tag:theconversation.com,2011:/fr/topics/basel-committee-1599/articlesBasel Committee – The Conversation2013-01-11T04:54:26Ztag:theconversation.com,2011:article/115702013-01-11T04:54:26Z2013-01-11T04:54:26ZBy watering down liquidity requirements, Basel III remains a bank’s best friend<figure><img src="https://images.theconversation.com/files/19156/original/k3t5wtbm-1357879709.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Mervyn King has lauded the amendments to Basel III liquidity requirements as a "very significant achievement".</span> <span class="attribution"><span class="source">AAP</span></span></figcaption></figure><p>The Group of Governors and Heads of Supervision (GHOS), the oversight body of the Basel Committee on Banking Supervision (BCBS), met earlier this month to consider the Committee’s <a href="http://www.ft.com/intl/cms/s/0/e4effd30-5820-11e2-b997-00144feab49a.html">amendments</a>to the rules governing the <a href="http://www.bis.org/publ/bcbs238.htm">liquidity coverage ratio</a> (LCR). </p>
<p>As expected, the recommendations were endorsed unanimously. The agreement was hailed as a “clear commitment to ensure that banks hold sufficient liquid assets"—the objective being to make them less vulnerable to unexpected mass withdrawals. Mervyn King, the present chairman of the GHOS and outgoing Governor of the Bank of England, described the agreement as a <a href="http://www.ft.com/intl/cms/s/0/e4effd30-5820-11e2-b997-00144feab49a.html">"very significant achievement”</a>, pointing out that “for the first time in regulatory history, we have a truly global minimum standard for bank liquidity”. This is rather ludicrous: for the first 20 years of its life, the Basel Committee could not care less about liquidity. It took the global financial crisis to convince the BCBS that liquidity does matter.</p>
<p>The objective of these new rules is to “promote short-term resilience of a bank’s liquidity risk profile” by enhancing the LCR, announced initially in 2010 as an integral component of the Basel III accord. According to the new rules, the LCR, which should be greater than or equal to 100%, is defined as the ratio of high quality liquid assets to total net cash outflows over the next 30 calendar days. Eligible assets are cash, central bank reserves, certain marketable securities backed by sovereigns and central banks, certain government securities, covered bonds, corporate debt securities, lower rated corporate bonds, residential mortgage-backed securities, and equities that meet certain conditions. In other words, any asset is a liquid asset, and no one knows what the word “certain” means.</p>
<p>When the agreement was announced, bank shares rallied, which was strange given that this was supposed to be a piece of restrictive regulation. What the Basel Committee did not tell us is that the announcement was a triumph for banks for two reasons. The first is that the original plan was to meet the LCR regulation by 2015 — the deadline has now been extended to 2019. The second is that the rules are much more flexible than the original version, in the sense of being more relaxed on what is considered to be a liquid asset (hence the long list of “liquid” assets). The new rules do not constitute an enhancement, but rather a downgrading of the LCR — a downgrading that has materialised as a result of intense lobbying by bankers. It is rather bewildering that they still receive preferential treatment from regulators at the expense of the rest of the society.</p>
<p>It is not obvious in what sense this agreement is a “significant achievement” for regulators, given that it is the outcome of the BCBS backing down under pressure from bankers. The denominator of the LCR — net cash outflow over the next 30 days — will be estimated by using internal models, which would give banks significant leeway in determining the ratio as they wish. Furthermore, most of the “liquid” assets are not that liquid. With quantitative easing running the current pace, even US Treasuries cannot be relied on as a liquid asset, as many observers predict mass selling as a result of quantitative easing. </p>
<p>Bill Gross of PIMCO, the biggest player in the bond market, declared that he will not buy US Treasuries until quantitative easing (which he describes as a Ponzi scheme) comes to an end. On 12 December 2012, Bernanke announced that he will run quantitative easing at the rate of $85 billion a month until the unemployment rate goes below 6.5%, which is unlikely to happen in Bernanke’s lifetime.</p>
<p>The new rules are no more than a tweaking around the edges of the faulty Basel accords. Introducing a brand new LCR will not solve the fundamental problems of Basel III. It remains backward-looking, a pure exercise in compliance, and a predominantly capital-based regulation that deprives medium and small enterprises from loanable funds. However, the rules will undoubtedly help finance the massive US budget deficit at a time when international confidence in US Treasuries is dwindling.</p>
<p>Mervyn King and his colleagues have chosen to ignore the fact that banking regulation cannot be unified internationally. The same rules cannot be applicable to banks in the US, China, India, Saudi Arabia and the Congo. They cannot be applied uniformly even in Hungary and Russia. The Basel Committee is doing nothing apart from creating unnecessary and expensive regulatory burden and fatigue that will be paid for by bank customers. Long live Basel III, and in anticipation of Basel IV!</p><img src="https://counter.theconversation.com/content/11570/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Imad Moosa receives funding from ARC.</span></em></p>The Group of Governors and Heads of Supervision (GHOS), the oversight body of the Basel Committee on Banking Supervision (BCBS), met earlier this month to consider the Committee’s amendmentsto the rules…Imad Moosa, Professor, Finance, RMIT UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/114882013-01-08T00:29:21Z2013-01-08T00:29:21ZIs the Basel process broken? You can bank on it<figure><img src="https://images.theconversation.com/files/19017/original/w6fv57jj-1357603356.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Earlier this week, Stefan Ingves (left), chairman of the Basel Committee on Banking Supervision's governing body, and Mervyn King announced amendments to Basel III's liquidity rules for banks.</span> <span class="attribution"><span class="source">AAP</span></span></figcaption></figure><p>This year, the Basel process of banking regulation is 25 years old. In 1988, the first set of global banking regulations, known as Basel I, was adopted by the world’s senior banking regulator, the Basel Committee on Banking Supervision (BCBS), which is based in the Swiss city of the same name. There have been three major (and a few minor) iterations of Basel proposals since 1988: Basel II in 2004 and Basel III, which was approved in 2010 after the GFC but revisited only this week.</p>
