PhD Chapter - better safe than sorry - paper review

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This time I would like to take a couple of important notes from my review chapter about being better safe than sorry. 

The full page of this chapter can be found here: Link to the article

From the abstract to the introduction 

Intro

• In particular, the notion of risk that lies at the heart of the Basel framework is still blind to extreme events. Climate risk and pandemic risk fall into this category. 
• We offer avenues for reforming macroprudential regulation in a way that would allow us to take those risks  into account.
• out why  current banking regulation is not adequate to face risks whose origin is grounded outside financial  markets – as is the case for both the pandemic and the climate risks

What missing from macroprudential policy

• Such an approach proved irrelevant once the crisis struck
  • Prior to the crisis, the common belief  was indeed that the combination between microprudential policies focusing on the soundness of financial institutions and monetary  policies keeping inflation low was sufficient to ensure financial stability.
  • for instance expressed by the G20, has therefore been the catalyst for the  adoption of macroprudential policies whose purpose is to stabilize the monetary and financial system at the macro level
  • Where the main  objective being to contain the systemic risk.  

How macroprudential work

• These latter aim at protecting the economy from systemic risk in its two dimensions (Borio, 2003): through time (temporal  dimension), and at every moment (cross-sectional dimension).
• systemic risk indeed materializes through the pro-  cyclicality of economic behaviors; and, on the other hand, it can spread thanks to the interconnections between financial institutions and  the concentration of risk at a given point in time.

The main MP instruments

• he main macroprudential instruments are the following  (Cerutti et al., 2017):
  • countercyclical capital buffer,
  • leverage ratio for banks,
  • dynamic provisioning rules,
  • caps on loan-to-value or  debt-to-income ratios,
  • limits on foreign currency loans,
  • limits on risk concentration and capital surcharges for systemically important  banking institutions.

The weakness of MP, from time perspective

• it remains focused on banks alone,  even though the non-bank financial intermediation (NBFI) – which mainly comprises pension funds, insurance corporations and other  financial intermediaries – has grown faster than the banking sector in the last 10 years. Indeed, the financial assets of the NBFI sector  amounted to $200.2 trillion in 2019, accounting for nearly half of the global financial system, up from 42% in 2008 (Financial Stability  Board, 2020).  
• These countercyclical rules  also seek to face the well-known paradox according to which any balance sheet item that serves as a shock absorber (liquid assets and/or  capital) against adverse and unpredictable shocks ceases to fulfil this function as soon as regulatory pressure – through the definition of minimum requirements – is put on it. Only capital exceeding those minimum requirements constitutes a natural absorber of unanticipated losses. Indeed, when capital strictly reaches minimum requirements, additional losses deplete regulatory capital and induce credit  rationing or other procyclical balance sheet adjustments such as fire sales. 
• From shock absorbers, regulatory minima consequently  become shock amplifiers. From a macroprudential perspective, the countercyclicality of prudential rules contradicts the invariance over  time of liquidity and capital ratios (Kleinnijenhuis et al., 2020)

The weakness of MP from cross dimensional 

• The imposition of capital surcharges for global systemically important banks (G-  SIBs) is a flagship measure.
• The philosophy of this measure was jointly developed by the Financial Stability Board and the Basel  Committee in 2011 and was adjusted in 2013. The idea is that each G-SIB is assigned a composite score based on a set of five categories  of quantitative indicators meant to indicate how systemic those banks are (size, interdependence, substitutability, cross-border activ-  ities, complexity). 
• Scores are then associated with additional capital requirements: the higher the score, the higher the amount of capital  required. There are 5 tranches ranging from a 1% capital surcharge to a 3.5%. The last tranche is deliberately let empty, the purpose  being to dissuade banks from becoming “too systemic”, hence the idea of a stigma associated with the simple fact of being in this last  tranche.  
• Indeed, when market participants are all subject to a  value-at-risk constraint, risk becomes endogenous so that the procyclicality of banks’ behaviors increases (Danielsson et al., 2009). 
• The unconditional support  given to the financial system, notably through unconventional monetary policies, has led to a postponement of the recognition that  market logic alone cannot constitute the cornerstone of regulation guaranteeing financial stability.

