Transcript International Aspects of Financial Regulation

Aspects of Financial
Regulation
MSc Financial Economics
Anne Sibert
Spring 2014
International Aspects of Financial Regulation
Purpose of financial regulation
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To protect consumers
To ensure competition
To lessen the likelihood of instability
I will mainly focus on the last of
these
Three aspects of retaining and
restoring stability:
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Lowering the likelihood of crises
• Lowering the likelihood of a liquidity
crisis
• Lowering the likelihood of a solvency
crisis
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Warning of crises
Managing a crisis
I will consider these three things in
turn
Lowering the likelihood
of a liquidity crisis
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Old-style depositor runs
New-style wholesale creditor runs
Speculative attacks on fixed
exchange rates
Adverse selection shutting down
markets
I will consider the first two of these
Averting old-style bank runs
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It is difficult for small retail investors to monitor
the health of a bank.
The government wants to protect these
consumers while still creating an incentive for the
private sector to monitor banks.
Provide deposit insurance with a ceiling and,
perhaps, exclude wholesale investors.
Public or private funds can insure deposits in the
event of a failure of a medium-size bank.
How does this work in practice?
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In the United States
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In Europe
In the United States
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The Federal Deposit Insurance Corporation
(FDIC) insures deposits in banks and thrift
institutions for at least $250,000.
Standard insurance will return to
$100,000 in 2014.
It is funded by premiums that banks and
thrift institutions pay for deposit insurance
coverage and from earnings on
investments in U.S. Treasury securities.
The FDIC is also a bank supervisor.
Backed by the Federal Reserve.
In Europe:
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The EU faces the problem of who is to insure the depositors
of a member country’s multinational bank branches that are
located in other member countries.
The provision of deposit insurance in the EU (and also in
the EEA countries Norway, Switzerland and Iceland) is
governed by a directive.
Directives are legislative acts that specify a result that
Member States must achieve, leaving the form and method
up to the Member States. This directive requires that
Member States are to have and monitor a deposit
guarantee scheme that protects most depositors up to EUR
100,000.
Member States are allowed to choose among different types
of schemes and the idea is that these schemes are to be
funded by charging resident banks.
Cyprus
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On 15 Mar 2013 the ECB ordered the
President of Cyprus to come up with
5.8 billion euros without increasing
his country’s indebtedness as part of
Cyprus’s contribution to a ESM
rescue package.
Without such an agreement
borrowing from the ECB would be cut
off and the Cypriot banking system
would collapse.
Catastrophe
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As it nice to have a banking system,
Cyprus would likely have been forced to
leave the Euro Area (and probably the
EU).
It would issue its own currency and use it
to recapitalize its banking system.
Consequently the value of the new
currency would plummet, as would the
value of residents’ bank accounts,
pensions and wages.
The president looked to the only
source of available cash
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The president proposed a levy on all
bank accounts.
Although it was not accepted, the
proposal had the approval of EU
policy makers at the time.
EFTA Court Ruling
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The EFTA court ruled that Iceland
was not legally required to
compensate UK and Dutch depositors
who had placed their money in
Icesave accounts.
EFTA court ruling
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The intent of the directive was to eliminate restrictions on
the establishment and provision of financial services within
the EEA while supporting the stability of the area’s banking
system and providing insurance for its savers.
The directive was intended to prevent EEA Member States
from impeding the activities of credit institutions licensed in
other Member States by invoking depositor protection.
The directive was not intended to protect depositors in all
instances.
Forcing the banking system to provide the funding
necessary to cover depositors in a systemic crisis would
undermine the objective of promoting the stability of the
banking system.
EFTA court ruling
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If the state were required to provide the funding
that the banking system this this would have a
negative effect on competition.
It also interpreted the wording of the directive to
suggest that it was meant only to cover the
failure of individual banks and not the failure of a
large part of the banking system that would
occur in a systemic crisis.
Finally, the Court ruled that it was permissible
for Iceland to treat depositors at home differently
than depositors in foreign branches.
Are deposits safe?
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German Finance Minister Wolfgang
Schäuble recently stated that,
‘[deposits] are safe, though only on
the proviso the states are solvent.’
The Cypriot bank deposits had the
highly enticing feature (from the
Cypriot point of view) that non-EU
residents owned a large fraction of
them, perhaps a third or even a half.
Are deposits safe?
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Moody's estimated that there were about USD 31
billion of Russian money in Cypriot bank
accounts.
Moreover, there was a widespread suspicion that
the Russian investment in Cyprus was driven by
corruption-linked money laundering.
The initial proposal to tax small as well as large
deposits may have been in part a result of a
belief that much of the Russian money in Cyprus
had been broken up and put into small, insured
deposits. Thus, the only way to access it was to
tax both small and large accounts.
However, ultimately even Cyprus in its dire
circumstances spared its insured depositors.
Are deposits safe?
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In practice, small deposit holders around the world have
been well protected.
In the United States, the Federal Deposit Insurance
Corporation (FDIC) was established in 1933 and no one has
ever lost a cent in an FDIC-insured deposit since then.
Not a single small deposit holder in an advanced economy
has lost their money since the financial crisis arose.
Perhaps the most recent example of a sovereign of what is
now a euro area state not fully protecting its deposit
holders is the Italian government’s levying a paltry 0.6
percent tax on bank accounts as part of its attempt to stave
off the collapse of the lira in July 1992.
Does depositor insurance
promote financial stability
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In the canonical story of depositor runs each
depositor believes that all other depositors will
run and, thus, the bank will fail. Thus it is optimal
for each depositor to run and a bank that would
otherwise be solvent can fail solely as a result of
self-fulfilling expectations.
This financial fragility argument has been used to
justify deposit insurance. If it is known that
deposits are safe and that consumers will always
have access to their money, then no depositor
has an incentive to run.
Deposit insurance and
moral hazard
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The problem with using deposit insurance to
avert bank runs, however, is that deposit
insurance also promotes moral hazard.