<p>Pronouncements from the Basel Committee tend to be written in impenetrable, bureaucratic jargon. For example, the latest <a href="http://www.bis.org/press/p130106.htm">announcement</a> is titled “Group of Governors and Heads of Supervision endorses revised liquidity standard for banks”. It could just as easily been labelled “After talking about this for two years, we have given into the banks, yet again”. To use the terminology of the ‘fiscal cliff’, regulators have “kicked the can” down the road, postponing final implementation of a critical component of Basel III, the so-called liquidity coverage ratio (LCR), until 2019 - a lifetime in the financial markets.</p>
<p>Before discussing this latest climb-down, it should be noted that the Committee has form in this respect. </p>
<p>A short history will illustrate how the Basel process has evolved. The first Basel proposal was relatively benign, requiring banks to maintain minimum levels of regulatory capital at a ratio of 8% of their credit risk- weighted assets. This meant that for each $100 of loans, banks had to retain $8 dollars against potential losses. This figure of 8% was arrived by a tortuous committee process that was far from transparent. After agreement, it was decreed that the banks covered by the initial rule would comply over a three-year “transition” period.</p>
<p>One might ask: why would implementation take three years?</p>
<p>Even though the calculation of the minimum capital required was — in the Committee’s own words — “simple”, in practice banks were forced to develop new computer systems and accounting processes to collect the data needed to do the relatively straightforward calculations. This scenario of rule-making, followed several years later by partial implementation is a recurring theme of Basel regulations.</p>
<p>In its first iteration in 1988, Basel I applied only to traditional assets, such as loans, which were “on balance sheet”. “Off-balance sheet” items such as currency and interest rate derivatives were not considered. In 1995, however, the venerable British bank <a href="http://news.bbc.co.uk/2/hi/business/375259.stm">Barings collapsed</a>. Regulators were shocked to discover that these new-fangled derivatives could actually bring down a functioning bank. Reacting late as usual, the Committee hurriedly proposed a new set of rules on the capital required to cover so-called “market risks”.</p>
<p>In 1996, the so-called Market Risk Amendment to Basel I was agreed by the Committee with a new concept, known as value at risk (VAR), embedded in the regulations. The concept of VAR has been the subject of much debate in the academic literature as to its usefulness as a robust measure of risk. Of concern was that fact that VAR does not give a reliable indication of what can occur in an extreme “<a href="http://books.google.com.au/books/about/The_Black_Swan.html?id=YdOYmYA2TJYC&redir_esc=y">black swan</a>” situation. However, despite the obvious drawbacks, VAR became the standard for calculating market risk capital, with disastrous consequences later.</p>
<p>The <a href="http://www.bis.org/publ/bcbs119.htm">1996 Amendment</a> marked a seachange in banking regulation that was not fully apparent at that time. In addition to decreeing a supervisory formulae for each type of derivative (the “standardised model”), the Committee introduced a new concept — the “internal model” — by which a bank could use its own internal calculations to estimate the capital that they needed. In other words, the inmates (i.e. the largest banks) had been allowed to take over the asylum, or at least the Basel capital calculation process. Regulators moved from their traditional role of setting strict limits on banking activity to becoming mere checkers of banks’ own internal models. This was an arms race that regulators were always going to lose, as banks had more money than regulators to buy computers and hire rocket scientists (literally) to develop mind-boggling mathematical models, which, as the GFC illustrated, often worked poorly in practice.</p>
<p>In 1999, the Basel Committee announced plans to introduce a new <a href="http://www.bis.org/publ/bcbs50.htm">capital adequacy framework</a>, which became known as Basel II. The Committee argued that Basel II was necessary because the banking industry had developed risky products that were not covered by Basel I. Boy, were they right!</p>
<p>For the next five years, the Committee toiled to agree on Basel II rules and, in 2004, produced the <a href="http://www.bis.org/publ/bcbs128.htm">“revised framework</a>”, a 239-page document that is utterly incomprehensible, filled with complex formulae for which no theoretical underpinning was ever provided. After four more years and billions of dollars spent complying with new rules, Basel II was implemented in 2008 in some of the world’s largest banking markets. Interestingly, the USA was not one of them.</p>
<p>But by the time that Basel II was finally implemented, it was already too late. Basel II was overtaken by the global financial crisis (GFC), which was exactly the type of credit-related calamity that Basel was meant to prevent. The Basel capital regime failed as supposedly well-capitalised banks (at least according to their own models) had to be bailed out by taxpayers and sovereign wealth funds. All sorts of risks that had been excluded from Basel rules — such as liquidity risks — had torpedoed some of the largest banks in the world, costing taxpayers billions.</p>
<p>Basel was not responsible for the GFC, but it was as useful as an umbrella in a hurricane. During the crisis, when it should have been in the forefront of efforts to tackle the crisis, the Basel Committee was missing in action, while bodies such as the G-20 and the IMF rolled up their sleeves to tackle the problems caused by the obviously insufficient banking regulations developed in Basel.</p>
<p>When the hubbub died down, the Basel Committee did what it does best, which was to issue new rules to fight the last war. In 2010, the Committee unveiled Basel III, which in itself is not an unreasonable set of rules to force banks to maintain capital to cover an increased range of risks such as liquidity risks. Unfortunately, Basel III still does not address some of the key root causes of the GFC, such as the shadow banking problem, or what to do about firms such as hedge funds, whose activities can undermine regulated banks.</p>
<p>What is really depressing about Basel III, is that, before the ink has even dried on the new rules, the world’s largest banks, aided often by their own governments, have found ways around the new rules. Australia is a good example.</p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/19018/original/x23y86kr-1357603363.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/19018/original/x23y86kr-1357603363.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=407&fit=crop&dpr=1 600w, https://images.theconversation.com/files/19018/original/x23y86kr-1357603363.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=407&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/19018/original/x23y86kr-1357603363.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=407&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/19018/original/x23y86kr-1357603363.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=512&fit=crop&dpr=1 754w, https://images.theconversation.com/files/19018/original/x23y86kr-1357603363.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=512&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/19018/original/x23y86kr-1357603363.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=512&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">Even Australia has found a way to circumvent Basel III regulations.</span>
