Transcript Lessons of Japan and America Bubble burst to China

Lessons of Japan and America
Bubble burst to China
A study of Bank capital adequacy, Basel
Accord, and Chinese housing bubble.
Fundamentals
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1988 Basel Accord I:
The 1988 Basel Capital Adequacy Accord was a
milestone in the approach to bank regulation.
Agreement was reached between the member
countries of the Basel Committee that a minimum
capital requirement of 8% would be required of
internationally active banks. The impetus behind this
move was widespread concern about declining
levels of capital held generally. Since that time the
Accord has been adopted by more than 100
countries.
Basel I
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capital (= Tier I + Tier II)/risk weighted assets> 8%
Problem: “Regulatory Arbitrage”
Bank’s obligation always the same, “8%”, banks offbalance sheet activities always replace low risk by
high risk investment or loan
Change proportion of loan/asset structure: e.g.
replace G-bond with resident mortgage.
Basel II
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Basel I + individual credit rating
Capital adequacy or BIS rate rise to 10%
Problems with Basel II internal credit risk
models (which relate to the fact such banks’
internal credit risk models were overly
sensitive in their implementation for the
calculation of regulatory capital, and
generated pro cyclical effects) were realized
during the recent Financial Crisis
Problems
Although the criticisms of the 1988 Accord have come from
more than one source, it seems that it is the pressure applied
by the internationally active banks that have led to the
proposals in the New Accord. As Moody's point out the, the
New Accord is very much geared towards the small number of
large internationally active banks.2 Hence, the major thrust of
the proposals aim to increase the risk-sensitivity of capital
requirements and thereby more closely align these
requirements with actual risks. To this end, a major proposal is
to move towards ever-greater use of banks' own internal risk
management systems.
However, although the focus of the proposals are aimed
towards the needs of major banks from the G-10, it is likely that
the New Accord, when implemented, will have significant, and
broadly negative, repercussions for the developing world, both
internationally and domestically.
Basel at developing countries
The Basel Committee does not have the right to impose its own
Accord on others, and has never, at least explicitly, sought to
do so. Nevertheless, more than 100 countries have
implemented the Basel Accord in some form. There are several
possible explanations: it is cheaper to pick one off the shelf
than to start from scratch; financial markets reward
governments and banks in developing countries where a Basel
regime is implemented; the international official community
(including the Basel Committee and the international financial
institutions) encourages them to do so; and financial institutions
from countries not complying with Basel standards find it
difficult to enter important financial centres such as London and
New York. Developing country regulators may feel that they
have little choice. If so, the Accord has the status, if not the
form, of customary international law, and those designing it
bear the responsibilities of international law-makers.
Basel III?
BASEL III is a new global regulatory standard on bank
capital adequacy and liquidity agreed upon by the
members of the Basel Committee on Banking
Supervision.1 The third of the Basel Accords was
developed in a response to the deficiencies in
financial regulation revealed by the late-2000s
financial crisis. Basel III strengthens bank capital
requirements and introduces new regulatory
requirements on bank liquidity and bank leverage.
The OECD estimates that the implementation of
Basel III will decrease annual GDP growth by 0.05 to
0.15 percentage point.
Basel III Changes:
Basel III will require banks to hold 4.5% of common equity (up
from 2% in Basel II) and 6% of Tier I capital (up from 4% in
Basel II) of risk-weighted assets (RWA). Basel III also
introduces additional capital buffers, (i) a mandatory capital
conservation buffer of 2.5% and (ii) a discretionary
countercyclical buffer, which allows national regulators to
require up to another 2.5% of capital during periods of high
credit growth. In addition, Basel III introduces a minimum 3%
leverage ratio and two required liquidity ratios. The Liquidity
Coverage Ratio requires a bank to hold sufficient high-quality
liquid assets to cover its total net cash flows over 30 days; the
Net Stable Funding Ratio requires the available amount of
stable funding to exceed the required amount of stable funding
over a one-year period of extended stress.
Problem
Basel III cannot address the problems caused by
regulatory arbitrage: to attract banks and to create
viable financial centers, national governments can
choose not to implement these international riskbased capital standards. And as regulations
become more onerous, the incentives increase to
instantaneously move capital from countries with
oppressive supervision to countries with a more
relaxed approach to financial regulation.