If depositors have no incentive to monitor the
activities of banks, then banks will engage in
riskier behavior.
As an empirical matter, it is not clear whether
deposit insurance promotes financial stability.
There are fewer runs but the quality of bank
assets is likely to deteriorate.
An empirical study
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Demergüç-Kunt and Detragiache (2002) use data from a
large panel of countries from 1980 – 1997 and find
evidence that offering explicit deposit insurance is
detrimental to bank stability.
Deposit insurance is not necessary to prevent bank runs.
For countries in the euro area, the Eurosystem can act as
lender of last resort in the event of a depositor run.
In other countries as long as banks’ deposits are not
allowed to become too large, the central bank can act as
the lender of last resort.
If it is fully credible that the central bank will always loan to
illiquid, but fundamentally solvent, banks then depositor
runs based solely on self-fulfilling expectations should not
occur.
Should large depositors be
protected?
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A Widows and Orphans argument for
large depositors? A lesson from
Cyprus: large depositors can be
firms, households and institutional
investors. Or, they can be criminals.
The differential treatment of insured
and uninsured deposits is less
relevant in the United States than in
Europe.
Who should foot the bill?
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Banks should pay insurance premiums and the amount could depend upon
readily measurable features that indicate its riskiness or how likely it is to
contribute to systemic risk. The EU has favored this ex ante approach.
The US has favored a bank tax. If Bank A fails the shareholders and some or
most of the uninsured creditors should lose their money before the taxpayers
step in. But why should Bank B should be assessed before the taxpayers?
• For a country with a small number of banks is that it gives each banks an
incentive to monitor each other.
• If Bank A failed for systemic reasons or if Bank A’s failure causes systemic
problems then Bank B has to come up with additional liquidity at a time it
might be pinched itself.
The current crisis was, to a great extent, the result of governments’ policy
blunders, the failure of policy makers to design institutions properly and failures
of supervisors and regulators to adequately oversee their charges. In the
democratic North Atlantic nations that experienced the financial crisis, the
electorate bears much of the blame. For it to share the burden is only fair and
encourages it to ensure that the same errors are not repeated.
Rules vs. discretion
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A legal system that does not spell out how much of a haircut each
type of unsecured debtor is supposed to take benefits only
lawyers.
Banks could issue securities such as contingent convertible bonds
(“Cocos”) that are clearly not protected. These are bonds which
are automatically converted into equity at a pre-specified price
when some trigger point is reached.
The Basel Committee wants the regulators to decide when the
trigger point is reached. The benefit is flexibility but it eliminates
one of the main advantages of Cocos: the rules of the game are
clear to all in advance.
An alternative is for the conversion to be triggered by some
readily observable and verifiable event. Credit Suisse, Rabobank
and Lloyds have all issued Cocos that are triggered if their Tier-1
capital falls below some specified level.
The future of deposit insurance in the EU
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There is going to be a single supervisory
mechanism for the Euro area.
Once there is a single resolution regime, the EU
can begin work on a single, harmonized deposit
insurance scheme.
Averting new-style bank runs
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The central bank can act as lender of last
resort, providing domestic currency loans.
There is a problem of determining whether
the financial institution is insolvent or
merely illiquid.
Countries that do not have an important
international reserve currency should not
let their financial sectors become too
large.
Famous Example:
The Bank of New York
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In 1985 the Bank of New York played a
key role in the market for US government
securities. It acted as a clearing house:
buying bonds and reselling them.
On 20 Nov 1985 a software mistake
caused it to lose track of its transactions
and at the end of the day it owed $23
billion that it did not have.
The Federal Reserve Bank of NY stepped
in and made a loan.
An international
lender of last resort?
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An international lender of last resort may seem like an
appealing reform measure, but it has never proved feasible
in practice.
One reason is that distinguishing solvent but liquid
borrowers from insolvent borrowers is difficult, particularly
if the lender of last resort is not also (or does not also have
a close relationship with) the supervisor and regulator of a
financial institution in need of a loan.
If a loan is made to a financial institution that turns out to
be insolvent and cannot repay, then the tax payers of the
countries who fund the international lender of last resort
must pay.
To fund an international lender of last resort requires deep
pockets and a willingness to transfer money from tax
payers in one country to the creditors of a defaulting
financial institution in another country when an ex post
incorrect decision is made.
The IMF as
lender of last resort?
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The IMF has not been especially successful at
playing the role of lender of last resort.
Traditional IMF loans -- with conditionality and
funds disbursed in tranches -- are not suited to a
liquidity crisis.
Recently, however, the IMF has expanded its
limited role as international lender of last resort
(to countries, rather than to specific financial
institutions) by introducing a flexible credit line
(FCL).
Access to the Flexible Credit Line (FCL) is
limited to countries with very strong
fundamentals, policies, and track records of
policy implementation. Disbursements under the
FCL are not phased or conditioned to policy
understandings.
Preventing Solvency Crises
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Restructure supervision and
regulation
Prevent financial firms from
becoming too big to fail
Prevent financial firms from
becoming too leveraged
Limit the activities of financial firms
Prevent bankers from having an
incentive to take on too much risk
Restructuring
supervision and regulation
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Many countries – such as the United States –
have an institutional system of regulation. That
is, supervision is organised according to types of
financial institutions.
In a world where the difference between types of
financial institutions is diminishing this makes
little sense and it has allowed some financial
institutions to be lightly regulated, or in the case
of hedge funds, to be not regulated at all.
The solution to this is to have a regulatory
system that is based instead upon objectives,
such as financial stability, consumer protection
and adequate competition.
Horrible example of what can go
wrong with an institutional system
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Perhaps even more than the 14 September 2008 collapse
of Lehman Brothers, it was the failure of American
International Group (AIG) two days later that marked the
beginning of the global financial crisis.
AIG (the subject of the largest government bailout of a
private company in US history) is a global insurance
company with a balance sheet of more than a trillion dollars
– the 18th largest publicly owned company in the world in
2008.
Regulated by the New York State Regulator of Insurance, it
developed a rogue investment banking unit that sold credit