<span class="attribution"><span class="source">AAP</span></span>
</figcaption>
</figure>
<p>During the GFC, a number of failed banks, such as <a href="http://www.economist.com/node/9988865">Northern Rock</a> and <a href="http://www.telegraph.co.uk/finance/financialcrisis/6173145/The-collapse-of-Lehman-Brothers.html">Lehman Brothers</a>, ran out of ready cash to pay the bills - in banking terms, they lacked liquidity. One of the more sensible rules in Basel III is for banks to be forced to maintain sufficient highly liquid assets (HLA), such as government bonds, to tide them over a crisis. The idea is that banks could, in a crisis, sell HLAs to keep them going for about one month, or at least long enough for the government to come up with a plan to bail them out.</p>
<p>So far, so good. But nothing is as easy as it seems, at least where Basel is concerned. Due to successive governments’ aversion to issuing government debt there is, in Australia, a distinct shortage of high-quality HLAs. So what to do? Should we force Australian banks to cut back their highly profitable activities today to comply with foreign banking regulations?</p>
<p>Enter the Reserve Bank of Australia (RBA). In a recent speech, Assistant Governor Guy Debelle <a href="http://www.rba.gov.au/speeches/2012/sp-ag-180912.html">described</a> a rabbit, the so-called committed liquidity facility (CLF), that had been neatly pulled out of the RBA’s hat. Stripped of technical twaddle, the CLF means that the taxpayer (in the guise of the RBA) will act as pawnbroker to the big banks when they are short of readies, taking whatever dross they have on their books and giving them cash to tide them over. With backing like that and the promise of an implicit government guarantee, is it any wonder that Commonwealth Bank’s <a href="http://www.smh.com.au/business/markets/commonwealth-banks-market-capitalisation-rises-above-100b-20130103-2c6yi.html">market capitalisation</a> has just topped $100 billion, pushing it into the list of top 10 banks by market capitalisation in the world?</p>
<p>If Australia is prepared to bend the rules to protect the profitability of the biggest banks, what can be expected of less trustworthy jurisdictions?</p>
<p>After 25 years, it is about time that the question was asked: is Basel doing a good job, and is that job worth doing?</p>
<p>The history of Basel shows that the process of developing robust regulations to prevent international banks failing is broken. The Basel process lacks transparency and accountability and has been captured by the very firms and governments that it is trying to regulate. It is based on inexplicable agreements that are arrived at through a convoluted committee process, producing results that take several years and millions of dollars to implement. The Basel bureaucrats are not evil or incompetent, but are simply outgunned by the bankers, who can afford to keep lobbying until rules are watered down and implementation is delayed.</p>
<p>Basel is broken. We needn’t wait until 2019 — or another GFC — for this to be confirmed.</p><img src="https://counter.theconversation.com/content/11488/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Pat McConnell does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>This year, the Basel process of banking regulation is 25 years old. In 1988, the first set of global banking regulations, known as Basel I, was adopted by the world’s senior banking regulator, the Basel…Pat McConnell, Honorary Fellow, Macquarie University Applied Finance Centre, Macquarie UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/92172012-09-05T20:32:55Z2012-09-05T20:32:55ZCrisis? What crisis? Five years on, we’ve surrendered to the global financial sector<figure><img src="https://images.theconversation.com/files/15009/original/csc4vffp-1346727274.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Taking care of business: given the glacial pace of financial reforms since the GFC, it is not unreasonable to expect another crisis of the same magnitude.</span> <span class="attribution"><span class="source">_Davo_</span></span></figcaption></figure><p>It has been five years since the sub-prime mortgage crisis emerged in the US. This was followed by financial institutions suffering liquidity shortfalls in both US and Europe, and their eventual collapse or public rescue.</p>
<p>What started off as a financial crisis in a limited number of economies affected the broader economy and other countries through the complex linkages of our contemporary global economy. The cost to the general public has been multifold: repossession of homes, job losses, and depreciation in value of investments among others.</p>
<p>Given the extent of the pain that many suffered, there were strong incentives to address shortcomings in the financial sector. Although corrective measures have been adopted in the last five years, progress has been slow and somewhat limited in nature. In light of actual outcomes, we can only conclude that we have a case of business as usual and that another financial crisis will soon reappear.</p>
<p><strong>Modest progress</strong></p>
<p>There was <a href="http://www.parliament.uk/briefing-papers/SN05100">broad consensus</a> at the height of the crisis that three main issues required further attention at the domestic level. One: improving regulatory and supervisory structures over the financial sector. Two: tightening the regulation of activities that financial institutions can conduct. Three: addressing the incentive structure for risky behaviour in the financial sector (e.g. bonuses). Progress on all fronts has been modest.</p>
<p>Let us focus, on developments in the US — the “genesis” of the current crisis and home to the most important financial sector in the world.</p>
<p>Regulators have recognised the importance of shifting their focus from “micro-prudential” (firm level) to “macro-prudential” (system level) regulation. However, there is still a lack of clarity on how this might be implemented and whether regulators would actually be able to identify systemic weaknesses. </p>
<p>An overarching Financial Stability Oversight Council was created to better facilitate ‘macro prudential’ supervision. But there are <a href="http://www.economist.com/node/21547784">signs</a> that actual implementation of the Dodd–Frank Wall Street Reform and Consumer Protection Act (2010) is paradoxically fragmenting the division of labour in supervision. </p>
<p>In addition, in the process of implementing the Dodd-Frank Act, a new raft of complex regulations were created, which are likely to serve as incentives to financial institutions to avoid regulation by shifting activities to as-yet unregulated areas.</p>
