules;

    Clear provisions on the distribution of profits; and

    Clearly definedfinancial liability for supervisory authorities.

    Further the Memorandum states that these are particularly relevant

    especially in not-well-developed political systems where central banks

    are most vulnerable to outside influence.10

    Whilst a reduction in central bank autonomy is occurring in juris-

    dictions such as Nigeria, in India, calls have been made for legislative

    reforms aimed at preventing the continual undermining and reduction

    of the institutional autonomy of the Reserve Bank of India. The fol-

    lowing are highlighted as issues in need of urgent redress:11

    The over dependency of the government on the Reserve Bank

    of India in generating much needed economic growth throughrate cuts;

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    The conferment by the Reserve Bank of India Act 1934, of a

    temporary status on the Reserve Bank of India, which is considered

    to be an issue which requires urgent and immediate redress;

    The central banks role as an investment bank for government-

    issued debt.

    The aforementioned clearly indicates tensions between government

    and central bank relations. Consequently, this has also had repercus-

    sions for the implementation of fiscal and monetary policy measures.

    Whilst political pressures definitely have consequences for price and

    monetary stability, a decision or response on whether a reduction or

    increase in central bank autonomy is required, will ultimately hinge on

    jurisdictional specific factors which include legal, historical, economic,

    and political factors.

    In an empirical analysis, performed by Moser,12 a distinction is

    made between three groups of countries: those with strong checks and

    balances in their legislation, those with weak checks and balances, and

    those with no check and balances.

    Moserfinds that:13

    1. Countries with strong checks and balances have more independent

    central banks compared to those with weak or no checks and balances.

    2. The countries in the last group have the most dependent central

    banks.

    Such results confirm the importance and need by less developed

    countries, for a greater level of central bank independence (both opera-tional and financial), autonomy and independence from political insti-

    tutions, as well as greater measures to ensure that accountability, trans-

    parency and enhanced disclosures are facilitated.

    Fiscal and Monetary Policy Objectives: The Essence

    of Narrowing the Scope of Inflation Targeting

    The distinction betweenfi

    scal and monetary policy objectives as well asthe focus offiscal policy objectives on growth and employment, and the

    INTRODUCTION xix

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    focus of monetary policy objectives on price stability, is certainly not

    a contentious matter. Lastra makes reference to the dual nature of mon-

    etary stabilityin addition to the internal dimension, there is also an

    external dimension, which refers to the value of the currency. The sta-

    bility of exchange rates (the exchange rate being the price of a currency

    in another currency) and the issue of which is the best exchange rate

    arrangement for a given country.

    Under the Keynesian policy modalities of the 1950s and 1960s

    fiscal policy had primacy and demand management policies (goals of

    growth and employment) were prevalent.

    Should inflation targeting be accorded a more prominent role in

    many jurisdictions or what factors are necessary in order for greater focus

    to be accorded to monetary policy objectives? What reforms will be

    required in order to achieve the objective of according greater priority to

    inflation targeting? Currently in the United Kingdom, efforts are being

    undertaken to recommence with bond purchasing or reduce interest rates

    although it is added that more fundamental changes and reforms will berequired as opposed to a proposed fine tuning of the present scope of

    inflation targeting.

    Other areas worthy of consideration include:

    Merits of targeting the size of the economy in cash terms instead

    of inflation.

    Reviewing the arrangements for setting monetary policies.

    Would merely a cut in interest rates be sufficient to boost the econ-

    omy, given several considerations (among which include the fact that

    banks, building societies interests also need to be taken into account)?

    To what extent does unemployment need to fall before a central bank

    decides to raise interest rates? Why should greater preeminence be given

    to monetary policy objectives than was previously the case? It has been

    demonstrated in several jurisdictions that inflation rates are usually

    higher than their targets and this being consistently the case given theimpact and influence of government fiscal measures on monetary policy

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    objectives. However, an absolute independence of the central bank from

    government (which is certainly not logical or feasible) is not advocated

    for, since there should be some degree of communication between Trea-

    sury and the central bank. The consequences of lack of effective com-

    munication between the regulator of financial services (the FSA), the

    central bank (Bank of England), and the Treasury were evident during

    the Northern Rock Crisis.