default swaps out of sight of the Fed, the FDIC or the SEC.
As Fed Chairman Bernanke, commented, “A.I.G. exploited a
huge gap in the regulatory system. There was no oversight
of the financial products division. This was a hedge fund,
basically, that was attached to a large and stable insurance
company.”
Preventing financial firms from
becoming too big
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Some financial firms are too big to
fail.
This causes them to take on too
much risk.
They receive better interest rates
and put smaller banks at a
competitive disadvantage.
Rajan, Raghuram, “A better way to reduce financial sector
risk,” Financial Times, 25 Jan 2010.
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Are size limits a good idea?
How should size be defined? Whether you use assets,
capital or profits there will be problems – banks will try to
economise on whatever measure is limited.
Limits on asset size: Banks would attempt to hide financial
activities from regulators off balance sheet.
Limit capital: Banks will economise on it as much as
possible, increasing risk.
Limit profits: Reward sickly banks by allowing them to
expand indefinitely.
Being large is neither necessary or sufficient for an entity to
be a systemic risk.
Instead of imposing a blanket ban on institutions growing
beyond a certain size, regulators should use more subtle
mechanisms such as prohibiting mergers of large banks or
encouraging the break-up of large banks that seem to have
a propensity for getting into trouble.
But there are always concerns about whether regulators will
use these sorts of powers arbitrarily.
Capital Requirements: preventing firms
from becoming too leveraged
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The Basel II accord sets out international standards for
banking regulators seeking to reduce excessive risk taking
by banks by imposing the amount of capital that banks are
required to hold.
It is widely believed that these capital requirements are
pro-cyclical. During an economic downturn, banks’
estimates of the likely losses on their loans rise and, under
the Basel II rules this increases their required capital. As a
result, their ability to make further loans is impaired and
this worsens the downturn further.
It is argued that the Basel II accord places an insufficient
emphasis on liquidity management and too much reliance
on internal risk management models and on ratings
agencies.
Satisfactory solutions to the inadequacies of Basel II are
not obvious, but resources should be devoted to developing
them.
Regulate the scope:
United States
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The Glass-Steagall Act prohibited banks from owning
shares of stock in corporations.
The main objection was the stock is too risky.
In 1987, J.P. Morgan found a loophole: banks may not be
affiliated with any firm engaged principally in underwriting
and dealing in firm securities. So, J.P. Morgan, Bankers
Trust and Citicorp set up affiliates that engaged in
underwriting and dealing with firm securities in a limited
fashion.
In 1999 the Gramm-Leach-Bliley Financial Services
Modernisation Act eliminated the contraints.
In the United Kingdom and many other countries universal
banking has been the norm.
Regulating Off-Balance-Sheet
Banking: securitisation
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Securitisation involves pooling loans with similar risk
characteristics and selling the loan pool as a tradable financial
instrument.
While allowing the diversification of idiosyncratic risk,
securitisation perverts the incentives of commercial banks.
Commercial banks exist as intermediaries between borrowers and
lenders because they can mitigate asymmetric information
problems in credit markets by collecting information about
potential borrowers (thus reducing adverse selection problems)
and by monitoring their behaviour (thus reducing moral hazard
problems).
A commercial bank that intends to securitise its loan portfolio has
little incentive to either gather information about potential
borrowers or to oversee the behaviour of borrowers once the loan
is made.
Regulatory reform need not eliminate securitisation, but it must
restore the proper central bank incentives. One way that this
could be done is to insist that a commercial bank or other financial
institution that securitises its loans retain some fraction of the
subordinate, or riskiest, tranche.
Changing Bankers’ Incentives
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Huge upside potential to taking on
risk; little downside risk.
Many executives at financial firms
that had to be bailed out lost large
amounts of money, but they remain
very wealthy.
Sir Win Bischoff presided over the
failure of Citigroup. Alistair Darling
supported his appointment as
chairman of Lloyds.
What can be done?
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Charles Krauthammer: “I would be for an
exemplary hanging or two.”
Keith Olbermann: "Certainly, we can screw these
guys out of these bonuses the way they screwed
us.”
Thomas Sowell: “If members of Congress can't
be bothered to read the laws they pass, then
they have no basis for whipping up lynch mob
outrage against people who did read the law and
acted within the law.”
Larry Summers: "The easy thing would be to just
say, you know, ‘Off with their heads,’ and violate
the contracts.
What can be done?
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Much of salary could be paid in stock that has to
be held for a significant period of time. This has
the drawback that it makes wage income and
non-wage income highly correlated.
“We must stop sending the message to our
bankers that they can win on the rise and also
survive the downside. This requires legislation
that recoups past earnings and bonuses from
employees of banks that require bailouts.” Boone
and Johnson
Supertaxes on bonuses
Are these good ideas?
Bill of attainder
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A bill of attainder is a legislative act that punishes a
person or group for a crime without a trial.
The Irish rebel, Lord Edward Fitzgerald, had had his
property confiscated in 1798 by a bill of attainder. Denied
medical treatment, he had died before a trial.
In 1779 the New York legislature confiscated the property
of suspected loyalist Parker Wickham and banished him
under threat of death. He claimed to be innocent, but was
denied a trial.
The UK had stopped passing bill of attainders after 1798
and they are banned by the US constitution.
An ex post facto law retroactively changes the legal
consequences of actions committed prior to the enactment
of the law. These are unconstitutional in the United States,
but technically possible in the UK.
Regulatory Capture
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The famous University of Chicago
economist and judge Richard Posner
said, “Regulation is not about the
public interest at all, but is a
process, by which interest groups
seek to promote their private
interest ... Over time, regulatory
agencies come to be dominated by
the industries regulated.”
Famous example
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In the 1880s the US Interstate Commerce Commission
(ICC) was set up to regulate the prices of railroad freight.
Richard Olney, a lawyer for the railroads was then
appointed US attorney general.
Olney's former boss, a railroad president, asked him if he
could get rid of the ICC. Olney replied, "The Commission . .
. is, or can be made, of great use to the railroads. It
satisfies the popular clamor for a government supervision
of the railroads, at the same time that that supervision is
almost entirely nominal. Further, the older such a
commission gets to be, the more inclined it will be found to
take the business and railroad view of things. . . . The part
of wisdom is not to destroy the Commission, but to utilize
it.“
Thomas Frank, “Obama and 'Regulatory Capture‘: It's time
to take the quality of our watchdogs seriously,” WSJ, JUNE
