A talk at the IIEA for the

1. Regulation from a European
perspective
Stephen Kinsella & Vincent O'Sullivan
UL

2. Apologies for the Acronym
Soup.

3. “Personal autonomy is the work of our
imagination, not the way we live. Yet we
have been thrown into a time in which
everything is provisional. New technologies
alter our lives daily. The traditions of the
past cannot be retrieved.
At the same time we have little idea of
what the future will bring. We are forced to
live as if we were free.
The cult of choice reflects the fact that we
must improvise our lives. That we cannot do
otherwise is a mark of our unfreedom.
Choice has become a fetish; but the mark
of a fetish is that it is unchosen.”
––John Gray, Straw Dogs pp 109-110,
emphasis my own.

4. Work building on
• O'Sullivan & Kinsella, 2009, 2010, 2011, 2012.
• Ourproject: describing and modelling the interactions
between financial regulation and the balance sheets of the
European Union macro economy, from 1980 and 2012
• Proposing alternative risk management mechanisms with
respect to the Irish case, but generalizable to EU situation.

5. Selected work
Regulatory Complexity and Uncertainty: CRD IV What caused the Irish banking crisis? UK Regulatory Reform
KPV O’Sullivan and S. Kinsella (in press); Harvard Law Forum KPVO’Sullivan et al (2010); Journal of Financial Regulation and Compliance KPV O’Sullivan with PwC; Compliance Officer Bulletin
Vincent’s paper on the Irish banking crisis was the PwC’s FS Regulatory Centre of Excellence wrote
This paper looks at complexity and uncertainty
Outstanding Paper Award Winner at the Literati the entire April 2012 edition of the Compliance
associated with the Capital Requirements Officer Bulletin. Vincent wrote an article on the
Directive (CRD) IV regime in Europe. It Network Awards for Excellence 2011. The paper
new European financial institutional architecture –
investigates current debates around giving explores the Irish banking crisis and explains how in particular the establishment of the European
member states additional discretion in applying various factors contributed to a collapse in asset Supervisory Authorities and the movement
further requirements than proposals, particularly prices and an economic recession. The paper towards a single rule book for financial regulation
as it pertains to macroprudential supervision. It seeks to document the dangers of pro-cyclical in Europe. Vincent also wrote a piece on
examines current technical standards associated monetary and government policies, particularly in macroprudential supervision and the current
with own funds which have been released by the an environment of benign financial regulation and difficulties in developing models to capture the
European Banking Authority and looks at the pent-up demand for credit. propagation of systemic risk.
whole question of bail-in funds.
Link to publication Link to publication
Link to publication
Is Ireland really the role model for An architecture for meta-risk regulation in Recapitalising European banks
austerity? banking KPV O’Sullivan and S. Kinsella (Ed.) (2011); Financial Regulation International
Stephen Kinsella (2011); Publishers: Cambridge Journal of Economics KPV O’Sullivan and S. Kinsella (Ed.) (2011); Journal of Banking Regulaton This lead article describes the EU recapitalisation
Stephen’s paper describes the causes and This paper describes the EU recapitalisation
consequences of Ireland’s economic crisis in the proposals which were announced as part its road proposals which were announced as part of the
context of the policy solution implemented to map to stability and growth on 12 October road map to stability and growth on 12 October
contain that crisis: protracted fiscal austerity. The 2011. The plans are calling for ‘significantly’ higher 2011. The plans call for ‘significantly’ higher capital
paper describes the causes of the recent crisis in capital reserves to help banks replenish their reserves to help banks replenish their balance
Ireland, and looks at the logic of austerity within a balance sheets to withstand market turmoil amid sheets to withstand market turmoil amid the
simple model. It discusses the measures the eurozone’s sovereign debt crisis. The papers eurozone sovereign debt crisis. The papers
implemented to date in the current crisis, tracing details how extra capital requirements may result details how extra capital requirements may result
their effects and, asks whether Ireland is, indeed, in significant restructuring across European banks in significant restructuring across European banks
the role model for fiscal austerity in the given the high costs of raising capital. given the high costs of raising capital.
Eurozone.
Link to publication
Link to publication Link to publication
Europe prepares to regulate shadow banks
Supervision of banking system in Ireland What causes banking crises? KPV O’Sullivan and S. Kinsella (Ed.) (2012); Journal of Banking Regulaton
KPV O’Sullivan et al (2008); Publishers: Cesifo Group S. Kinsella (in press) What causes banking crises?’ Research Int. Biz and Fin.
This editorial examines global efforts to regulate
Vincent’s article looks at financial supervision in the shadow banking system, in particular the
Ireland and the likely knock-on impact that the US green paper released by the European
subprime crisis could have on the Irish financial Commission in March 2012. It suggests that the
system. It demonstrates that a benign financial financial market landscape in Europe is currently
regulator allowed Irish banks to lend imprudently in flux and large swings in market activity —
during the domestic property boom and are now either through financial innovation, changing
heavily leveraged and expose to fluctuations in market preferences or regulatory arbitrage —
property prices. The paper shows that Irish banks may unravel the work done by regulators in
exposure to US subprime mortgages (either shoring up their financial systems.
directly or through securitization) was minimal.
Link to publication
Link to publication Link to publication

