The Financial crisis of 2007/8 has not only been expensive to clean up,
but has had a dramatic effect on society and the growth in countries where it
occurred. Banking crises are not a recent phenomenon. The history of banking
over the last two centuries is dotted with periods of turmoil and failure. Financial
systems are fragile and vulnerable to crisis. When government oversight fails,
the costs can be enormous. The global financial crisis revealed a number of
shortcomings in policies and practices at financial institutions, regulatory
authorities and supervisory agencies. These shortcomings are best summarized as:
· Insufficient ‘quality’ of capital held
· inadequate management of liquidity
risk by financial institutions;
· inadequate prudential supervision,
corporate governance and risk management practices;
· lack of understanding of the scale and complexity of
operations at large financial institutions – particularly ‘pillar’ banks with
· inadequate oversight of the derivatives
· insufficient institutional capacity
· insufficient visibility of
interconnectedness among financial institutions, including between the
regulated and shadow banking sectors, and across borders.
The international policy response to
the crisis set out four key pillars for regulatory reform which sought to
harmonize existing standards and create new ones where gaps were identified.
The first area of reform addressed the riskiness of financial institutions by
strengthening prudential regulatory standards, led by banking reforms known as Basel III. The second addressed the problem of an institution
being ‘too big to fail’, where the threatened failure of a systemically important financial institution would leave authorities with no option but to bail it out using public
funds. The third limited the scope for contagion arising from interconnections between counterparties in the
derivatives markets. The fourth addressed risks arising from shadow banking and
activities outside the regular banking system that are associated with credit
intermediation and maturity/liquidity transformation.
The lack of early direct access for regulators to tactical and strategic
information at banks was a significant handicap for National Competent
Authorities as well as for the European Central Bank (ECB). Available market
liquidity was a major issue for market participants. The ECB acted early
flooding the euro-area with liquidity and following the Lehman failure,
governments in Europe and the U.S. guaranteed all of the liabilities of their
largest (or pillar) banks.
The adjustments over the last ten years
have been pronounced compared to policies and understanding that was in place
prior to the crisis. Much of the new legislation was necessary and set out to address
deficiencies that existed in macro, prudential and micro
regulation of the industry and the firms operating
within the sector. While the future is uncertain, I believe that a benefit of
the introduction of the new policies, rules and regulations is that there is
now a much more reduced threat of systemic damage being inflicted on society.
Regulators have the necessary supervisory and conduct of business tools together
with early warning mechanisms in place. In my opinion, the key challenge for
regulators is to ensure that ongoing policy formulation and implementation is proportionate with a level playing field preserved amongst all comparable market
participants. This is particularly so considering the emergence of Fintech in
financial services (as discussed in CAI).
knowledge on this topic is broad. I reviewed ten sources of knowledge/opinion. The
authoritative sources reviewed are listed in Appendix I, with pertinent points
from these sources highlighted throughout this assignment together with my own
industry experience. To assist in the analysis, I tried to frame for the
most part, impacts and perspective as it relates to European banks. The
comparable impacts are similar and are reflected in other geographical regions
around the world.
CHANGES INTRODUCED FOLLOWING THE CRISIS & THEIR PREDICTIVE VALUE
Major regulatory initiatives following the crisis have aimed to make
banks safer for depositors and tax payers by introducing measures to
de-risk and re-capitalize banks. The Basel III
framework amended the pre-crisis Basel II for capital adequacy and increased
the required amount of loss absorbing capital for banks. Basel III also
includes a de-risking element in the form of liquidity management for safer
Banks are now more capitalized than
ever before with various counter cyclical and contingency buffers in place.
There is also better understanding from regulators of the geography and
‘plumbing’ of organizations through the implementation of Basel Committee of
Banking Supervision Standard No. 239 (‘BCBS239). BCBS239 sets out overarching principles for effective risk management reporting and governance. It focuses on banks developing the
right capabilities versus just meeting published compliance dates. Many of the
findings from the crisis showed that banks, their management teams and staff
lacked deep technical competence and knowhow. There was a presumption that
somebody else was taking care of risk management and ‘it was not my job’. The Fitness and Probity regime that was introduced
addressed competency and knowledge gaps at all regulated firms.
In my opinion, the financial system is now better organized and
capitalized following the crisis than before. Taxpayers’ exposure to bailouts is
reduced in regard to potential future crises. Also, consumers are better
informed and can avail of various protections including deposit guarantees up
to Euro 100,000 per account per person (in the case of Ireland).
The key structural
challenges that were addressed by post crisis regulations are summarized
below. In my view, these structural changes reduce potential future societal
impacts should there be another financial crisis.
1. A SAFER
FINANCIAL ECO SYSTEM
The key defence mechanisms created by new rules and regulations
following the 2007/2008 crisis are:
now hold more capital
rebuilt their balance sheets in the wake of the global financial crisis and are
now much safer. They increased the amount of the highest quality capital they
hold by multiples when compared to the beginning of the financial crisis. They
also hold significantly more liquid assets
which would enable them to survive a liquidity induced stress, as
happened in 2007. By 2019, when Basel III is fully implemented, banks will be
even more robust – see Appendix II, which sets out key implementation dates.