24, 2009
Warning of a crisis
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Economists have been widely reviled in the popular press
for failing to predict the current financial crisis.
To some extent, this criticism is unfair. Future economic
outcomes are functions of future fundamental random
variables. Even if economists could perfectly model the
world and even if they knew all of the potential
fundamental random variables and their distributions, they
could at most describe the statistical distribution of future
economic outcomes.
However, even if economists could not have predicted the
timing of the current collapse, it might be argued that they
should have realised the extent of the systemic risk in the
financial sector.
If economists had properly assessed the systemic risk in
the global financial system in early 2007, the vulnerability
of financial institutions would have been recognised, and it
would have been understood that if events triggered the
collapse of just one or a few important financial firms, then
an entire national, or even the international, financial
system could be endangered.
Why didn’t economists
warn of systemic risk?
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Yet, few – if any – economists sounded a widely heard
alarm on this point. In the period prior to the credit crisis of
August 2007, many economists voiced concerns about the
rise in US house prices and the size of global imbalances.
Not many, however, argued that systemic risk was
excessively high in the financial sector.
One reason for this is that systemic risk is not yet well
understood. Another reason is that, while housing and
balance of payments data is widely available, few
economists knew that financial firms had become so
leveraged or comprehended the nature of the real-estatebacked assets that these firms held.
Most economists had little incentive to analyse systemic
risk; they were rewarded for doing other things. Identifying
systemic risk in the financial sector will require having the
data to measure it and rewarding some body of research
economists and related professionals for spotting it.
Definition of systemic risk
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G10 definition: “the risk that an event will trigger
a loss of economic value or confidence in, and
attendant increases in uncertainty about, a
substantial portion of the financial system that is
serious enough to quite probably have adverse
effects on the real economy”
Or, it is the risk that one or a few financial
institutions might fail, at least partially because
of institution-specific factors. Then, because of
the size of the failed entities or the interlinkages
between these entities and other financial
institutions, additional financial firms would begin
collapsing until entire markets or even the whole
financial system is endangered.
Previously economists have tried to
predict when and where crises will occur
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Unfortunately, we haven’t been very good
at it.
A recent paper by Rose and Spiegel
(2009) illustrates the difficulties. They try
to do something simpler. They ask given
that the financial crisis occurred, can they
come up with a model that predicts the
incidence across countries.
Rose, Andrew and Mark M. Spiegel,
“Cross-Country Causes and Consequences
of the 2008 Crisis: Early Warning,”
unpublished paper, Sept. 2009.
Extent of the crisis
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First task: measure the extent of the
crisis in 107 countries
Use data from 2008 and early 2009.
The authors use real GDP growth,
variance financial market indicators
such as stock market growth and
exchange rate appreciation, the
country ratings from Institutional
Investor.
Predict the incidence
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Explanatory data is from 2006 or
before
Country size, country income,
measures of financial policies,
condition of the financial sector,
asset price appreciation,
international imbalances,
macroeconomic policies, state of
economic institutions, geography
Results are disappointing
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Only a few variables have even weak
predictive power
Countries with large stock market
increases relative to GDP, large current
account deficits relative to GDP, or few
reserves relative to short-run debt were
more apt to have crises than other
countries.
Real estate price increases were
statistically insignificant.
What went wrong?
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Maybe the crisis arose in just one or a few countries and
spread to the rest via contagion.
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Maybe the crisis was caused by different factors in different
countries.
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Maybe it is not individual variables, but combinations of
variables, that matter. An example from Lo (2009): higher
real estate prices, falling interest rates and increased
availability of financing may not be bad on their own. But,
together they are associated with home owners becoming
more leveraged with no way of reducing their exposure
when house prices drop.
Maybe the crisis depends on things we cannot measure:
say, business ethics.
Measuring systemic risk
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Maybe measuring systemic risk is an
easier and better way of providing an
early warning system.
We can’t predict when a big financial
firm will fail, but maybe we can
predict the likelihood of a dominolike collapse, given the failure of one
big firm.
To predict systemic risk in the euro area,
we need to know the balance sheet for
the euro area as a whole
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Small changes in financial prices can have devastating
consequences for highly financial firms. How leveraged is
the euro area?
If a financial firm is in trouble, it may have to sell its illiquid
financial assets at fire sale prices. So, how liquid is the euro
area?
How correlated are the prices of euro-area assets? How
sensitive are they to changes in conomic conditions?
We want market prices on on- and off-balance sheet assets
and liabilities of all euro area financial firms, including those
in the shadow banking sector.
See Lo, Andrew, “The Feasibility of Systemic Risk
Measurements: Written Testimony for the House Financial
Services Committee on Systemic Risk Regulation,” Oct.
2009.
Interlinkages
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We would like to measure how relationships between
financial institutions contribute to risk.
Are some financial institutions, such as AIG, too
interconnected to fail?
Economists are using network theory to consider this
question.
Some results: Increased connectivity may ensure more
risk sharing, but can amplify shocks. If a larger than
expected number of institutions are more connected than
average, than the system may be less vulnerable to
random shocks, but more vulnerable to shocks to the hubs.
Soramaki et al (2007) use a network map of the US
Fedwire interbank payment system to look at
connectedness in the US financial system.
Soramaki, K., Bech, M. Arnold, J., Glass, R. and W. Beyeler,
“The Topology of Interbank Payment Flows,” Physica A 379,
2009, 317-333.
Problems with a
systemic risk data set
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It would need new laws to get firms to comply.
It would be very expensive to collect the data,
store it and turn it into something usable. A new
agency would probably be required.
As many financial firms are multinational
enterprises, international coordination, say
through the BIS or IMF, would desirable, but that
may be politically difficult.
The data will, at most, allow policy makers to
observe the symptoms of financial vulnerability.
Using a systemic risk data set in an early warning
system is no substitute for sensible economic
policy and good supervision and regulation.
Connectedness is
not well understood