    Hence regulatory structural reforms are also required in addition to

    the implementation of certain measures aimed at ensuring that the cen-

    tral bank is not overly influenced by those authorities responsible for

    determiningfiscal policy measures, or aimed at ensuring that the central

    bank is well placed at the required level of communication with those

    authorities responsible for settingfiscal policy measures.

    Furthermore a grant of greater or reduced powers to the central

    bank would also require consideration of the system of checks and bal-

    ances in operation. In view of regulatory reforms, two categories merit

    consideration:

    1. Reviewing the structure of financial regulation (which involveswhether the structure of regulation is that of a unifiedfinancial ser-

    vices regulator or functional regulator. It also involves whether

    greater powers should be granted or entrusted to central banks).

    There are several debates revolving around whether the Fed should

    be granted more powers, given the degree of powers it already pos-

    sesses. However, there are also several grounds for arguing that

    supervisory powers should be transferred back from the United

    Kingdoms FSA to the Bank of England.2. Reviewing the system of regulation (on site and off site system of

    supervision which embraces the financial regulators use of external

    auditors in exercising certain regulatory functions). The use of external

    auditors should also serve as a means of incorporating increased checks

    and accountability into the regulatory process. The transfer of supervi-

    sory powers back to the Bank of England in July 2013 should signify

    an era which introduces (or rather reintroduces) greater implementation

    of external auditors

    expertise in contrast to that which embraced thereduced level of use of external auditors by its predecessor, the FSA.

    INTRODUCTION xxi

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    Focus on low long-term interest rates appear to be a recipe for the

    success attained by Canadas central bank. Should such a policy simply

    be adopted by other jurisdictions or should present existing institutional

    frameworks and historical considerations be taken into account before

    deciding to adopt certain measures? Certainly jurisdictional specific fac-

    tors, as well as legal, political, economic, and other factors which vary

    over time, need to be considered, even though regulatory structural

    reforms may still be required.

    Sola et al.14 argue that the central bank in Brazil has been able to

    gain increasing discipline over the monetary system, partly owing to:

    The economic stabilization plan and, not;

    As a result of prediction premised on conventional wisdom,

    namely, not on the basis of the argument that price stability follows

    from an autonomous central bank. Further, they argue that economic

    stabilization has less to do with getting the institutions right and that

    it is more consequential of a dynamic bargaining game between the fed-

    eral executive, legislators and sub national governments. The substantialshift in the political game between legislators, executive, and governors

    during the 1990s is also highlighted.

    Rogolon adds that the positive theory reveals that the degree of

    independence is negatively correlated with the mean inflation, the infla-

    tion variability, and the inflationary uncertainty, but is positively corre-

    lated with the credibility of monetary policy. And further, that practice

    as regards the Brazilian experience involves discussions of the impor-

    tance of the Central Bank of Brazils independence for the efficiency ofthe stabilization policy, focusing on the periods of high inflation (1980/

    1993) and moderate inflation (1994/).15

    Conclusion

    It was illustrated in the previous section that whilst regulatory structural

    reforms are required in certain jurisdictions before goals relating to price

    stability can be achieved, certain country and jurisdictional experienceshighlight the fact that economic stabilization has less to do with getting

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    the institutions right and that it is more consequential of a dynamic

    bargaining game. Certain jurisdictions have been engaged in legislational

    reforms not necessarily aimed at increasing central bank independence

    but targeted at achieving price and economic stabilization.

    Hence it is to be concluded that central bank independence,

    though an essential contributor to price stabilitydepending on

    jurisdictional considerationscannot be considered to be the sole deter-

    mining factor in predicting a country or economys state of monetary

    stability. Theory appears to support the widely accepted view that cen-

    tral bank independence is a principal contributory factor to price and

    monetary stability. However investigations and empirical evidence relat-

    ing to developed, transition, and developing economies highlight

    distinct trends in relationships between central bank independence,

    price stability, and levels of inflation.

    As concluded by Sola et al., in studying monetary authority and

    central bank institutions, the analyst should identify the relevant actors,

    their interests, and how economic and political conjunctures are able to

    shift the relevant bargaining position of those very actors.16 Moreover,

    as highlighted also by Lastra, central bank independence remains animportant tool in maintaining price stability, particularly in economies

    where the control of the money supply is an important instrument of

    economic policy that can address various political needs, most notori-

    ously the financing of government needs.

    To which it is also to be added that in studying and investigating

    monetary policies and central bank independence, legal, political, histor-

    ical considerations as well as various other jurisdiction specific factors

    also merit special focus.