6. Other regulatory/macro research
• O’Sullivan, K.P.V. and Kennedy, T. (2008) ‘Supervision of the Irish Banking System: A Critical Perspective”, CESifo DICE Report (3), 22-
26.
• Kinsella, S. (2009) ‘Financial Fragility and Corporate Governance in Ireland’, in Ronan Keane and Ailbhe O’Neal, (eds), Corporate
Governance and Regulation: An Irish Perspective, Dublin: Roundhall Press, 147-170.
• O’Sullivan, K.P.V. and Darragh, F. (2012) ‘A Discussion on the resilience of command and control regulation with regulatory behaviour
theories,’ Journal of Governance and Regulation, 1(1), 23-45.
• Kinsella, S. and O’Sullivan, K.P.V (2012) ‘Financial and Regulatory Failure: The Case of Ireland’, Journal of Banking Regulation, advance
online publication, January 18, 2012.
• Kinsella, S. (in press) ‘What causes banking crises?’ Research in International Business and Finance.
• Kinsella, S. and O’Sullivan, K.P.V. (forthcoming) “Regulatory Complexity and Uncertainty: the Capital Requirements Directive IV”, The
Harvard Law Forum on Corporate Governance and Financial Regulation.
• O’Sullivan, K.P.V and Kinsella, S (2011), Recapitalising European Banks, Financial Regulation International, 14(8), 1-8 (lead article).
• O’Sullivan, K.P.V. and S. Kinsella (2012) ‘2012: the year of deleveraging in Europe?, Financial Regulation International’, 15.1, pp 1-6 (lead
article).
• O’Sullivan, K.P.V. and S. Kinsella (2012) EC examines structural policy in banking, Financial Regulation International 15(3), pp 1-5 (lead
article).
• O’Sullivan, K.P.V. (2012) Concern mounts over ESMA's workload 15(3), pp 4-9.
• O’Sullivan, K.P.V and Kinsella, S (2012), ‘Regulating Financial Market Infrastructures, 15(4), 1-8 (lead article).

7. Why is this topic important?
• Pace
of regulatory reform has been feverish since the financial crisis in
Europe
• Higher capital requirements for banks (CRD III)
• Regulating Credit Rating Agencies (CRA I, II)
• Further
transparency and disclosure requirements (Regulators: we need
more and higher quality data!) (COREPS)
• Recovery and resolution plans
• New governance and internal controls requirements (remuneration)

8. What about regulators?
• New pan-European regulators across all financial sectors:
Ø European Banking Authority (based in London)
Ø European Securities and Markets Authority (based in Paris)
Ø European Insurance and Occupational Pensions Authority (based in
Frankfurt)
• New EU macroprudential regulator, the European Systemic Risk Board
• Pushtowards a ‘single rule’ book for financial regulation across the EU to
help promote the single market
• New ‘intrusive’ and ‘judgements’ based supervisory philosophy (out with
the ‘principles-based’, ‘risk-based’ failed regime)

9. Lots more to come
Key
RRPs: Recovery and Resolution Plans
D-F: Dodd–Frank Wall Street Reform and Consumer Protection Act
RDR: Retail Distribution Review
COREPS: Common Reporting
EMIR: European Market Infrastructure Regulation
AIFMD: Alternative Investment Fund Managers Directive
FICOD: Financial Conglomerates Directive
CRD/R: Capital Requirements Directive/Regulation
MAD/R: Markets Abuse Directive/ Regulation
PRIPS: Packaged Retail Investment Products
IORP: Institutions for occupational retirement provision
MiFID/R: Markets in Financial Institutions Directive/Regulation
CRA: Credit Rating Agencies
UCITS: Undertakings for Collective Investment in Transferable Securities

10. A need for further research
• Theregulatory agenda in Europe has lacked rigorous
macroeconomic analysis (cost-benefit analysis accompanying
regulations is not adequate in the presence of so much institutional
uncertainty, see OECD, 2012).