A key feature of a crisis caused by systemic risk factors is
the domino-like collapse of a chain of financial institutions
after the demise of a just one or a few. This may be
because of the size of the first institutions to go, or it may
be because they were too interconnected to fail without
damaging the entire system. But, neither size nor
conventional connectedness may be necessary for a
financial crisis to propagate.
A new or old-style bank run or speculative attack in one
market may make a similar run or attack a focal outcome.
Recent research by Stephen Morris and Hyun Song Shin
(2009) demonstrates that a tiny amount of contagious
adverse selection can shut down a market.
Morris, Stephen, and Hyun Song Shin, “Contagious Adverse
Selection,” unpublished paper, 2009.
A systemic risk warning board


The data set cannot be used
mechanistically
Thus, along with an agency to collect and
manage the data, the Eurozone must have
a systemic risk assessment committee to
interpret this and other relevant data, in
light of the current macroeconomic and
regulatory and supervisory environment.
Designing a systemic risk board


The board should be small and diverse. I suggest
that ideally it should be composed of five people:
a macroeconomist, a microeconomist, a financial
engineer, a research accountant, and a
practitioner.
The reason for diversity is that spotting systemic
risk requires different types of expertise. A board
composed of entirely of macroeconomists might,
for example, see the potential for risk pooling in
securitisation, whereas a microeconomist would
see the reduced incentive to monitor loans.
Why five members?