1.2. Ring-fencing of activities
The world’s largest banks have had their investment arms separated from
their retail arms. This improves the resilience and resolvability of banks by
protecting retail banking services from risks and contagion effects elsewhere in the financial system.
1.3. Bail-in of creditors
Following the crisis, the European
Single Resolution Board strengthened its position for a single point of entry
through requiring ‘bail-in’ strategies for banks. This required the
establishment of group holding companies for large systemically important banks. Banks are now required to issue loss
absorbing debt at a holding company level to minimize the impact on taxpayers
in the event of a future financial crisis. Furthermore, banks are now required
to put in place recovery and resolution strategies in relation to any future ‘doomsday
scenario’. These living ‘wills’ set out asset coverage, liquidity supports and
how banks would be would up in an orderly manner. Deficits in banks are
required to be funded by creditors as opposed to bail out monies from
Some countries, for example the UK, have adopted a statutory bail-in power enabling the Bank of England to expose
certain creditors of a failed bank to loss by writing down or converting their
interests into new capital. This type of orderly resolution ensures that the
critical functions a bank provides to the economy can be continued in the event
of its failure. This is a key tool for government and regulators to end the
problem that banks are considered too big to fail. This is in response to European regulatory rules
designed to reduce taxpayer exposure in the event of a bank going bust. In an Irish context, we have seen in recent times capital restructurings
at both AIB and Bank of Ireland. Both banks have created new holding companies so
as to limit future tax payer exposure and to prioritise third party bond and
shareholder capital in a distressed scenario.
1.4. Less exposure to risky positions
Banks have restructured their balance sheets to reduce exposures to riskier
trading assets. European banking authorities have requested
banks across the EU to deal with residual Non-Performing Loans (‘NPL’) on
balance sheets in an effort to draw a line under the remaining riskiness of
bank balance sheets. Such NPL’s are being packaged by banks and auctioned to private
equity and vulture funds in exchange for more liquid cash consideration.
1.5. Stress tests
Pittsburgh Summit in 2009, G20 Leaders called on the Financial Stability Board
(‘FSB’) to propose possible measures to address ‘too-big-to-fail’ problems
associated with systemically important financial institutions (SIFIs). SIFI’s are financial institutions whose distress or disorderly
failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and
economic activity. In 2010 at the Seoul Summit, the G20 leaders endorsed the
FSB framework for reducing the
moral hazard of SIFIs. The world’s
largest banks now take part in annual stress tests on capital, loan books and liquidity. In the EU, the
Single Supervisory Mechanism supervises such tests as it relates to SIFI’s.
1.6. Liquidity vs. Solvency
The crisis exposed the stark contrast between liquidity
and solvency. What matters
most during a bank run is not whether a bank is solvent, but whether it is
liquid. Solvency means that the value of the bank’s assets exceeds the value of
its liabilities. In other words, the bank has a positive net worth. Liquidity
measures whether the bank has sufficient reserves and immediately available
marketable assets to meet depositors’ demand for withdrawals. Efforts by
regulators globally since the crisis has now brought into sharp focus the
requirement for banks to have ‘war chests’ of liquidity available on short term
call so as to be in a position to meet depositor demands at all times.
REMUNERATION & RISK ALIGNMENT
The key changes to executive
remuneration and risk alignment are summarized as follows:
2.1. Variable compensation – % deferred
Senior and highly paid bank employees, or those who can take material risks on behalf of their banks, are now subject to remuneration rules and
caps. The rules require that at least 40% of annual bonuses paid be deferred
over at least three years, and can be reduced or cancelled if poor performance
or conduct issues subsequently come to light.
2.2. Aligning risk
There has been a significant shift away from cash bonuses to rewarding
staff with shares. Under the remuneration rules, bankers classed as “Code
Staff” have at least half of their awarded bonuses now paid in shares. This
means that bankers are not rewarded for failure but are incentivised to make
decisions that benefit their businesses, shareholders and the broader economy.
Regulators now stipulate clawback mechanisms that for all variable
(bonus) pay – both deferred and un-deferred. The clawback applies to senior
material risk takers in banks. Bonuses for affected staff are capable of being
clawed back for up to seven years following award by employers where there is
evidence of employee misbehaviour or a material failure of risk management.
This removes the asymmetry that existed previously where bankers were rewarded
for their successes but not penalised for their failures.
2.4. Bonus pools
Bonus pool for bankers in Europe, Middle East and Africa (EMEA) region
have fallen by 50% since 2009. The average bonus received by individual staff
members in EMEA has reduced by 35%. McLagan Review of the Reward Environment
in the Banking Industry, January 2015.
3. STRONGER BANKING
There is now a more intrusive supervisory regime within financial
services. New European Supervisory Authorities
(ESAs), including the European Banking Authority (EBA) and the European
Securities and Markets Authority (ESMA) are now in place. ESMA directly
supervises credit rating agencies and has set up strict rules to avoid in
particular conflicts of interest which were a feature of the crisis.
