Basel III: ‘The only game in town’
Hyun Song Shin interviewed by Viv Davies, 25 March 2011
Hyun Song Shin of Princeton University foretells Viv Davies about his current focus on global liquidity and highlights the paradox of the way the US, while being the biggest net debtor on earth, is also a considerable net creditor in the global bank operating system. In addition they discuss the Basel III requirements, bank capital ratios and the lending capacity of bank equity. Shin stresses the need for international coordination to the success of financial and regulatory reform. The interview was recorded in Washington DC in March 2011 at the IMF conference, ‘Macro and Growth Policies in the Wake of the Crisis’. [ Also browse the transcript ]
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Viv Davies interviews Hyun Song Shin for Vox
Transcription of a VoxEU audio interview [
Viv Davies : Hello, and welcome to Vox Talks, a number of audio interviews with leading economists from all over the world. I’m Viv Davies from the guts for Economic Policy Research. It is the 8th of March 2011, and I’m in Washington D.C. attending a conference hosted by the IMF on Macro and Growth Policies in the Wake of the Crisis. I’m speaking with Hyun Song Shin, Professor of Economics at Princeton University. Professor Shin discusses the primary points of the presentation he gave at the conference on capital flows between advanced and emerging economies. He also discusses his views on Basel III, capital ratios, and macro prudential policies. I began the interview by asking Professor Shin to briefly outline the primary points of his earlier presentation on global liquidity.
Hyun Song Shin : The reduced interest policy and the expanse of monetary policy pursued by the advanced countries in the aftermath of the crisis has tripped a fierce debate about capital inflows to emerging markets, and about carry trades, and the down sides that that creates for the monetary policy of the administrative centre recipient country, etc. Which raises some fundamental issues about the role of the U.S. dollar. I believe we are fairly acquainted with the role of the U.S. dollar, for example, the currency that’s used for invoicing, and for that reason, the currency that’s used to stay real transactions. And in addition, we’re relatively acquainted with the role of the dollar as a global reserve currency. It’s a currency that’s used as a store of value.
However the dollar can be the currency that underpins the global bank operating system, in the sense that it is the funding currency of preference by the global banks. And why by that’s if we consider the cross border flows of dollar funding that’s raised in the U.S. capital markets, a whole lot of this goes via the U.S. branches of the foreign banks back again to the top office. One way we are able to gauge that’s through the inter office accounts of the foreign banks in the U.S.
What we see is that from the mid 80s onwards, we visit a very rapid growth in the quantity of funds that’s channeled from the U.S. by the foreign banks. And lots of these banks will be European banks. And one way we are able to gauge who these actors are is to look over the set of those banks that received liquidity support through the recent financial crisis, therefore the banks that received the Federal Reserve Term Auction Facility, for example.
The big U.S. banks are represented there, a lot of the banks are actually European banks too. And because these global banks could have portfolio decisions concerning how exactly to deploy the funds that they’ve raised, they, in place, become the carrier of liquidity conditions across borders.
Which means you have something of a paradox really that the U.S. is, in ways, the largest debtor country, vis-a-vis, all of those other world. However in the banking sector, they will be the biggest net creditors, in the sense that the total amount that foreign banks remove of the U.S. is a lot larger than the total amount that the foreign banks bring in to the U.S. from their hq. Therefore the U.S. is a net creditor in the banking sector though it is an extremely large debtor overall. So in place, the U.S. borrows long and lends short through the banking sector.
So among the ramifications of this will be that through the portfolio decisions. so whenever a European bank borrows dollars in the U.S. capital markets and decides how exactly to deploy those funds, at the margin they’ll need to earn an identical rate of return wherever they deploy the funds. So if there’s very ample liquidity conditions and funding is quite cheap in the U.S., through the actions of the global bank operating system that liquidity condition will be transmitted during that portfolio decision.
On the other hand, since it were, the portfolio decisions of the global banks will manifest themselves by means of capital inflows, through increases in the banking sector loans to emerging market banks, for instance. So emerging market banks who borrow in dollars will be borrowing from other banks, specifically, global banks. And capital inflows through the banking sector which build-up the vulnerability to future deleveraging will be very much among the consequences of the liquidity flow.
