Hello, everyone. Welcome to the second video of the first week of the MOOC Global Financing Solutions. In the previous video, we have seen how key the financial system is in fostering long-run growth in economy. As stated among others by Rajan and Zingales in their 1998 paper on financial dependence and growth, the development of a country's financial sector greatly facilitates its economic growth. It thus seems essential to encourage the development of the financial sector. However, as we have seen multiple times in history, during the Great Depression of 1929 or the global financial crisis of 2007-2009, for example, the failure of markets or of a few high-profile financial institutions can have major consequences on the economy and society at large. These crisis have real and long-lasting consequences on the functioning of economies. It has been a disaster for businesses and millions of people who have lost jobs, homes, and savings. It also resulted in missed opportunities that would have prevailed without these events and significantly impaired economic growth. To avoid such dramatic events, the financial system is heavily regulated and today we are going to talk about the legal obligations existing within the banking system. Although that may seem obvious given our introduction, we will first explain the reasons behind the heavy regulation of the banking system. Then we will see who regulates the banking system and how. And finally, we will show how regulation has been evolving and will continue to do so. Why is the banking system regulated? As we have seen in the previous video, even though it has evolved towards new activities over time, one traditional and key role of banks remains to collect money from households and corporations willing to save it for some time and use this money to provide financing to those having investment perspectives. In a nutshell, banks, among other financial intermediaries, collect or borrow money on one side and lend it or invest it on the other. This activity should be profitable. The bank has to finance its activities and projects, repay its depositors with accrued interest, if any, and pay dividends to its shareholders. But this activity generates risks that must be correctly managed to avoid bank failures. There is generally a maturity mismatch between the funds collected and the funds invested. Money is collected on short-term deposits while money is lent for long-term financing. This maturity transformation is a key function of banking that brings with it a specific risk called liquidity risk. In the 2021 Journal of Finance article, Drechsler, Savov and Schnabl, report that aggregate bank assets have an average estimated duration of 3.7 years versus only 0.3 years for liabilities. This mismatch of about 3.4 years is large and stable over time. Another key risk, which is generated by the lending activity of the bank is the default risk. We can broadly define it as the risk that a borrower fails to make full and timely required payment of principal and/or interest on their debt obligation. Given that the bank acts both as a lender and a borrower, it faces both sides on the coin: If borrowers default, the bank may itself be in a situation where it is unable to repay its lenders. Liquidity risk and default risk are key drivers for the need of regulation. Given these risks, it's pretty easy to understand why we need regulations which guarantee the viability of banks. Depositors do not intend to take the same risks as shareholders and bank holders who know they may not get their money back and expect to get a specific reward for this type of risk. Depositors lent money to the bank that is providing a very useful service to society and want it back when needed. Even though we tend to forget it at times, examples of bank failures around the world frequently remind us that banks are indeed vulnerable. When a bank fails, depositors will possibly not get all their money back once all assets are liquidated. One issue is that we know that we don't have the same information as the bank manager about the risks taken by the bank. In a nutshell, there is information asymmetry. We have seen that these are exactly the conditions that would make people reluctant to deposit their money, which will in turn make financial institutions less viable and society less prosperous. Given that we don't know whether our bank is the good bank or not, and that on top of it, if a bank fails, it's likely to impact even well-managed banks, even manageable events could possibly turn into a bank run, where depositors run to the bank to withdraw their funds first, thereby creating additional risks for the whole system. Trust is key here, and the creation of the safety net for depositors can be seen as a solution to create this trust. Yet, government guarantee on deposits also has counter-productive effects that may lead some actors to take more risk than desirable and generate systemic risk. The global purpose of the regulation is precisely to guarantee that banks will stay viable and continue providing the service to the economy which they are intended to provide. Now, who is in a position to regulate banks? Governments regulate the financial systems via national or regional regulatory bodies like central banks, but also market regulators like the Security Exchange Commission, the SEC in the US, or the European Securities and Markets Authority, the ESMA in the Euro area. But financial institutions also generally operate overseas and international bodies are necessary The Basel Committee is the one that takes care of the banking system. Please also note that some professional association issues some norms for the financial institutions on the way they should behave among themselves, but also with investors, and depositors. How are banks regulated? We distinguish two levels of regulation, a microprudential level