The reason for the small size is that, consistent with the
familiar jokes, it is a stylised fact that the output of
committees is not as good as one would expect, given their
members.
Process losses due to coordination problems, motivational
losses, and difficulty sharing information are well
documented in the social psychology literature; not
everyone can speak at once; information is a public good
and gathering it requires effort; no one wants to make a
fool of themselves in front of their co-members.
As the size of a group increases so does the pool of human
resources, but motivational losses, coordination problems,
and the potential for embarrassment become more
important.
The optimal size for a group that must solve problems or
make judgements is an empirical issue, but it may not be
much greater than five.
It should be independent


The committee should be composed of researchers outside
of government bodies and international organisations;
career concerns may stifle the incentive of a bureaucrat to
express certain original ideas. It is of particular importance
that the board not include supervisors and regulators. This
is for two reasons.
• First, it is often suggested that supervisors and
regulators can be captured by the industry that they are
supposed to mind, and this may make them less than
objective and prone to the same errors.
• Second, a prominent cause of the recent crisis was
supervisory and regulatory failures, and these are more
apt to be spotted and reported by independent
observers than the perpetrators.
Finally, it is important that the board be made sufficiently
visible and prominent that a member’s career depends on
his performance. Given the importance of the task, pay
should be high to attract the best qualified, and the
members should not have outside employment to distract
them.
The European Systemic Risk
Board (ESRB)


The Eurozone has already swung into action, creating the
European Systemic Risk Board (ESRB), set to begin this
year. Unfortunately, this board, responsible for macroprudential oversight of the EU financial system and for
issuing risk warnings and recommendations, is far from the
ideal. It is to be composed of the 27 EU national central
bank governors, the ECB President and Vice-President, a
Commission member and the three chairs of the new
European Supervisory Authorities. In addition, a
representative from the national supervisory authority of
each EU country and the President of the Economic and
Financial Committee may attend meetings of the ESRB, but
may not vote.
This lumbering army of 61 central bankers and related
bureaucrats is a body clearly designed for maximum
inefficiency; it is too big, it is too homogeneous, it lacks
independence, and its members are already sufficiently
employed.
Could the IMF
provide early warnings?




The IMF is intensely bureaucratic. Its culture may result in
staff who are socialised to think in a particular way. To see
a looming crisis before others typically requires thinking in
a highly independent and unconventional way.
The IMF is an exceedingly political organisation; to argue
one’s unusual and possibly sensitive view may not be a
career-enhancing move for a staff member.
While the IMF has the expertise to analyse financial account
crises, its emphasis on macroeconomics may mean that it
does not have the expertise to predict financial sector crises
based on microeconomic failures.
The objections raised to the IMF as provider of early
warnings apply to a great extent to other international
organisations and central banks.
It is vital to have a good resolution
regime for banks


Because of systemic risk factors that are
not yet well understood, there is the fear
that the demise of just one or a few
sufficiently large or interconnected banks
could lead to the domino-like collapse of a
chain of banks and even an entire national
or the global financial sector.
Because the real economy is so dependent
upon the orderly functioning of the financial
system, this could be a damaging or even
devastating blow that could lead to years of
recession or worse.
Conventional bankruptcy regimes
are not enough


We need a special regime for banks. Conventional
bankruptcy regimes are too slow and cumbersome
and can interact badly with foreign countries’ regimes
in the case of multinational banks.
The regime needs to
•
•
•
•

specify when and how a bank is to be declared bankrupt
rank the claims of different types of creditors
provide an orderly process for realizing these claims
provide a mechanism for allowing the parts of the bank
that are to be kept on as going concerns to continue to
operate.
Designing and implementing a bankruptcy regime for
banks is challenging!
Using conventional
insolvency laws




Lehman Brothers filed for Chapter 11 bankruptcy protection
on 15 September 2008.
At Lehman, all spare cash held by the London subsidiary –
a corporate entity subject to British bankruptcy legislation –
was sent to the New York parent at the close of each
business day.
When the directors of this subsidiary realised on Sunday 14
September 2008 that their US parent was going to file for
bankruptcy protection the next day, they realised they no
longer had the cash to fund their operations.
Under British law the firm had to be put into administration: its access to exchanges and clearing systems was
frozen with a large number of trades left open.
Lehman illustrates the problems with using
conventional bankruptcy laws





Putting the British subsidiary into administration created a
further problem as well.
The British subsidiary used a bewildering array of complex
legal structures to hold its client assets.
The Lehman Brothers group had a group-wide IT system
that was operated out of New York and, after the
bankruptcy filing, it ceased to be updated for British
subsidiary.
This made it difficult for the administrators to return the
client assets – worth about $35 billion – held by this
subsidiary.
The resulting delay greatly increased the market disruption
caused by the failure of Lehman Brothers.
Taxpayer-funded bailouts





United States: American International
Group (AIG)
Germany: Hypo Real and Commerzbank
United Kingdom: Royal Bank of Scotland
Group and the TSB-HBOS Group
Netherlands, Belgium and Luxembourg:
Fortis Bank
Ireland: Anglo Irish Bank.
These are not politically popular
In Ireland, parties campaigning
against the continued use of tax
payers’ money to repay the senior
unsecured bondholders of Irish banks
gained a large majority in the Irish
parliamentary elections of 25 February
2011.
Moral hazard problem?