<p>Where activities of financial institutions are concerned, the sale of standardised derivatives are being shifted to public exchanges where there will be greater transparency and supervision. There are now also tighter <a href="http://online.wsj.com/article/SB10001424052702303822204577464661833507038.html">rules on proprietary trading</a> by financial institutions. </p>
<p>However, financial institutions are still permitted to “innovate” their products and customised derivatives will remain largely unsupervised under the cover of private trades. In other words, the laws only capture risks that were exposed by the previous crisis while leaving the ability for new risks to be introduced into the market.</p>
<p>Talk of capping bonuses paid to executives has all but disappeared. While there is widespread recognition that remuneration structures should be sensitive to the incentives created, the levels of compensation are no longer questioned. Although this is an important recognition, it is hard to imagine that employees would not take undue risks if it can improve their performance at the work place when potential rewards remain so attractive.</p>
<p><strong>Why has progress been slow?</strong></p>
<p>Lobbying from industry has watered down many of the stronger proposals that were first floated. This is not unique to the US. In the UK, similar developments have transpired. The Chairman of the Independent Commission on Banking <a href="http://www.guardian.co.uk/business/2012/jun/14/vickers-george-osborne-banking-reforms">recently criticised</a> its government for weakening the effectiveness of some of the reform measures that the Commission had earlier proposed. Appeals to protect the “competitiveness” of national markets have also proved to be too alluring to legislators, resulting in a compromise on the “lowest common denominator”. </p>
<p>Some of this might have been mitigated if we were able to harmonise regulations at the international level. However, that is not the case with the exception of capital ratios and very general principles agreed at the Basel Committee on Banking Supervision, to which countries are not obliged to subscribe and if and when they do can be modified through national forms of implementation. Instead, we continue to live with national-based regulatory and supervisory systems while financial markets continue to become increasingly internationalised.</p>
<h2>Business as usual?</h2>
<p>In short, global financial sector reform thus far has really only tweaked the margins. None of the changes challenge the underlying dynamics — where risky behaviour is seen as a form of value creation — nor do they question the increasing disconnect between the financial sector and the “real” economy. The structural (as opposed to institutional) incentives of the contemporary financial system do not leave much room for an optimistic prognosis on the likelihood of future crises. Indeed, economists (such as <a href="http://www.project-syndicate.org/commentary/is-global-financial-reform-possible-">Paul Volcker</a>) consider the most important task of the day to be the development of approaches to deal with the imminent failure of systemically important institutions. Instead of reform, one might argue that we have surrendered.</p><img src="https://counter.theconversation.com/content/9217/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Jikon Lai does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>It has been five years since the sub-prime mortgage crisis emerged in the US. This was followed by financial institutions suffering liquidity shortfalls in both US and Europe, and their eventual collapse…Jikon Lai, Lecturer in International Relations, The University of MelbourneLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/64172012-04-15T23:18:18Z2012-04-15T23:18:18ZA system at risk: the case for regulatory overhaul in Australia’s banking sector<figure><img src="https://images.theconversation.com/files/9576/original/6gf4w7s4-1334295519.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">If one of Australia's big four banks were to fail, it would be disastrous for the economy and the financial system.</span> <span class="attribution"><span class="source">AAP</span></span></figcaption></figure><p><strong>The focus of <a href="http://www.australiancentre.com.au/wp-content/uploads/ANZSFRC-statement-number-10-SIFIs-final1.pdf">the statement by the Australia-New Zealand Shadow Financial Regulatory Committee</a> asks whether the systemic importance of the big four Australasian banks warrants special regulatory treatment. Firstly, what constitutes a systemically important bank?</strong></p>
<p>One of the issues that came out of the global financial crisis was recognition that there are substantial interrelationships between banks, particularly the large, complex banks, which means that if they fail or get into financial difficulty, it creates spillover effects or what is often referred to as negative social externalities, which impact on the functioning of the economy and financial system.</p>
<p>That has led to concerns in regulatory circles about how we best deal with and regulate what are referred to as systemically important banks (SIBs).</p>
<p><strong>What is the Australian government’s policy on dealing with the prospect of bank failure? Is the system well equipped to handle the possibility of contagion, given the interconnectedness of our main financial institutions?</strong></p>
<p>The Australian regulators have done a lot of work over recent years in putting together better plans and mechanisms for dealing with failures of banks. These are good moves, although we still have some issues on how they would deal with one of the the big four, if they were to get in trouble here or in their New Zealand subsidiaries. </p>
<p>In our statement, we’ve coined the phrase “too big to swallow” as being an issue that distinguishes the big four from the other banks in Australia and New Zealand. Traditionally what happens when an institution gets into trouble in Australia has been that the regulator, APRA, has found some way to induce another institution to take over a bank or institution in difficulty. So, it’s able to make a smooth exit without it really being known that it was in difficulty.</p>
<p>The problem with the big four is that they’re too big to swallow. It’s too hard for another bank to quickly and smoothly take them over.</p>
<p>It’s very hard for anyone to know exactly what the losses are for a bank in difficulty. For a bank to take over a large organisation, it would face very substantial risks that would make it hesitant to do so. </p>
<p>In Australia, the only institutions that could take over one of the big four would be another one of the big four. That would create further concerns about increased concentration in banking. </p>
<p>There is a provision under the Financial System Stability Special Account for a standing budget appropriation of $20 billion to help in a takeover of a troubled institution, but that’s nowhere near enough to cover the potential losses associated with one of the big four.</p>