Viv : A few of these ideas came from a brief paper you wrote recently titled "Macro Prudential Policies Beyond Basel III." You begin that paper by stating that “in its current form, Basel III is nearly exclusively micro prudential in its focus, worried about the solvency of individual banks, instead of being macro prudential and worried about the resilience of the economic climate all together”. What did you mean by that?
Hyun : I had been somewhat provocative with that statement. I believe one particular associated with Basel III may possibly disagree with that statement. But what I was trying to highlight was the actual fact that the core elements which have now recently been agreed, – and also have now an agreed group of standards – are almost exclusively micro prudential, in the sense that they pertain to individual bank capital ratios. Therefore the core of Basel III is a requirement that banks hold common equity of seven percent of risk rated assets.
And there are associated liquidity rules, and there are associated rules on leverage, on liquidity, and so forth, which is phased in over an extended period. So they are micro prudential, in the sense that they pertain to losing absorbency of bank capital. If the bank’s loans go south, then your bank has enough equity to soak up the losses.
I think among the problems in concentrating on the increased loss of absorbency of capital and capital ratios is that it diverts attention from the full total size of assets, and specifically, how fast assets are growing in a boom. So if you have the banking sector whose loan book is increasing at, suppose, 20 25% a year, that is a speed which far outstrips the growth of the true economy. Therefore, the financial sector is now very large.
And even during this expansion, we would start to see the capital ratios of the banks looking very, very healthy, because throughout a boom, the profitability of banks is quite high. And calculated risks, when you look at market prices, or look at market indicators of risk, they indicate very benign market environments. In order that when you calculate the chance rated assets which may be the capital over the chance rated assets of the lender a bank can look very, very healthy. But that still masks the underlying vulnerability to a downturn.
Viv : Basel I and Basel II succeeded each other and took around a decade each, I believe, to implement. Would you anticipate Basel III to be any not the same as that? If not, it will likely be around 2018 by enough time the recommendations are fully implemented, where time, I would believe lots of the recommendations and proposals will be irrelevant. Do you consider that is clearly a problem?
Hyun : Well actually, Basel III was already agreed. And I believe one of the good stuff about Basel III is how rapidly the agreement was reached. And the essential blocks were all agreed in September of this past year. There are a couple of loose ends related to systemically important finance institutions, and some of the facts with the liquidity rules etc, but Basel III was already agreed. This is among the differences between Basel III and its own two predecessors. In the sense that, the sense of crisis concentrated minds into arriving at an extremely rapid agreement. My point, rather, is that the elements which were most easily agreed were those that, in ways, were least controversial. And what’s least controversial will not be what may be most reliable going forward. I believe it’s that contrast that I needed to indicate in this memo.
Viv : From what extent, if, will be the ideas and suggestions about risk and capital requirements etc reflected in the Dodd Frank Act?
Hyun : The Dodd Frank Act will focus a lot more on the legal structure and on the processes, instead of on the substance. I believe what the Dodd Frank Act is, in a few ways, complementary, or in a few ways it is also tangential to the debate about capital and about these other quantitative restrictions. So, it’s a thing that has been driven by U.S. agenda. It is due to the reform of the regulatory structure and about establishing of new institutions, including the Financial Stability Oversight Council, and about the brand new consumer protection regulator, etc. Whereas, the discussion in Basel III have focused a lot more on the detailed capital rules which will be imposed to the internationally active banks.
Viv : Would you say that the U.S. has been making more progress in these areas than Europe?
Hyun : In a few respects the U.S. has been making some progress, but I believe the best success or failure should be observed in terms of how effective a number of the institutional reforms could have been, given time.
Viv : Let me talk just a little about developing countries. Developing countries take into account almost half of global growth, and one atlanta divorce attorneys three banks can be situated in those countries. A potential issue is, perhaps, that developing economies’ markets will not be deep enough to improve the capital dependence on the banks, and borrowing internationally is probably not a choice. So, given the main one size fits all nature of the Basel III proposals, could this perhaps undermine efforts to determine a far more stable global economic climate?