Why we need to focus on unpredicted risk or systemic risk 

• The revival of the theme of market  value in recent years, whether through market discipline as defined by the prudential corpus or fair value as defined by accounting  standards (IFRS and US GAAP), paradoxically illustrates a reinforced confidence in the proper functioning of the market, while the  swelling of central banks' balance sheets testifies to its malfunctioning.  
• he Covid 19 crisis and the climate  crisis are, as such, of a completely different nature. Indeed, they have their origin in processes which are, by their very nature, external to  the functioning of financial markets.
• The main lesson is the need for a re-embedding of finance in socio-economic realities.

The discussion

• As it has been implemented in the aftermath of the 2007-08 crisis, macroprudential policy does not radically renew the foundations  of pre-crisis banking regulation (Baker, 2013). In fact, the macroprudential instruments presented in the introduction appear more as  extensions added to a regulatory corpus whose general intention remains microprudential, than as real breakthroughs. 
• The main instrument of prudential regulation still consists in a risk-weighted capital ratio
• The problem of this ratio is that its  computation is based on a definition of risk that does not allow to capture either fat-tailed risks and/or risks with no historical record,  which are precisely great sources of systemic risk.
• “[…] traditional approaches to risk management consisting in extrapolating historical data based on assumptions of normal  distributions are largely irrelevant to assess future climate-related risks. Indeed, both physical and transition risks are charac-  terised by deep uncertainty, nonlinearity and fat-tailed distributions.” (Bolton et al., 2020, p. 10).  
• Risk can then be measured  as the volatility of these prices and estimated using value-at-risk models.
• banks. Indeed, with Solvency 2, insurance companies  have to comply with capital requirements whose computation is based on the same philosophy as that on which rests Basel 3. More  precisely, under Solvency 2, the Solvency Capital Requirement (SCR) is meant to absorb one-year expected losses in 99.5% of cases.
• This is problematic for at least two reasons. On the one hand, it  extends to other financial institutions the risk management methods that have already shown their limits in the case of banks (Dan-  ıelsson et al., 2004 ́ ). On the other hand, the application to insurance companies of rules similar to those that banks must comply with  may lead to an excessive homogenization of financial behaviors, whose impact on financial stability could be potentially very negative  (Wagner, 2008, 2010).  
• asset. In this case, according to the three-level  definition of fair value proposed by IFRS 13, fair value is estimated using a model, either based on public information (Level 2 fair  value) or on the basis of information privately held by the company that holds the asset (Level 3 fair value).
• As already indicated, such a method entirely rests on the well-functioning of financial markets and proves to be much more  difficult to implement in times of crisis.1  
• Market discipline is indeed by nature a microprudential  instrument (Stephanou, 2010). The idea behind market discipline is that prices have an informative and incentive power capable of  driving banks, and more generally financial institutions, to adopt the right behaviors in terms of risk management.
• of risk that remains deeply linked to the well-functioning of financial markets.
• liquidity risk and systemic risk, it remains blind to all risks whose origin lies outside the market. T
• Covid crisis highlights the extent to which risk can, in a hyper-connected world and, moreover, at the verge of a climate crisis, mate-  rialize outside the market.  
• 3.1. From this  perspective, the Covid crisis could act as a “dress rehearsal” and as such inspire the future structuring of macroprudential policy to  prevent and mitigate climate-related financial risk. W
• The constitution of a shadow banking system, in which banking activities are mingled with financial activities, bears witness  to this complexification. Such a complexification of banking and financial activities harms any attempt to regulate them. Indeed, the  ever-increasing possibilities of escaping regulatory constraints, either because of regulatory arbitrage (Carruthers and Lamoreaux,  2016), or because of the complexity associated with the implementation of rules which leaves great room to “manipulate” regulatory  ratios (Mariathasan and Merrouche, 2014), offers banks an unquestionable advantage over their regulator.
• In the light of the pandemic and climate crises: paths to a reinvention of macroprudential policy  