11. Practical implications
• This
lack of analysis could be an obstacle preventing authorities
pushing forward needed reforms in the face of mounting
opposition.
• We are already seeing significant pull-(and push-) back from
Ø regulators (who have insufficient resources)
Ø firms (concerned about additional costs-particularly in raising
high quality capital)
Ø investors (facing lower returns on equity)
Ø industrial organisations (worried about a fall-off in lending to
the economy)
Ø general public (frustrated by the slow pace of changes)

12. What is regulation?
Recognition that banking is unstable, important to impose rules to constrain
risky behavior
Specifically:
1. Capital adequacy ratios (Basel I, II, III). Now Min. 8% of Risk
weighted assets.
Tier 1 Capital Equity capital, highly sub. Bonds
Other sub. Bonds
2. Valuation issues abound. Concept of VaR during crises

13. Our theoretical frame
• Kindleberger/Minsky/Koo (not Eggerston/Krugman), See Kinsella
2009.
• Creditcreates its own reversal, essentially. Regulation is necessary
to attenuate scale of the crisis.
• Inthe absence of effective monetary/fiscal policy, regulation is the
third best solution, but actually given where we are, is the most
likely route to successful reform.
• However, remember John Gray: regulation, like choice can become
a fetish. We must be aware of its limitations.

14. Defining Regulation more carefully
Standard Definition: an effort exerted by an authoritative agency to
change the behaviour of economic agents to a certain, pre-
defined condition.
Effort-some element of standard setting, information gathering and
monitoring.
Changing behaviour- the purpose regulation is usually to influence
individual and firm-level behavioural patterns
Authoritative agency- recognises the growing importance of non-
state institutions as regulators.
Economic agents- reflects regulation as fundamentally a politico-
economic concept which can be best understood in relation to
economic or legal organisation.

15. Why Regulate?
1. Market Failure (Public choice theories)
1. Externalities Monopoly / oligopoly
2. Information failure
3. Principal/agent problem – Information failures
2. Economic Theory (Private Choice Theories): “regulation is
acquired by certain interests who design and operate it for their
own benefit” (Stigler 19710)
3. Institutional theory: Organisations create regulations and regulate
new areas to establish legitimacy, expand their budgets and,
ultimately, survive.

16. Why has regulation become important?
Growth of the ‘risk society’ (Scott2000),where governments are increasingly
responsible for regulating risk.
Privatization of semi-state firms during the Reagan/Thatcher administrations.
Propagation of the “regulatory state”, big government and the European
Union (Majone 1994).
Industrial and financial failures(e.g. Collapse of Enron resulted in the
Sarbanes-Oxley Act).

17. Coordination
Balance sheet
damage
Perfect Complexity
storm
Fiscal
constraints Contagion

18. Current Balance Sheet View:

19. Macroeconomics: It's all b/s
Taylor, 2010, pg. 135

20. Macroeconomics: It's all b/s
Households Firms Government Central Bank
Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities
Money Mortgages Capital Loans “Faith & Bonds Bonds Bank
Bonds Net Bonds Credit” Reserves Reserves
Equity Worth Equity (Int’l)
Housing Net
Worth
Commercial Banks SPVs Leveraged Finance Rest of World
Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities
Loans Money Mortgages CDOs CDOs Loans Int’l
Mortgages Equity NAMA’d Repos Repos Reserves
Bank stuff Equity (net
Reserves worth
Taylor, 2010, pg. 135

21. Fiscal Issues

22. Imbalances

23. Coordination
Balance sheet
damage
Perfect Complexity
storm
Fiscal
constraints Contagion

24. Concentration & Complexity are
features of modern banking.
P. Gai, A. Haldane, S. Kapadia, Complexity, Concentration and Contagion, Journal of
Monetary Economics 58(2), 2011

25. Concentration & Complexity are
features of modern banking.
• Coordination as patchwork recognized back in1996 as a
potential disaster wrt regulatory arbitrage.
• Supervisory authorities on top of national regulators include
AFME, AIMA, EACH, EBF, FOA, ICMA & ISDA.
• One rule book approach still developing
• No solution to ‘financial innovation’ just yet.
See Adrienne Heritor The accommodation of diversity in European policy-making and its outcomes:
Regulatory policy as a patchwork, Journal of European Public PolicyVolume 3, Issue 2, 1996.

26. Concentration & Complexity are
features of modern banking.
• Complexity of rules ensure heterogenous implementation &
are inimical to coordination.
Andrew Haldane, Executive Director, Financial Stability, Bank of England, Capital Discipline, speech at the American Economic Association,
Denver (Jan. 9, 2011) at http://www.bankofengland.co.uk/publications/speeches/2011/speech484.pdf

27. Haldane, 2011:
“As a thought experiment, imagine instead we
were designing a regulatory framework from
scratch. Finance is a classic complex, adaptive
system. What properties would a complex,
adaptive system such as finance ideally exhibit to
best insure about future crises? Simplicity is one.
There is a key lesson, here, from the literature on
complex systems. Faced with complexity, the
temptation is to seek complex control devices. In
fact, complex systems typically call for simple
control rules. To do otherwise simply compounds
system complexity with control complexity.”
Andrew Haldane, Executive Director, Financial Stability, Bank of England, Capital Discipline, speech at the American Economic Association,
Denver (Jan. 9, 2011) at http://www.bankofengland.co.uk/publications/speeches/2011/speech484.pdf