If financial firms believe they are likely to be bailed out if
they run into difficulties then this would tend to cause them
to engage in excessively risky behaviour.
But, if the market also believes that insolvent financial
firms are likely to be bailed out, then these firms can
borrow at more favourable rates than they otherwise could.
This raises the value of solvency and might, in principle,
mitigate this problem to some extent.
A recent study of German banks during the period 1996 –
2006 does not support this. It was found that the removal
of public guarantees significantly reduced risk taking.
They might not be possible



The failed banks may be too large for tax payer
bailouts to be feasible.
The size of the Icelandic banking sector’s balance
sheet was about 11 times the size of Icelandic
GDP before it collapsed. Fortunately, the
Icelandic government did not attempt to save its
banks, as this would have dragged the sovereign
into insolvency along with the banks.
The Irish attempt at bailing out banks that were
too big to be saved is now threatening sovereign
solvency.
It might violate the Treaty


State support of financial institutions may conflict with
Article 107.1 of the Treaty on European Union (consolidated
version) which says, “Save as otherwise provided in the
Treaties, any aid granted by a Member State or through
State resources in any form whatsoever which distorts or
threatens to distort competition by favouring certain
undertakings or the production of certain goods shall, in so
far as it affects trade between Member States, be
incompatible with the internal market.”
However, Article 107.3 (b) may provide an exception in
sufficiently important cases as it allows aid “to remedy a
serious disturbance in the economy of a Member State”.
Selling Troubled Firms




Fortis’s Belgian banking operations were
sold to the French bank BNP Paribas
(while its Dutch ABN-Amro operations
were sold to the Dutch sovereign)
Merrill Lynch was sold to the Bank of
America
Bear Stearns was merged with JP Morgan
Chase
HBOS was acquired by Lloyds TSB.
Problems with this approach




It may require a taxpayer sweetener (Bear
Stearns) to get another firm to go along.
Negotiations can be acrimonious (as in the case
of Fortis) and lengthy. Shareholders may try to
block the deal if it lowers the value of their
shares or reduces their control (Fortis and JP
Morgan).
It may weaken the institution that acquires the
failed firm. Lloyds TSB share values fell by about
a third in value after HBOs posted unexpectedly
high losses in early 2009.
Some financial firms are too large to be digested
by another (RBS).
The US Approach: FDIC




Washington Mutual (WaMu) of Seattle was the 6th largest
bank in the US, with assets valued at $328 billion in 2007.
It suffered heavy losses in the US subprime mortgage
market and the price of its shares plummeted from 30
dollars to two dollars between Sept 2007 and Sept 2008.
On 15 Sept 2008 its depositors began to run, withdrawing
about $17 billion. On Thursday 25 Sept the US Office of
Thrift Supervision, which regulated WaMu, closed the bank
and appointed the Federal Deposit Insurance Corporation
(FDIC) as receiver.
The FDIC auctioned off a package including most of the
WaMu’s assets and all of its deposits and secured debt. On
Thursday 25 Sept, JP Morgan Chase was informed that it
was the winner.
Seamless handling




The collapse of WaMu was the largest bank
failure in US history and the 2nd largest
bankruptcy after Lehman Brothers.
Unlike in the collapse of Lehman Brothers,
WaMu’s business operations proceeded without
interruption after its demise.
Its branches opened as usual on the morning of
Friday 26 September, albeit as JP Morgan
branches.I
ts ATMs continued to operate and its online
services remained available.
FDIC




In the US the FDIC runs a receivership regime for
failed banks, selling their good assets and
winding down their bad assets.
It insures up to $250,000 per depositor per bank.
If there are more than sufficient funds to pay
insured depositors from a bank’s recovered
assets, then it uses the extra funds to pay, in
order, general unsecured creditors, subordinated
debt and stockholders.
If there are insufficient funds to pay insured
depositors, then it makes up the difference with
its Deposit Insurance Fund.
27 February 2009 press release from
the FDIC states:
“Throughout the FDIC's 75-year history, no
depositor has ever lost a penny of insured deposits.
While deposits insured by the FDIC are backed by
the full faith and credit of the United States
Government, the FDIC is funded not with taxpayer
money but with deposit insurance premiums
imposed on banks. Though the FDIC has the
authority to borrow from the Treasury Department
to meet its obligations, it has never done so to
cover losses.”
The FDIC’s job is easy compared to
that of EU policymakers


WaMu was a big bank by American
standards, but it was small compared
to behemoths such as BNP Paribas or
Royal Bank of Scotland which have
assets worth $3 trillion or more.
Moreover, and crucially, WaMu was a
domestic corporation with a
relatively uncomplicated balance
sheet.
The FDIC has resolved plain vanilla
depository institutions



They have not had complex contingent claims on their
balance sheets.
They have not combined principal and agent roles in their
transactions, as do the US broker-dealers that act as
custodians and clearing agencies in OTC transactions as
well as transacting in the same securities on their own
accounts.
They have not had complex cross-border structures of
branches and subsidiaries and, thus, they have not had the
coordination and technical problems associated with
multinational groups with corporate entities located in
several jurisdictions.
Banks can be large and
complex




They have complex contingent claims on their balance
sheets
They can combine both principal and agent roles in their
transactions, they act as custodians and clearing agencies
in OTC transactions and transact in the same securities on
their own accounts.
They have complex cross-border structures of branches and
subsidiaries and all of the coordination and technical
problems associated with multinational groups with
corporate entities located in many countries.
Over 14 banks around the world, two of them US banks,
have assets valued at over two trillion dollars.
Lehman Brothers