    INTRODUCTION xxiii

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    CHAPTER 1

    Great Expectations,Predictable Outcomes, andthe G20s Response to the

    Recent Global FinancialCrisis: When Matters

    Relating to Liquidity RisksBecome Equally as

    Important as MeasuresAddressing Procyclicality

    1.1 Introduction

    The meeting of the Governors and Heads of Supervision on September 12,

    2010, their decisions in relation to the new capital framework known as

    Basel III, as well as the endorsement of the agreements reached on July 26,

    2010, once again reflect the typical situation where great expectations

    with rather unequivocal, and in a sense, disappointing results are deliv-

    ered. The outcome of various consultations by the Basel Committee on

    Banking Supervision (BCBS), consultations which culminated in the

    present Basel III framework, also reflects the focus on measures aimed

    at addressing problems attributed to Basel II, that is, measures aimed at

    mitigating procyclicality. This is rather astonishing given one critical

    lesson which has been drawn from the recent financial crisiscapital

    measures on their own were, and are, insufficient in addressing and

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    averting the financial crisis. Furthermore, banks which have been com-

    plying with capital adequacy requirements could still face severe liquid-

    ity problems.

    In addition to an increase of the minimum common equity

    requirement from 2 to 4.5%, the recent agreement and decisions of the

    Governors and Heads of Supervision also include the stipulation that

    banks hold a capital conservation buffer of 2.5%, hence consolidating

    the stronger definition of capital (as agreed in the previous meeting held

    by the Governors and Heads of Supervision earlier in July 2010).

    This chapter considers and highlights the reasons why matters

    related to procyclicality and capital measures should not be the sole

    focus of attention of the initiatives of the G20. In so doing, it kicks off

    with a section which introduces the topic procyclicality, a subsequent

    section that aims to highlight the importance of liquidity risks, and a

    third section that looks into the degree of prominence that the G201

    has accorded to these respective issuesnamely, procyclicality and

    liquidity risks. Having considered these aims, the chapter finalizes with

    a concluding section.

    1.2 Procyclicality

    Procyclicality is a term used to denote the tendency for periods of finan-

    cial/economic downturn or boom to be further exacerbated by certain

    economic policies.

    An example of a fundamental source of procyclicality, as provided

    by the Committee of European Banking Supervisors (CEBS),2 is attrib-

    uted toexcessive risk-taking during periods of expansion, which results

    in the buildup of vulnerabilities.

    Recommendations Put Forward and Highlighted as Means of

    Addressing Procyclicality

    The Basel Committee has proposed to build up buffers aimed at

    addressing and mitigating procyclical effects through a combination of

    countercyclical capital charges, forward-looking provisioning, and capital-

    conservation measures.

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    The promotion of financial stability through more risk-sensitive

    capital requirements constitutes one of Basel IIs primary objectives.3

    However, some problems identified with Basel II are attributed to pro-

    cyclicality and the fact that not all material credit risks in the trading

    book are adequately accounted for in the current capital require-

    ments.4 The procyclical nature of Basel II has been criticized since

    capital requirements for credit risk as a probability of default of an

    exposure decreases in the economic upswing and increases during the

    downturn,5 hence resulting in capital requirements that fluctuate over

    the cycle. Other identified6 consequential effects include the fact that

    fluctuations in such capital requirements may result in credit institu-

    tions raising their capital during periods when it is costly7 for them to

    implement such a rise, which has the potential of inducing banks to

    cut back on their lending. It is concluded, risk sensitive capital

    requirements should have pro cyclical effects principally on under

    capitalised banks.8

    Regulators will be able to manage systemic risks to the financial

    system during such periods when firms that are highly leveraged

    become reluctant to lend where more market participants such ascredit rating agencies are engaged in the supervisory process. The

    Annex to Pro cyclicality9 not only significantly emphasizes the fact

    that regulatory capital requirements do not constitute the sole deter-

    minants of how much capital banks should hold, but also highlights

    the role of credit rating agencies in compelling banks to increase their

    capital levels even where such institution may be complying with reg-

    ulatory requirements.