<p><strong>International regulators have recommended additional capital requirements for 29 international banks, but Australia’s big banks aren’t included. Why is that?</strong></p>
<p>The international body looked at 73 large international banks, which included the major Australian banks, but ultimately it didn’t include them in their final list of global, systemically important banks.</p>
<p>It’s a mixture of several things, I think. Australian banks aren’t global. They are very important regionally, but they’re not systemic in that global sense. Also, their activities are much more focused on plain lending - in particular, housing finance - and they have lower involvement in trading activity. From the perspective of global interdependence, that’s probably the reason they weren’t included.</p>
<p><strong>Let’s discuss the idea of special regulatory treatment. What sort of capital requirements and measures would be adequate?</strong></p>
<p>I don’t want to put a number on an appropriate minimum capital ratio requirement. But a higher requirement, and various other sorts of suggestions you hear around the world for dealing with the large banks, are aimed at trying to reduce the probability that they might fail, and trying to reduce the negative external social costs associated with one of them failing. And its worth remembering that governments tend to bail out systemically important troubled banks creating costs for taxpayers. To the extent that people believe that will happen, monitoring and market discipline by bank stakeholders is reduced and bank management incentives for appropriate prudence can be diminished. </p>
<p>The various ways suggested to try and reduce the negative social externalities associated with SIBs include things like stopping them from being so big and interdependent. There are suggestions for forced restructuring or sell-offs and so on. In the UK, the <a href="http://bankingcommission.independent.gov.uk/">Vickers report</a> has argued for retail ringfencing - separating retail banking from their other components, so you don’t get spillover effects.</p>
<p>In the US, the <a href="https://theconversation.com/risks-or-rewards-what-the-volcker-rule-means-for-wall-street-5503">Volcker Rule</a> - named after former Fed Governor Paul Volcker and part of the <a href="http://www.clmr.unsw.edu.au/article/accountability/dodd-frank/will-dodd-frank-ever-work">Dodd-Frank Act</a> - requires separation of proprietary trading by banks to try and stop spillovers. </p>
<p>People have also suggested that we impose taxes on large banks, inducing them to become smaller. There have also been suggestions for living wills (recovery and resolution plans), where bankers are required to have in place a living will that outlines what they will do if the bank starts get into trouble.</p>
<p>The Basel committee has put forward the idea of higher minimum capital requirements for globally systemically important banks (G-SIBs). While not necessarily disagreeing with that, we think, slightly differently, that there is merit in requiring systemically important banks to have some minimum level of <a href="http://lexicon.ft.com/Term?term=contingent-capital">contingent capital</a>. Contingent capital takes the form of hybrid securities which mandatorily convert into equity on certain triggers being hit when a bank is in trouble. That has two benefits. First additional equity is automatically created when it is needed. Second, holders of those securities will be likely to monitor and exert market discipline over the bank given their exposure to it. Of course, the appropriate design of those securities has to be carefully thought through.</p>
<p><strong>You also mention the importance of leverage ratios. Can you explain their role?</strong></p>
<p>One of things that’s happened with the development of bank regulation over the last 20 years is that the Basel committee has continually increased the complexity and intrusiveness of the financial regulations they propose. And over this period the leverage of banks has increased - reflected in ongoing declines in the ratio of common equity to assets (or exposures).</p>
<p>In particular, the focus has been upon having capital requirements that are risk-adjusted, such that if the bank is engaged in risky activity, the bank is required to have a higher capital ratio to act as a buffer to protect depositors against loss.</p>
<p>The trouble is, how do you actually define risk? What we’ve seen over the past 20 years is that is that it is hard to adequately define risk precisely, and there are all sorts of incentives for banks to engage in activities that are not treated as highly risky by the regulators. Financial innovation continually undermines whatever the requirements are.</p>
<p>So, an alternative approach is to put in place a simple, but higher leverage ratio, where the leverage ratio is defined to be a minimum amount of capital relative to the size of its overall exposures. The risk there, of course, is that banks might respond to that by getting into higher-risk activities. But there’s no reason why the regulators, can’t increase the minimum capital ratio that they require for any individual bank. </p>
<p>Our observation is that there’s no clear evidence that this increasingly complexity and apparent sophistication of the risk-based approach has proved to be particularly successful. A careful review of the relative costs and benefits of the complex risk based regulatory approach of the Basel Committee against simpler approaches (recognising of course that good supervision is the key) is, we believe, warranted. </p><img src="https://counter.theconversation.com/content/6417/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Kevin Davis, like most other Australians, owns shares in Australian banks (either directly or indirectly via superannuation), but there are no conflicts of interest relevant to the content of this article.</span></em></p>The focus of the statement by the Australia-New Zealand Shadow Financial Regulatory Committee asks whether the systemic importance of the big four Australasian banks warrants special regulatory treatment…Kevin Davis, Research Director, Australian Centre for Financial Studies Licensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/53642012-02-14T19:15:56Z2012-02-14T19:15:56ZRates of wrath: understanding the Big Four’s actions on interest rates<figure><img src="https://images.theconversation.com/files/7659/original/d97j63dk-1329200511.jpg?ixlib=rb-1.1.0&rect=25%2C9%2C962%2C574&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Decoupled: The Reserve Bank of Australia's decision to hold interest rates has been ignored by the banks.</span> <span class="attribution"><span class="source">AAP</span></span></figcaption></figure><p>Last week, the Reserve Bank defied market expectations to announce the 4.25% cash rate would remain unchanged. But the surprise decision by Australia’s Big Four banks to act independently of the Reserve Bank and raise their standard variable interest rate- even as they announce record profits - has caused much ire among customers and Treasurer Wayne Swan.</p>
