Is a stable financial system better than a profitable one?

Since the 2008 financial crisis, governments and authorities have been issuing a number of regulations in order to prevent the systemic risk from generating negative consequences on the financial system once again.

The 2007 events related to the US housing market and its consequences on the global financial markets were caused by different factors, such as:

  • The financial deregulation started in the ‘70’s;
  • The abuse of financial derivatives, like MBS (mortgage backed securities) and CDO (collateralized debt obligation);
  • The overall level of financial leverage in the economy.

These elements were the cornerstone of the systemic risk increase in financial markets.

Focusing on Europe, the regulation in force during the banking system “contagion” in 2008 was the so called “Basilea 2”, the application of which started in January 2007.

Basilea 2 framework was based on three points:

  • Minimum capital requirements: banks obliged to maintain a level of capital proportional to the current level of risk weighted assets (RWA);
  • Supervisory review process: a mechanism which requires banks to adopt valuation measurement tools of their risk profile (e.g. ICAAP – internal capital adequacy assessment process);
  • Market discipline: enhanced transparency in relation to capital requirements and risk evaluation processes.

Some differences were introduced in April 2008 through “Basilea 2.5” but the material impact on financial markets has come from the introduction of “Basilea 3”, a 2010 agreement then implemented in 2014 through the directive CDR4 (e.g. Capital Requirements Directive 4) and the regulation CRR (e.g. Capital Requirements Regulation).

This new framework has introduced new restrictive rules, among others, about minimum capital requirements, liquidity limits and financial leverage.

The minimum capital structure of Basilea 2 was composed of:

  • 2 % of RWA (e.g. risk weighted assets) of Common Equity Tier 1
  • 2 % of RWA of Hybrid Tier 1
  • 4 % of RWA of Tier 2

Going up from Common Equity Tier 1 to Tier 2 there is a declining level of subordination in the loss absorbing mechanism. Conversely the financial instruments used to build on this structure show declining riskiness.

Basilea 3 has adopted the following changing to the existing structure:

  • Increased the Common Equity Tier 1 of 2.5%
  • Removed the Hybrid Tier 1
  • Added 1.5% of Additional Tier 1
  • Reduced the Tier 2 of 2%

Overall, the minimum capital required has been hold at 8% of RWA.

Furthermore, some capital “Buffer” have been introduced:

  • Systemic Buffer (from zero to 2.5% of RWA)
  • Capital Conservation Buffer (2.5% of RWA)
  • Countercyclical Capital Buffer (from zero to 2.5% of RWA)

These new rules aim at making the banking system more stable by requiring capital quality enhancement, providing banks with additional loss absorbing buffers and implementing a countercyclical mechanism, which should help the economies during downturn periods.

While Basilea 3 was being implemented, a new directive has been introduced, called BRRD (Bank Recovery and Resolution Directive). This rule gives more efficient instruments to prevent financial crisis, plan early crisis management and introduces the financial tools for bank resolution, as an alternative to liquidation.

The directive provides the supervisory authorities with the tools to request banks to implement reorganization plans. Furthermore, authorities are required to prepare banks resolution plans in advance of the crisis manifestation. When the solution for banks’ solvency problems is a resolution mechanism, it must be managed through private transactions before resorting to public aids.

In November 2015, the Financial Stability Board (FSB) issued the TLAC (e.g. Total Loss Absorbing Capacity) provisions. These are conceived to reduce systemic risk and provide banks with a better capacity to absorb losses. In particular, Global Systemically Important Banks (GSIB) are required to reach a TLAC of 16% in relation to RWA by 2019 and a 18% by 2022.

Source: Credit Suisse

Considering this regulatory wave, which started to have impacts on the financial world since 2008, it has been underlined the actual tradeoff between a higher level of banks capital solidity and their profitability. In fact, the more capital the banks have to put aside to grant the financial stability, the less productive that capital will be.

From one point of view, it is of course desirable to have a more stable financial system and mechanisms which allow banks with solvency problems to be “bail-in-able”, in alternative to the public sector saving them, as for the subprime mortgages crisis. From another point of view, the managerial one, to put aside that considerable amount of money without investing it in more profitable assets may bring to disappointing growth. This tradeoff represent a pivotal challenge for the financial system.

Andrea Tundo, Alessia Santoro

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