    Even though the implementation of higher levels of capital bufferscould serve as a means for the management of systemic risks, liquidity

    requirements have also been acknowledged by many as having a funda-

    mental role to play in mitigating contagion, thus assuming a role which

    is similar to that of capital buffers. The link between countercyclical

    buffers, capital, and liquidity standards is further demonstrated through

    the impact generated as a result of the implementation of capital and

    liquidity standards. Countercyclical buffer schemes could serve as a

    means of enhancing the following effects generated by higher capitaland liquidity standards, namely,10

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    making the financial system more resilient and

    reducing the amplitude of the business cycles within the financial

    system.

    The association between systemic risks and liquidity risks and the

    rather apparent lack of due recognition accorded to liquidity risks under

    Basel II constituted other reasons (apart from procyclicality) for the

    growing criticism of Basel II.

    1.3 Liquidity RiskThe definition of liquidity, as provided by Bank for International Settle-

    ments (BIS), is

    the ability of a bank to fund increases in assets and meet obliga-

    tions as they come due, without incurring unacceptable losses.

    The fundamental role of banks in the maturity transformation of

    short-term deposits into long-term loans makes banks inherently

    vulnerable to liquidity risk, both of an institution-specific natureand that which affects markets as a whole.11

    In their report, Addressing Pro cyclicality in the Financial System:

    Measuring and Funding Liquidity Risk, The Financial Stability Forum

    (FSF) noted that at the onset of the recent financial crises, the complex

    response offinancial institutions to the deteriorating market conditions

    was, to a large extent, attributed to liquidity shortfalls that reflected on

    and off balance sheet maturity mismatches and excessive levels of lever-age.12 This has resulted in an increasingly important role for liquidity

    provided by central banks in the funding of bank balance sheets.13

    Furthermore, the FSF highlighted the urgency of both authorities,

    namely, supervisors (in their monitoring of liquidity risks at banks) and

    central banks (in their design and implementation of market operations)

    collaborating in order to restore the functioning of inter bank lending

    markets.14

    As identifi

    ed in the European Central Bank

    s (ECB

    s) FinancialStability Review (December 2009), the specific knowledge that banks

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    possess about their borrowers make bank loans particularly illiquid.15

    The connection between liquidity and systemic risks is further

    highlighted in the review where it elaborates on possible consequences

    resulting from a banks failure:16 the destruction of such specific

    knowledge which banks have about their borrowers and the reduction

    of the common pool of liquidity.17 Such reduction in the common

    pool of liquidity may also trigger the failure of other banks with the

    result that (a) the value of such illiquid bank assets diminishes and

    (b) further problems within the banking systems are aggravated.18

    Endogenous risks could also be generated depending on the type

    of information which the bank possesses about their borrowers and how

    the dissipation of such information to the public, if it has the potential

    to trigger a bank run, can be prevented.

    According Greater Attention to Liquidity Risks

    In February 2008, the Basel Committee on Banking Supervision

    (BCBS) published a paper titled Liquidity Risk Management and Super-

    visory Challenges, which highlighted the fact that many banks hadignored the application of a number of basic principles of liquidity risk

    management during periods of abundant liquidity.19

    An extensive review of its 2000 Sound Practices for Managing Liquid-

    ity in Banking Organisations report was also carried out by the Basel

    Committee as a means of addressing matters and issues arising from the

    financial markets and lessons from the financial crises.20

    In order to consolidate the BCBSs Principles for Sound Liquidity Risk

    Management and Supervision report of September 2008, which should leadto improved management and supervision of liquidity risks of individual

    banks, supervisory bodies will be requiredto develop tools and policies to

    address the procyclical behavior of liquidity at the aggregate level.21

    In responding to the apparent gaps which exist with Basel II, as

    revealed by the recent crises, proposals that are aimed at imposing

    penalties for the occurrence of maturity mismatches22 have been put

    forward.23 The degree of disparity which exists between the maturity of

    assets and liabilities is crucial to determine the state of a companys

    liquidity. Such penalties aimed at deterring the occurrence of maturity

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    mismatches could include higher capital requirements for banks which

    finance their assets with overnight borrowing from the money markets

    than banks which finance similar assets with term deposits.24

    The inability of bank capital to address funding and liquidity pro-

    blems on its own has been acknowledged by many academics. As a

    result, further proposals, in addition to the above-mentioned amend-

    ment to Basel II, have been put forward. These include coupling of the

    existing regulatory framework with capital insurance or liquidity insur-

    ance mechanisms.