<p>Are these interest rate hikes justified? Professor Kevin Davis from the University of Melbourne argues that although the banks are looking to protect their profits, the rising cost of funding - not to mention structural challenges in the sector - are driving the increases. </p>
<h2>Australian banks have justified interest rate hikes as a necessary, arguing global repricing of bank debt has made wholesale funding more costly. Is this the main motivation behind the rate hikes, or does Wayne Swan’s “bank bashing” have some merit?</h2>
<hr>
<p>I think it’s certainly the case that Australian banks are experiencing changes in the costs of various parts of their funding. Part of the problem in this area is that it’s very hard, for anybody outside of the banks’ treasuries, to really know exactly what the cost of funds for banks are. The reason for that is because they raise funds for deposits by borrowing in international capital markets. I think for the moment, what one can say, is that given the state of nervousness in international capital markets, the cost of raising funds has probably gone up. But at the moment, the banks also are in a situation where they’re rolling over a lot of the borrowing that they did during the global financial crisis under the federal government’s guarantee.</p>
<h2>Could you elaborate on that guarantee?</h2>
<hr>
<p>After Lehman Brothers collapsed, in October 2008, the federal government introduced a scheme whereby Australian banks borrowing in international capital markets could, for a fee, get a government guarantee over those borrowings. That enabled them to continue accessing capital markets in a time where it was almost impossible to do so otherwise, particularly as other governments had commenced providing similar guarantees. The Australian banks borrowed quite substantial amounts of money over the next year or thereabouts in those international capital markets, paying the fee to the government for a guarantee. A fair proportion of those borrowings would be due now or in the next year, and the banks have to replace those borrowings by borrowing without the guarantee. So, one of the issues is the extent to which the cost of that replacement funding is greater than what they were paying on those previous borrowings. </p>
<p>It’s a bit hard to work out what the exact effects are. I think one can safely say that the banks wouldn’t be seeking the political bashing that they’re getting, and we would need to accept that their actions indicate the cost of funding has gone up.</p>
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<img alt="" src="https://images.theconversation.com/files/7663/original/f8n894qk-1329200835.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/7663/original/f8n894qk-1329200835.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=907&fit=crop&dpr=1 600w, https://images.theconversation.com/files/7663/original/f8n894qk-1329200835.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=907&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/7663/original/f8n894qk-1329200835.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=907&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/7663/original/f8n894qk-1329200835.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=1139&fit=crop&dpr=1 754w, https://images.theconversation.com/files/7663/original/f8n894qk-1329200835.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=1139&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/7663/original/f8n894qk-1329200835.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=1139&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<span class="caption">Treasurer Wayne Swan has urged unhappy customers to ditch their banks.</span>
<span class="attribution"><span class="source">AAP</span></span>
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</figure>
<h2>Does the considerable reliance on overseas funding by Australian banks present a structural problem?</h2>
<hr>
<p>It’s a structural problem in the Australian economy more generally, as we are running a current account deficit on our balance of payments. There has to be capital inflows in some form to finance the deficit. Historically, this has primarily been done by the Australian banks, because it’s been easy for them to borrow in international capital markets. Having said that, they’ve reduced their reliance on international capital over the last few years. One of the relevant issues of the moment is the much slower growth in Australian financial markets, in terms of lending growth. There is much less need for banks to borrow in international capital markets because, in a sense, their balance sheets aren’t growing at the rates that they were before the global financial crisis, when they were relying very heavily on international capital markets to support their growth. </p>
<h2>How will the capital reforms and liquidity requirements in Basel III affect Australian banks?</h2>
<hr>
<p>There are two major reforms in Basel III. One is the capital requirements. I think, in the case of Australian banks, that there’s not a lot to get concerned about because our banks already have pretty high capital ratios. Even though APRA is implementing a much more rapid timetable of bringing in those changes, the Australian banks are well-placed to meet those. It’s not really clear to me that those increased capital requirements will be a major driver in terms of increasing the cost of funding for banks, partly because our dividend imputation taxation system reduces the tax benefits of debt/deposit funding.</p>
<p>A more relevant issue is the liquidity requirements. There are two liquidity requirements: one is the liquidity coverage ratio, requiring banks to hold a certain amount of highly liquid government securities, which, however, aren’t in large supply in Australia. The Reserve Bank has introduced a facility where the banks - rather than competing in the capital markets over the short supply of eligible securities - can pay a fee for an overdraft facility with the central bank. </p>
<p>The other liquidity requirement is the stable funding ratio. Shorter term borrowing in international capital markets isn’t viewed as a stable source of funding. There are pressures on the banks to move towards getting more domestic term deposit funding, but that’s also a limited market. Whether those things increase the cost of funding by much is, again, a difficult question - but I wouldn’t have thought it’s a major issue either. </p>
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<img alt="" src="https://images.theconversation.com/files/7662/original/jhhwhsys-1329200749.jpg?ixlib=rb-1.1.0&rect=468%2C27%2C522%2C629&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/7662/original/jhhwhsys-1329200749.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=399&fit=crop&dpr=1 600w, https://images.theconversation.com/files/7662/original/jhhwhsys-1329200749.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=399&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/7662/original/jhhwhsys-1329200749.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=399&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/7662/original/jhhwhsys-1329200749.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=501&fit=crop&dpr=1 754w, https://images.theconversation.com/files/7662/original/jhhwhsys-1329200749.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=501&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/7662/original/jhhwhsys-1329200749.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=501&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<span class="caption">ANZ was the first of the Big Four banks to independently raise rates.</span>