28. Example
• ESMA’s regulation of Credit Rating Agencies required the following:
• ESMA, Consultation Paper - Regulatory Technical Standards on the Information to Be
Provided to ESMA by a Credit Rating Agency in its Application for Registration and
Certification and for the Assessment of its Systemic Importance, ESMA/2011/302 (Sep. 19,
2011); ESMA, Consultation Paper - Regulatory Technical Standards on the Assessment of
Compliance of Credit Rating Methodologies with the Requirements Set out in Article 8(3)
of Regulation (EC) No 1060/2009, ESMA/2011/303 (Sep. 19, 2011); ESMA, Consultation
Paper - ESMA’s Draft Regulatory Technical Standards on the Presentation of the Information
That Credit Rating Agencies Shall Disclose in Accordance with Article 11(2) and Point 1 of
Part II of Section E of Annex I to Regulation (EC) No 1060/2, ESMA/2011/304 (Sep. 19,
2011); ESMA, Consultation Paper - ESMA’s Draft Regulatory Technical Standards on the
Content and Format of Ratings Data Periodic Reporting to Be Submitted from Credit
Rating Agencies, ESMA/2011/305 (Sep. 19, 2011)

29. Coordination
Balance sheet
damage
Perfect Complexity
storm
Fiscal
constraints Contagion

30. Historical context
• Allof this has happened before. It will happen again. Regulation
is not the solution to attenuating the Minsky cycle, but part of
it.

32. Schularick, Jorda, and Taylor, 2011

33. Digression on the Irish Crisis

37. All of the preceding data
taken from regulator/CBI

38. “History repeats itself…
• ….. in financial matters because of a kind of sophisticated stupidity.”
• “Financial memory should be assumed to last, at a maximum, no more
than 20 years. This is normally the time it takes for the recollection of
one disaster to be erased and for some variant on previous dementia
to come forward to capture the financial mind.”
• “The world of finance hails the invention of the wheel over and over
again, often in a slightly more unstable form.”
• “It [the collapse of 1837] introduced a distinctly modern attitude
toward the loans that were outstanding...Anger was expressed that Galbraith 1993
foreign banks and investors should now, in hard times, ask for payment
of debts so foolishly granted and incurred. A point must be repeated:
only the pathological weakness of the financial memory...allows us to
believe that the modern experience of Third World debt...is in any way
a new phenomenon.”

39. Banking crises hits growth
Source: Richmond Fed, Nov 2011

40. Not that different from the past
Distance in years from first year of crisis
Source: Citi Investment research Dec 2011 & IMF. * shortfall is compared to average for countries with systemic banking crises, 1980 –
2011)

41. Debt.

42. ECB: carry that load
Source: ECB

43. Flow of funds in the eurozone
Households Financial
corporations
Rest of World
Households
Source: ECB, ICFR calculations

44. See Handout.
Deleverage? Credit growth/
decay
Deleveraging the Eurozone. VoxEU, 17 December 2011. (With
KPV O’Sullivan)

45. Current Challenges
• Crisis is evolving, today's solution is not tomorrow's.
• Low high-quality information environment.
• Banks are not passive actors, regulation does not help
them.
• Balance is not something to strive for in this space.

46. Our ‘SADLIR’ Financial Regulatory
Cycle

47. New Issue(s)
• How long can monetary and fiscal policy support banks?
• Raising capital
• Profitability
• Shadow banking. Huge issue, see O’Sullivan & Kinsella (2012)
• Macroprudential supervision: who, how and why?
• What about ‘good regulation’ principles? Are there any?

48. Core tier 1 capital of G-SIFIs
9% target set by the
EU Leaders by July
2012
*= Global systemically important financial institutions as per IMF's (Nov. 2011) list: http://www.financialstabilityboard.org/
publications/r_111104bb.pdf, excluding Banque Populaire which is not listed. Data sourced from Thomson Reuters.

49. Loan assets of financial
Base Jan
2008=100 institutions

50. Deleveraging starting to bite in
Europe
(net % of banks contributing to tighter lending standards, euro area)
Source: ECB bank lending survey January 2012, q1 2010-q4 21011

51. The Future?
Meta-risk regulation: Trades off Micro vs Macro stability.
Three Mile Island crisis in 1979.
Move from just inspecting compliance of rules to evaluating risk
management systems.
Seeking to establish if senior managers have the “risk analysis
intelligence” to deal with unforeseen events.
Regulator needs to establish institutional structures to support a
more towards MMR
Connecting MMR into a macroeconomic framework is the next step