    1.4 Mitigating the Procyclical Effects of Basel II

    Basel III and Recent Efforts to Address Procyclical

    Effects of Basel II

    In response to the recent financial crisis and to the realization that capi-

    tal levels (which banks operated with) during the period of the crisis

    were insufficient and also lacking in quality,25 the Basel Committee

    responded by raising the quality of capital as well as its level.26

    Further consequences of the recent Basel reforms also include:27

    a tightening of the definition of common equity;

    limitation of what qualifies as Tier-1 capital;

    an introduction of a harmonized set of prudential filters; and

    the enhancement of transparency and market discipline through

    new disclosure requirements.

    The introduction of Basel II resulted in changes being made to the

    1988 Basel Capital Accord to provide for a choice of three broad

    approaches to credit risk.28 This was introduced into Basel II in view of

    the realization that the optimal balance may differ significantly across

    banks.29 The increased focus on risk (and particularly credit risk)

    resulted from growing realization of the importance of risk within the

    financial sector. The range of approaches to credit risk, as introduced

    under Basel II, and which also exists for market risk, consists of thestandardized approach (which is the simplest of the three broad

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    approaches), the internal ratings based (IRB) foundation approach, and

    the IRB advanced approach.30

    Under the standardized approach, regulatory capital requirements

    are more closely aligned and in harmony with the principal elements of

    banking risk owing to the introduction of wider differentiated risk

    weights and a broader recognition of techniques which are applied in

    mitigating risk.31

    However, problems with Basel II internal credit risk models (which

    relate to the fact that such a banks internal credit risk models were

    overly sensitive in their implementation32 for the calculation of regula-

    tory capital, and generated procyclical effects) were realized during

    the recent financial crisis, as particularly exemplified by the case of

    Northern Rock.

    Do the recent Basel III efforts reflect a situation where some appar-

    ent lessons from the recent financial crisis have deliberately been

    ignored by the G20, or is it yet another case of typical summits which

    generate great expectations but fail to deliver the expected and corre-

    spondingly expected results?

    1.5 Conclusion

    Whilst efforts taken by the Committee (Basel Committee) appear to

    have focused on capitalas evidenced by its Consultative Document on

    Counter Cyclical Capital Buffer Proposalmore forward-looking provi-

    sions as well as provisions that are aimed at addressing losses and unfore-

    seen problems attributed to maturity transformation of short-term

    deposits into long term loans

    would be greatly welcomed. To an extent,this move could address the problem attributed to liquidity risks.

    Further, the CEBS has acknowledged that tools which could be

    implemented as measures for mitigating cyclicality exist beyond those

    measures proposed by the Basel Committee. As a result, it has taken up

    initiatives in relation to measures such as dynamic provisioning and

    supplementary measures that include leverage ratios.33

    Recent efforts aimed at addressing the financial crisis also include

    two new liquidity requirements, namely, the Liquidity Coverage Ratio(LCR) and the Net Stable Funding Ratio (NSFR), which serve the

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    purposes of ensuring that banks have adequate funding liquidity to

    survive one month of difficult funding conditions (the LCR), and to

    address the mismatches between the maturity of a banks assets and that

    of its liabilities (the NSFR).34 Whilst such liquidity requirements

    would help to address the critical issues arising as a result of maturity

    mismatches, the implementation of countercyclical capital buffers as

    well as these new liquidity requirements (the LCR and the NSFR)

    would be bolstered by introducing more forward-looking provisions.

    Despite the above liquidity-related efforts, the results and efforts

    relating to liquidity risks do not correspond to its overwhelming contri-

    bution to the recent financial crisis; neither they accord justice to its sig-

    nificance. The G20s response to the recent crisis could also be regarded

    as a case aimed at appeasing the needs and demands of various jurisdic-

    tions, in relation to those who had favored tougher rules and those who

    had appealed for not too stringent rules. Whilst such a tendency to

    appease the needs of different jurisdictions may serve as a formidable

    weapon in achieving the goal of regulatory convergence, it may also

    serve as a hindrance in the realization of the all-importance objective of

    deterring regulatory arbitrage.Furthermore, given the urgency of addressing liquidity risks and

    maturity mismatches, the transition periods for implementing the two

    new liquidity requirements are questionable even though as with capital,

    consideration is to be had to the impact of limited transition periods.

    In the new economy, information, education, and motivation are

    everything.

    Bill Clinton

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