Rethingking the macroprudential policy 

• carries. It is indeed the voluntary slowing down of the economy to fight the pandemic that induces a rise in global risks in the financial  sphere and not the endogenous risk that characterizes its functioning. From this point of view, the financial side of this crisis is totally  different from that of the 2007-08 crisis
• onary pressures on the  economy. They do not stem from the credit drifts and bubbles that they feed, nor do they stem from the illiquidity of the balance sheets  of financial intermediaries or the concentration of financial risks. However, these are aggravating factors that are pushing for the  consolidation of certain developments that are already well under way in macroprudential policy.  
• the health crisis reinforces the pivotal role of central banks on financial stability issues and illustrates the interde-  pendence between global financial risk management and risk prevention.
• The non-directly  observable nature of macroprudential policy successes (financial cycle smoothing and financial crisis avoided) and the time lag between  its immediate costs and its more difficult-to-measure and time-displaced benefits are among the notable difficulties facing its imple-  mentation. T
• There is  thus a “bias to inaction” specific to macroprudential policy (Houben et al., 2014). This form of temporal incoherence is further rein-  forced in policies aimed at protecting the financial system from the systemic risks generated by the transition to a low-carbon economy,  i.e. in the design and implementation of “green” or “climate” macroprudential policy. This is the famous tragedy of the horizon  popularized by Marc Carney (2015).  
• The “inaction bias” inherent in macroprudential policy is thus exacerbated in the case of climate macroprudential policy. The  temptation to wait for a better analytical understanding and appreciation of climate risks and their dynamics leads to inaction.
• he simple recognition of the consensual scientific knowledge  – carried by the IPCC (2014) – on the “material” effects of global warming, on the hysteresis bifurcations characterizing the tipping  points and the irreversible changes in the climate system that they induce, even if our knowledge on the “conversion” of these into  financial risks is very insufficient, should lead to the application of the precautionary principle. 

Decision making under radical uncertainty 

• Taking seriously the fact that we live in a world of radical uncertainty must lead to an equally radical transformation in the methods  of economic and financial policy decision-making.
• In particular, the risk of catastrophic damage associated with a very low probability  of occurrence – but with a considerable and irreversible impact – argues for a very ambitious transition to a low-carbon economy  implemented as soon as possible (Weitzman, 2009).
• This recommendation, which is guided by the “generalized precautionary prin-  ciple”, is hampered by the “tragedy of the horizon” (Carney, 2015) that paralyzes political decision-makers
• Consequently, collective action must be shaped by an ethical principle  that integrates the well-being of future generations (Aglietta and Arrondel, 2019).
• When risk theory is no longer able to guide the actions  of governments, central banks and regulators, an approach based on “enlightened catastrophism” can take over. It must result in the  implementation of a generalized precautionary principle in the structuring of public policies and thus of macroprudential policy
• This is the paradox of “enlightened  catastrophism”, which bears a similarity to the figure of the murderous judge who murders criminals before they commit their crimes. In  doing so, the crimes do not exist and therefore the motivation for action does not exist either
• The usual partition between the time dimension (procyclicality) and the cross-sectional dimension of  systemic risk (common exposures and interconnections) is irrelevant for preventing climate-related systemic financial risks.
• We do not observe a carbon cycle that could be defined as a succession of periods of  overfinancing of industries with high greenhouse gas (GHG) emissions and periods of contraction/correction of these drifts to which  would correspond a cyclicity of GHG emissions. Carbon emissions have been steadily increasing and accelerating since the end of the  Second World War due to “carbon lock-in” (Unruh, 2000).
• This “carbon lock-in” reflects the dependence on the path of  Techno-Institutional Complexes based on fossil fuels. Conversely, the cross-sectional dimension of systemic risk must be central to the  structuring of a “climate” macroprudential policy. This part of financial stability policy focuses on the interrelationships between  different markets and between different financial institutions to account for common exposures, risk concentration, and credit re-  lationships at a given point in time. I
• transition risk must be understood through cascades of failures due to the upstream and  downstream interdependencies of the fossil fuel extraction and consumption industries, it is indeed the cross-sectional dimension of  systemic risk that is relevant for structuring a “climate” macroprudential policy.  
• he implementation of IFRS 9 in January 2018 could go against the objective of such policy since IFRS 9 mainly prescribes  to resort to fair value to account for financial assets, which is known to deter financial institutions from investing in long-term assets (Le  Quang, 2021; O'Hara, 1993).
• Fair value accounting thus incentivizes banks to focus on short-term assets and could impede the financing  of the transition towards a greener economy.