<span class="attribution"><span class="source">AAP</span></span>
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<h2>Back to interest rates - clearly banks have a duty to maximise shareholder returns and protect profit margins. But given rising levels of public resentment, could this decision actually harm them? Will we see people switching en masse to non-bank lenders?</h2>
<hr>
<p>Certainly, all the political hassle doesn’t help the banks with their reputation. It is the case that the government has introduced legislation to make it easier for borrowers to switch banks, so that people with housing loans - who don’t like what the banks are doing - are able to switch. One of interesting things to note is that a major source of competition in the housing loan market is securitisation, whereby capital markets fund mortgage loans created by mortgage originators, or by banks or other institutions. One of the things we can see at the moment is that there’s been not much activity in that market in terms of standard securitisation issues since the start of the year. What that suggests is that those securitisers aren’t able to get funding at cheaper rates than the banks claim they’re facing and, because of that, they’re not able to make loans on competitive terms with the banks. The capital market situation is such that the securitisers aren’t able to compete at current housing loan interest rates, which the banks could point to and say that it reflects the problems they’re facing as well. Now, that might change quite rapidly if international capital markets settle down - but that’s a big “if”. </p>
<h2>There have been concerns over the lack of competition in our financial sector. Is this is a valid claim, or is the level of concentration the price we pay for a robust and stable banking industry?</h2>
<hr>
<p>There’s always a debate about the interrelationship between concentration and competition. The Australian banking sector is probably a bit more concentrated than most other banking sectors. Australian concentration has gone up, in terms of the small number of institutions that dominate our loan and deposit market since the global financial crisis. There’s certainly quite a lot of competition in particular markets amongst the banks, and that competition points to the level of concentration not suggesting there is an absence of competition. </p>
<p>But at the same time, we do know that the Australian banks are quite profitable. The Australian banks are probably in the upper end in the profitability stakes internationally; of course, given the state of most
banking sectors in the rest of the world, it certainly isn’t very hard. My impression is that Australian banks probably have higher profitability than banks elsewhere, which may reflect the state of competition and concentration. On the other hand, a lot of people say that it’s better to have a profitable banking sector than a broken one. </p><img src="https://counter.theconversation.com/content/5364/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Kevin Davis, like most Australians (via their superannuation or other investments), owns shares in a number of banks!</span></em></p>Last week, the Reserve Bank defied market expectations to announce the 4.25% cash rate would remain unchanged. But the surprise decision by Australia’s Big Four banks to act independently of the Reserve…Kevin Davis, Research Director, Australian Centre for Financial Studies Licensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/37312011-10-07T03:18:40Z2011-10-07T03:18:40ZCan ‘living wills’ protect the banking system?<figure><img src="https://images.theconversation.com/files/4207/original/ecb2.jpg?ixlib=rb-1.1.0&rect=164%2C73%2C3778%2C2482&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Euro banks have been urged to reinforce their balance sheets.</span> <span class="attribution"><span class="source">AAP</span></span></figcaption></figure><p>Eurozone leaders have moved to address liquidity fears, with the European Central Bank announcing <a href="http://www.smh.com.au/business/world-business/ecb-holds-rates-but-offers-banks-a-lifeline-20111007-1lc2k.html">new measures</a> to head off a credit crunch. Britain has also announced quantitative easing measures.</p>
<p>Outgoing European Central Bank President Jean-Claude Trichet has urged banks “<a href="http://www.bloomberg.com/news/2011-10-06/trichet-s-opening-remarks-at-ecb-s-press-conference-text.html">to do all that is necessary to reinforce balance sheets”</a>, as efforts continue to rescue Franco-Belgian banking group Dexia, in trouble due to its significant exposure to Greek and Italian debt.</p>
<p>One recent suggestion to prevent contagion among troubled banking institutions has been the concept of banks preparing “living wills” - a basic plan of how a bank could be pulled apart without damaging the broader industry. </p>
<p>The <a href="http://www.financialstabilityboard.org/">Financial Stability Board</a> has been asked to report a detailed plan to the next G20 meeting in November.</p>
<p>Professor Kevin Davis, Research Director at the Australian Centre for Financial Studies at University of Melbourne explains the concept.</p>
<h2>What do living wills mean for banks?</h2>
<p>One of the things that came out of the global financial crisis was general recognition that the powers of the regulators to resolve a troubled financial institution are not as good as they should be, so that when large banks get into difficulty we find there are all sorts of problems in them making a smooth and graceful exit from the industry. </p>
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<img alt="" src="https://images.theconversation.com/files/4201/original/trichet.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/4201/original/trichet.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=902&fit=crop&dpr=1 600w, https://images.theconversation.com/files/4201/original/trichet.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=902&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/4201/original/trichet.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=902&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/4201/original/trichet.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=1133&fit=crop&dpr=1 754w, https://images.theconversation.com/files/4201/original/trichet.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=1133&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/4201/original/trichet.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=1133&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<span class="caption">Reinforce balance sheets: Jean-Claude Trichet.</span>