Hyun : No. On the other hand, I believe for developing countries, their banking regulation had been a lot more stringent than for the advanced countries, and capital ratios will never be a problem for some of the emerging market countries. Actually, in those countries that experienced the emerging market financial crises of the 1990s, they curently have very, very stringent financial regulations rules and far higher capital ratios than even the numbers that are mentioned in Basel III. There exists a more general point about the result of financial regulation on financial intermediation activity. So, one argument you frequently hear is that excessive regulation will choke off funding to borrowers, and, actually, that it is the eventual borrowers who’ll be experiencing excessive regulation.
I think we need to be clear in regards to what the arguments are. I believe if we announced today that each bank must double their capital ratios, then your likely consequence of this is that would generate an extremely large incentive for the lender to meet up those capital ratios, not by raising new equity, but by shrinking assets.
And, if that’s so, then clearly, that may result in scarcer credit and also have a direct effect on the economy. If the additional capital is raised by retention of profits or by raising of new equity, i quickly the effect is a lot more benign.
And we saw through the U.S. bank stress test outcomes, for example, in ’09 2009, that whenever push involves shove, and when a few of the stigma mounted on the bank’s raising of new equity is removed by this coordinated proceed to raise new equity of the banking sector all together, then the banks can raise new equity.
And, if the banks raise equity, that’s money which can be lent out. And not just could it be lent out, the increased equity will raise the ratio of capital to the full total assets of the lender. Therefore, it actually generates very good incentives and also gives resilience to the bank operating system, as well.
The theory that somehow equity is expensive has really happen very recently, in the sense that banks are targeting, or used to focus on, 20 percent return on equity. But we ought to take a lengthy run view of the, for the reason that it wasn’t forever that the banks have already been targeting 20 percent return in equity. The banks used to have higher capital ratios, if we look back 50, a century.
This implies that if a bank includes a massive amount equity, that is money which can be lent out. It isn’t that the equity must stay static in some inert form, as in cash, that’s not lent out. The equity could be lent out. It’s that of the amount of money that’s lent out, a whole lot of it is by means of the owner’s stake, instead of money that’s borrowed from either depositors or from the administrative centre market.
Viv : I see, and how important, do you consider, is international coordination in banking regulation and financial reform? Or is there fundamental differences, for instance, between your U.S. and Europe, regarding what’s required in the years ahead?
Hyun : International coordination is vital, in the sense that banking regulation always has both of these aspects. On the main one hand, the domestic regulator would want to impose regulations to insure stability of its banking system and economic climate. But, alternatively, the regulator, wearing the hat of the champion of the national banking industry, or the national financial industry, won’t want to handicap its domestic institutions unnecessarily in the global marketplace. So, really, virtually once you have global competition in the banking industry or in the financial industry generally, the regulators and the financial policymakers will always confront this problem. Do you drop hard by yourself institutions to preserve stability, or do you truly provide them with a competitive edge so that you can pursue the national interest?
And by having international coordination, you can mitigate that dilemma somewhat by insuring that whatever is agreed is applied uniformly. So, that the standards are applied in a good way, in order that there’s an even competitive playing field. But that competitive playing field must have sufficient prudential safeguards in order that it is not only your banks, but also, the global economic climate that’s safeguarded.
Viv : Are you optimistic about the near future for regulatory reform and global financial recovery?
Hyun : I believe what we’ve seen with the Basel III process is that as the crisis abates, the urgency with that you pursue financial reform is somewhat dulled along the way. So, the actual form, the agreed type of Basel III certainly will be much less comprehensive than a few of the initial aspirations might have been. But, nevertheless, what the Basel III process shows, and what the G20 process shows, in general, is that is really the only game around. And that we need to persuade sovereign countries, whose interests have become closely interlinked, to coordinate their policies. There will inevitably be give and take, but this can be the best that people have, and we must make the very best of it.
And, up to now, it’s worked pretty much. I believe last year’s G20 in Korea, I believe, is an excellent example. I believe The Economist magazine called it "urgent incrementalism," for the reason that the changes are pretty incremental, but it’s probably faster than the pace of which a number of these international negotiations follow.
Viv : Hyun Song Shin. Thanks quite definitely for talking to us today.
Hyun : Many thanks very much.