Rethinking instruments  

• I. Two options are possible: reducing capital  constraints for “green” financing or increasing them for “brown” financing.
  • First option It would consist in reducing the capital  requirements of banks for the “green” financing they provide by reducing the risk weightings in the calculation of the denominator of the  capital ratio. In other words, projects considered as “green” would be financed with more leverage and therefore less capital.
  • A second optionalso integrates the non-measurable nature of climate-related financial risks, pleads for sectoral leverage  ratios to supplement the brown penalizing factor by limiting excessive debt on asset classes backed by carbon-intensive sectors (D'Orazio  and Popoyan, 2019) and therefore presenting a greater stranding risk.
    • Basel 3 introduces, within Pillar 1, a leverage ratio that requires  banks to finance at least 3% of their assets, regardless of the associated risk, with equity.
    • stranding. The leverage ratio is more  transparent and easier to determine than the risk-weighted capital ratio and thus limits the risk of undercapitalization due to the  adoption of opportunistic behaviors by banks (Mariathasan and Merrouche, 2014).
    • Sectoral capital requirements (SCR) are already part of existing macroprudential instruments. By requiring additional capital to  cover exposures to a given sector, they are designed to complement the countercyclical capital cushion.
    • The objective is to improve the  resilience of banks to excessive growth in debt in the targeted sector and to provide incentives for banks to reduce their exposure to that  sector
    • An instrument to restrict the concentration of exposures to the same type of counterparty could also be considered. This prudential  instrument exists and aims to limit the maximum possible losses in the event of default by a counterparty or a group 
    • The activation of the systemic risk buffer (SRB) would also be a possible protection against climate related financial risks. Defined in  Article 133 of the Capital Requirement Directive IV (CRD IV), the SRB “aims at preventing or mitigating systemic risks of a ‘long-term  non-cyclical’ nature which could disrupt the financial system and have serious negative consequences on the real economy of a given  Member State”. T
    • Since insurance undertakings also finance fossil fuel companies and their activities via equity and corporate bond investments, they  should be included within the scope of the “climate” macroprudential policy that is here considered.

4.4. For an holistic approach of financial regulation  

• As implemented following the 2007-08 crisis, macroprudential policy focuses exclusively on banks. This narrow perspective con-  tradicts the growing importance taken by non-bank intermediation especially since the financial crisis (Financial Stability Board, 2020).  This limited scope is a major weakness because global financial risks could be generated and amplified by non-bank financial in-  termediaries.
• risk. According to the NGFS  technical report (2021), the question of the “climate mandate” of central banks is now considered as both legitimate and necessary.
• This  climate mandate may translate into a collateral policy where “green” collateral would be favored and “brown” collateral penalized. Such  a penalization could either take the form of a limitation of the assets accepted as collateral or that of a haircut policy applied to “brown”  collateral. S

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