Japan’s case
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The world during 2007-2010 resembles Japan in the 1990s-the early 2000s.
– Property and other asset price bubbles and their collapse with serious
effects on the financial system.
– The bubbles turned on too easy macroeconomic environment and
regulatory failure to reign in excessive speculation.
– After the burst of the bubble, monetary policy rates were lowered
aggressively from fairly high levels, reaching eventually near zero levels.
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Policies to address financial system problems were also adopted more
quickly in the current episode.
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Central banks in 2007-09 acted more rapidly than in Japan in the early to mid
1990s.
In Japan, it was possible to hide bad loan problems for a while due to the bank
centered nature of the financial system unlike in the current case.
If the world fails to avoid deflation or a near zero inflation rate, however, it may
look like Japan 1999-2006 for years to come.
The world is also following Japan with regard to the heavy burden on fiscal
authorities.
America’s case: Fear of deflation led the
Fed to adopt ultra easy policy in 2003-04
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a substantial fall in inflation at this stage has the potential to interfere
with the ongoing U.S. recovery, and that in conceivable--though
remote--circumstances, a serious deflation could do significant
economic harm. Thus, avoiding a further substantial fall in inflation
should be a priority of monetary policy. (B. Bernanke, July 2003)
"the Committee believes that policy accommodation can be
maintained for a considerable period." …. Today inflation is at the
lower end of the range consistent with optimum economic performance,
and soft labor markets and excess capacity create a further downward
risk to inflation. As a result, I believe that increased economic growth
may not elicit the same response from the Fed that it has sometimes
elicited in the past. (B. Bernanke, September 2003)
Japan and US’s eagle
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Japan
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17 of the 25 world’s
largest financial
institutions were
Japanese as of 1989.
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US
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The U.S. economy has
conquered the business
cycle. (R. Dornbusch, R.
Lucas.)
The U.S. economy has
become very flexible and
resilient. (A. Greenspan.)
Distorted Incentives leading up to the Bubble:
regulatory failure
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Japan
– Deregulation in the bond
market.
– But banks were not allowed to
move into securities
businesses, unlike in the US.
– Banks increased property
related lending.
 Also, through Jusen.
– Neither banks nor regulators
were equipped with risk
management techniques to
look at the entire bank loan
portfolios.
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US
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BIS capital regulation, financial
innovation and some deregulation
encouraged the formation of the
shadow banking system, which
was not policed well by regulators.
BIS regulation on security trading
was effectively eased in 1996.
The SEC policy change toward
investment banks in2004.
SEC policy toward rating agencies.
Derivatives.
Government’s housing policy.
Compensation.
Lesson
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Ultra easy--say, easier than the Taylor rule--monetary policy
sometimes generates major financial imbalances.
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In both Japan and China the ultra easy monetary policy came from the fear of
deflationary effects of stronger currency.
Financial imbalances are exacerbated when financial regulation does
not catch up with financial innovation or when pace of deregulation is
uneven across sectors.
Bubbles lead to systemic events if financial intermediaries are at the
heart of their formation.
People learn from others’ mistakes, but not always.
The world is not out of the woods yet.
– Large budget deficits and buildup of government debt
– Disinflation is continuing.
Conclusion:
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Even though Basel Accord is self-improving
according to changing world banking
circumstances, and it is the best available,
and most commonly recognized “guild line”
so far, but concerns about how well it will fits
developing countries is still in question.
China’s housing bubble situation need to
learn from Japan and America’s mistake.
References
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http://ssrn.com/abstract_id=348461
http://ssrn.com/abstract=1680886
WORKING PAPER NO. 04 THE NEW BASEL ACCORD AND
DEVELOPING COUNTRIES: PROBLEMS AND
ALTERNATIVES Jonathan Ward
http://en.wikipedia.org/wiki/Basel_III
Japan’s bubble and America’s bubble: some implications for China
By: Kazuo Ueda, Professor of Economics University of Tokyo.
Will the proposed new Basel Capital Accord have a net negative
effect on developing countries? By: S Griffith-Jones & S Spratt
Institute of Development Studies University of Sussex Brighton BN1
9RE
http://ssrn.com/abstract=1693622