of regulation, and a macro prudential level of regulation. Before the global financial crisis, financial institutions faced a micro-prudential supervision focusing on the safety of financial institutions at the individual level. As it became clear with the recent financial crisis, financial institutions are strongly connected and contagion may easily take place between institution facing problems and others a priori healthy, hence, a macro-prudential level has been added that focuses on the safety of the financial system as a whole. The objective is to make sure that banks always have enough capital to face bad shocks. To do so, at the micro level, the regulation intends to provide directives: on how to measure the social capital available within financial institutions to cover the risks they take, and on how to measure the capital which is at risk within the financial institutions. Banks' capital consists of different sources with different qualities that are qualified as Tier 1 and Tier 2. Tier 1 capital is a restrictive concept of capital, which consists of shareholders equity and retained earnings. Tier 2 is a broadened concept of capital, which is related to some of the money deposited within banks, which can be considered as social capital like revaluation reserves, hybrid instruments, and subordinated term debt. To measure the capital at risk, not all the exposures are weighted the same way, and the regulations provide a way to weight each exposure depending on how risky it is. Capital at risk is the aggregation of all these different exposures. Banks are required to maintain the bank capital and the capital at risk such that their ratio remains above given thresholds. Should their ratio go belong these thresholds, corrective actions are taken and when seriously undercapitalized, a bank may be closed down. At the macro level, regulation now includes a limit to the leverage that a firm can take. Basically, the idea is to limit the leverage that can be taken by some financial institutions, so as to mitigate system-wide fire sales. Leverage ratio measures a bank's core capital relative to its total assets and should be kept above defined thresholds that may evolve according to the market situation. Such constraints are meant to avoid systemic risk related to the excessive exposure financial institution may have taken. Another pillar of the regulation is related to the risk management and transparency. Even though ratios are above threshold, a bank could face bankruptcy due to significant trading losses related to complex instruments. Some exposures appear complicated to measure, and banks are given the freedom to design internally the models to help them assess the specific exposures. The regulatory body does require some governance and good practices in the way the bank measures its exposures, but also in the way they manage it. Not only are the models evaluated, but also the risk management process. Disclosure requirements ensure clear information is made available to all stakeholders. While the main focus of the regulation was primarily on the amount of capital held to limit the risk of default, the financial crisis of 2007-2009 highlighted the importance of the liquidity of the bank's assets. The ratio have been introduced to control the liquidity of a financial institution. The first ratio is a short-term ratio, which is called the liquidity coverage ratio. It is aimed at controlling the liquidity risk of the banks for the next 30 days. But there is also a measurement, long-term liquidity ratio, which is called the net stable coverage ratio, which is aimed at controlling the liquidity risk of the bank at the medium and the long term. These two liquidity ratios aim at helping banks to control their activity, not to expose themselves too much to short-term, or medium, and long-term liquidity risk. Over the last century, financial regulation has evolved all over the world and will continue to do so with the development of financial innovation as well as the definition of new needs and objectives in society. Obvious examples of new products and trends are the rise of passive investments such as exchange-traded funds, the growth of Bitcoin and crypto-assets, or the development of decentralized finance. Society and governments may also have new requirements, as clear with the adoption by all United Nations member states in 2015 of the 2030 Agenda for Sustainable Development at the heart of which lies 17 Sustainable Development Goals, the so-called SDGs. We will cover positive impact finance and ESG during week 7, but it is important to stress here that such constraints are accounted for in the latest regulations the banking industry faces. The most recent developments in banking regulation were related to climate change. Climate risk was introduced in the banking sector via the updated ESG disclosures and the European Central Bank climate stress test. But climate is only one subsection of the E in the ESG. Next changes will certainly go beyond it in the years to come. The task force for nature-related financial disclosures that was formally launched in 2021 and the increased focus on biodiversity, especially in the EU, are examples of the changes that will likely impact regulation and disclosure requirements in the financial industry. To conclude, what should we take away from this lecture? Well, given the importance of the financial system and banks to finance and sustain long-term growth, we need clear rules to guarantee their safety on the long run. Regulatory bodies and public authorities act in that direction, trying not to hamper their capacity to finance the economy. Financial legislation needs to adapt to new challenges, and financial institutions will have to adapt to the new rules and new aspirations of clients, as will be emphasized in one of the next videos. Thank you very much for your attention.