<span class="attribution"><span class="source">AAP</span></span>
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</figure>
<p>So part of the attention of regulators around the world has been to try to find ways to improve that whole process. That involves looking ahead and saying, if an institution gets into trouble, what’s involved in helping it exit the industry in a way that doesn’t disrupt the financial system and also makes life easier for customers?</p>
<p>The notion of living wills relates to the fact that regulators are planning to require large institutions to develop a “book” they can take off the shelf that would say if we get into trouble, here are the issues that will have to be worked out in terms of pulling the institutions apart and possibly transferring its business to other institutions.</p>
<h2>Why isn’t there something like this in place already?</h2>
<p>I think these things aren’t in place because people tend to work on the assumption that you are going to live forever. </p>
<p>Financial institutions and companies in general typically operate on the principle that they are going to survive and be profitable and should they get into a situation where there is a risk of trading when insolvent, then standard bankruptcy or insolvency procedures would come into play, with administrators or receivers appointed. </p>
<p>We do have those resolution mechanisms in place, but they don’t work well in the case of financial institutions where there are large amounts of outstanding creditors to repay. So resolution becomes a lot more messy.</p>
<p>Also, these large organisations are operating across borders and there are very significant problems in trying to develop resolution procedures across countries that fit together well. </p>
<p>In Australia, we recently passed legislation that adopted the UN’s model guidelines for resolution of international institutions. </p>
<p>If a subsidiary operating in Australia fails, it would normally be administered by a local entity and liquidation would proceed under Australian court rules.</p>
<p>Under the new legislation, if there is an insolvency process going on for a parent, then Australian arrangements would be subsumed under those more general insolvency arrangements. </p>
<p>In the case of banks, we have situations where there are large amounts of obligations to domestic creditors where it becomes a lot more complicated.</p>
<h2>And how will banks respond?</h2>
<p>It’s a complex task and a very big ask of management. But on the other hand, for bank boards it’s probably a very good process to go through in the context of actually understanding more about the nature of their institutions, the inter-relationships between various parts of it and the things that could go wrong and what you might do to prevent things going wrong. And importantly, how you could act quickly when things do go wrong and head it off at the pass.</p>
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<img alt="" src="https://images.theconversation.com/files/4200/original/dexia2.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/4200/original/dexia2.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=900&fit=crop&dpr=1 600w, https://images.theconversation.com/files/4200/original/dexia2.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=900&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/4200/original/dexia2.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=900&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/4200/original/dexia2.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=1131&fit=crop&dpr=1 754w, https://images.theconversation.com/files/4200/original/dexia2.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=1131&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/4200/original/dexia2.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=1131&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<span class="caption"></span>
<span class="attribution"><span class="source">AAP</span></span>
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<h2>So could this ensure we don’t see a repeat of the spectacular bank crashes we saw in 2008?</h2>
<p>You may still get spectacular collapses but one would hope that regulators in particular will be able to step in much more quickly in conjunction with the managers of the bank and effectively organise things such as a transfer of business, by being able to identify which bits of the business can be separated and sold off or merged into some other viable entity and which bits need to be wound down. </p>
<p>And in a sense, that is really one of the critical issues. In a bank failure, there will generally be some good and bad parts of the bank. You want to be able to separate those bits out in such a way that you can keep the good bits going without too much disruption to the economy, but manage the bad bit out of the industry.</p>
<p>The main benefit is that you have this living will and that you never have to execute it, so the main process is one of discovery about potential risks and issues. </p>
<h2>Do we need something like this in Australia?</h2>
<p>My <a href="http://www.abc.net.au/news/2011-07-20/apra-asks-banks-for-living-wills/2803170">understanding is it one of the things on Australian Prudential Regulation Authority’s (APRA) agenda</a>. It is something they will be focussing on for the very big banks because of the G20 and the Basel Committee’s reform agendas. It will be expected of large banks in all countries and so you’d expect it to be be part of the APRA tool kit.</p>
<h2>Troubled bank Dexia passed a stress test just three months ago. Could living wills help here?</h2>
<p>A living will would tell you what to do when you don’t pass a real live stress test. Any stress test involves a set of hypothetical assumptions about what scenario you are choosing to test them against and you won’t always pick the one that happens. There are lots of cases where stresses could arise - such as after Lehman Brothers when international capital markets froze up - and one of the real issues in banking is that organisations that are essentially viable and solvent suddenly find a liquidity crisis hits and funding dries up. </p>
<p>They then become forced to make a fire sale of assets and it then creates a situation where selling assets at depressed market prices puts them into insolvency, which is of course not what you want. </p>
<p>Trying to ensure there is adequate liquidity and government support in appropriate ways that convinces the market that they needn’t run on this bank, is very important.</p><img src="https://counter.theconversation.com/content/3731/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>The author holds shares in a number of Australian banks</span></em></p>Eurozone leaders have moved to address liquidity fears, with the European Central Bank announcing new measures to head off a credit crunch. Britain has also announced quantitative easing measures. Outgoing…Kevin Davis, Research Director, Australian Centre for Financial Studies Licensed as Creative Commons – attribution, no derivatives.