In my opinion, the correction in policy
since the financial crisis has been necessary. Policies and rule configurations
have been strengthened significantly across the industry. I believe that the
policy changes will most likely reduce/limit the social impact on society
should there be another financial crisis in the future. The benefit to
consumers is also welcome; particularly in relation to deposit
insurance/protection and limits on bank credit policies relating to prior
un-sustainable bank lending practices. Following the crisis, there are a number
of bodies playing different roles protecting consumers. For example, in
Ireland, the Central Bank ensures that financial firms deal fairly with
consumers. The Competition and Consumer Protection Commission provides personal
financial information and education to consumers. Finally, the Financial
Services Ombudsman assesses complaints of individual consumers and can direct
redress against firms.
4. NEW RULES &
Since 2007, the banking sector has experienced one of the most intensive
periods of regulatory change in modern history, with close to 100 substantial
pieces of legislation passed so far. The pertinent reforms introduced include:
• Banking Conduct of Business
(BCOBS) requires banks to be fair, clear and not misleading in their
communication with customers. Regulators can fine banks or strike them off if
they infringe these rules.
Concept of ‘Approved Person’
Regulators now operate a ‘boundary check’ that requires bankers to be “fit and proper” for key management roles. Competency,
honesty, integrity and financial soundness are all taken into account in appointments
and ongoing assessments.
• The European Market Infrastructure
Regulation (‘EMIR’) introduced new requirements to improve
transparency and reduce the risks associated with the derivatives market.
• New Capital Requirements Directives (‘CRD’)
introduced – CRD II & CRD III make banks safer by making
them hold more capital and improve their management of liquidity risk. CRD IV implements internationally-agreed standards on “more capital, more
liquidity” across the EU, making it easier for banks to facilitate
international trade, provide additional forbearance for customers in mortgage arrears
and introduce caps on executive remuneration. Basel III Banking Reform implemented a framework for ring-fencing the largest
banks to better protect consumers’ deposits; legislate for bail-in measures to
ensure that taxpayers’ money will not be used to save failed banks; introduce a
senior person regime to hold key decision-makers to account and make severe
misconduct a criminal act. The Bank Recovery and Resolution Directive requires banks to prepare recovery plans to be ready to resolve failed
banks without recourse to the taxpayer whilst requiring creditors to be
‘bailed-in’. The Single Resolution Mechanism complements the Single Supervisory Mechanism and
provides a structure within which to coordinate the resolution of a failed
bank, including the possibility of creating a Single Resolution Fund.
• Deposit Guarantee Scheme
Directive enhances protection for bank account holders
by increasing the coverage and transparency of their deposit guarantee. In
Ireland, the Deposit Guarantee Scheme (DGS) is part of the
Central Bank of Ireland’s strategy to ensure that the best interests
of consumers of financial services are protected. The DGS is
administered by the Central Bank and is funded by the credit
institutions covered by the scheme. Similar schemes operate in other countries
across the developed financial markets and money centres.
• MiFID II improves investor protection, increases transparency, and continues the
harmonisation of regulation across the EU. MIFID II comes into effect on 3
January 2018 and is widely regarded as one of – if not the – single largest and
most significant regulatory initiative undertaken by the European Union since
the 2008 crisis. As a result, it is likely to reshape the face of European
capital markets and will have a major impact on investment firms from both a
commercial and operational perspective (KPMG – May 2017).
MiFID II, when combined with the European Market Infrastructure
Regulation (EMIR) completes the European response to the G20 commitment made in
Pittsburgh in 2009 to manage risks associated with over the counter (OTC)
The 2007/2008 financial crisis has been the largest and most severe
financial event over the last fifty years and has reshaped the world of finance
and investment banking. The crisis revealed many weaknesses in the
financial system. Reforms like CRD IV now oblige banks to hold more quality capital
in order to better absorb losses. An increase in equity has afforded banks the
opportunity to cope with economic shocks while continuing to finance the
economy. In addition, limitations on banker bonuses has cut-off incentives that
led to previous excessive risk taking.
Regulations introduced since the crisis has led to the introduction of
more coherent supervision and a single rulebook, specifying in particular the
prudential requirements and resolution procedures for banks. The derivatives
market, which had evolved in a nebulous and largely unregulated environment,
increased contagion after the collapse of Lehman Brothers. EMIR regulations
introduced since 2013 has now made derivatives more transparent, simpler and
Following the crisis, penalties for misconduct by banks are heavier. Retail
customers now need to be fully informed, understand and are appropriately
advised on products sold by banks. Retail depositors are also protected by
various country deposit guarantee systems. Retail customer deposits still
account for a significant source of funding for banks (in some banks up to
50%). Ensuring ongoing confidence in the system post the crisis is important in
order to secure ongoing deposit commitment from depositors. Having consistent
and transparent rules and regulations together with banks being appropriately
and sufficiently capitalized is an important feature of modern financial services.
This is necessary so as to ensure that the impacts on society are minimized
relating to future crises.