Lehman Brothers Holdings, Inc. was a firm
with $639 bn in assets and $613 bn in
liabilities.
It consisted of over 7,000 legal entities in
over 40 countries.
At the time it filed for bankruptcy it had
almost a million derivative contracts with a
notional value of $39 trillion outstanding.
Within days of it filing for bankruptcy about
80 foreign receiverships and insolvency
proceedings were brought against it.
And its chaotic demise



On Sunday 14 September 2008 the Federal
Reserve Bank of New York directed Lehman
Brothers to initiate a bankruptcy case by
midnight.
The bank was completely unprepared; it had had
no intention of even considering bankruptcy and
had made no plans for this contingency.
It put together what is said to be the most barebones chapter 11 petition ever filed by 2:00 the
next morning.
Living Wills




The resolution authority must choose between the different
ways of resolving the bank: all of them can have large and
unpredictable costs
It must act quickly: the longest it has to choose is the 36 or
48 hours between close of business on Friday in Europe and
North America to the opening of markets in Asia on
Monday.
The bank must provide the authority with sufficient
information to allow it to make the best choice.
8 US banks were covered by the G-20 agreement; the
Dodd-Frank Act extends this by mandating that the more
than 100 U.S. banks with over $50 billion in assets must
prepare living wills. The 4 biggest UK banks were covered
by the G-20 agreement, 2 more were told to comply and
now all UK banks – about 250 of them – are to prepare
living wills.
Measuring insolvency is hard


If insolvency occurs when the firm is unlikely to be able to
repay its debts then declaring a firm to be insolvent
requires the judgement of the regulators.
More mechanical definitions that rely less on judgement:
• negative net worth under accepted accounting principles
• the firm would have a negative net value if it were liquidated
• the firm no longer has enough liquidity to continue to pay its bills


These criteria are unreasonable when markets become
dysfunctional and a financial asset’s price is far below its
reasonably expected DPV if it were held to maturity.
It is unrealistic to rely on a rules-based approach to
determining when a firm has failed. Regulators must be
allowed discretion. But this entails a loss of security of
property rights and, hence, of government legitimacy.
Shareholders, however, should have the opportunity to
contest the regulators’ actions ex post in court.
Shareholder rights vs. efficiency



To ensure that the operations of a financial institution are
uninterrupted and to limit systemic risk, supervisors and
resolution authorities must act quickly when they suspect
that a bank might be in danger of becoming insolvent.
Unfortunately, this raises the possibility that the authorities
might liquidate a bank that might have remained solvent if
left alone or for which a sale might have been arranged
that would not have wiped out the shareholders’ claims.
The Fifth Amendment of the US constitution states, “No
person shall be … deprived of life, liberty, or property,
without due process of law; nor shall private property be
taken for public use, without just compensation.” In the
United States if a bankruptcy case is filed then the case
must be presented in a bankruptcy court and approved by a
judge.
Property rights vs. Efficiency





Some tell a different story about the FDIC and WaMu.
In their version, WaMu had been looking for a buyer since
early Sept 2008. On 25 Sept the FDIC announced that JP
Morgan Chase had won an auction to buy the bank.
So, the FDIC must have alerted potential purchasers that
the bank was going to be seized some time before the sale,
making it impossible for WaMu to find a buyer: why buy a
bank from its shareholders and be required to take on all of
its liabilities when you can purchase select parts of it in a
government-run fire sale?
The resulting rumours might have provoked the bank run.
WaMu was solvent and might have remained so; the FDIC
provoked its liquidity crisis and the subsequent seizure
amounted to confiscation.
Does the FDIC trample on
property rights?


On 20 Mar 2009 the shareholders of
WaMu, who were nearly wiped out in
the FDIC’s sale of WaMu to JP
Morgan Chase, filed suit against the
FDIC.
They are seeking damages for what
they view as the unjustified seizure
of the institution and its sale at an
unreasonably low price.
Dodd-Frank Act



Until recently, the FDIC’s authority has been limited to
depository institutions; this is why Lehman Brothers fell
outside of its scope.
The Dodd-Frank Act of 21 Jul 2010 extends the reach of the
FDIC to financial firms whose potential collapse might
jeopardise the financial stability of the US.
Funding is to be provided by an Orderly Liquidation Fund
that is to be set up by collecting risk-based assessment
fees from eligible financial firms. The fees are to be
adjusted as necessary so that any borrowing from the
Treasury is repaid within five years and, thus, no taxpayer
money is used.
Dodd Frank




If the Secretary of the Treasury decides a bank is insolvent or likely to become
so, he notifies the bank. If the bank acquiesces, the FDIC is appointed the
receiver and liquidation commences.
If the bank objects then he petitions the District Court to appoint the FDIC as
receiver. The Court t has 24 hours to notify the bank, hold a hearing at which
the bank can oppose the petition and to reach a verdict. If the Court exceeds
the 24 hour limit, the FDIC is automatically appointed receiver and the
liquidation begins. The result is final.
Suppose the Secretary files his petition and his vast amount of paperwork at
the end of the day. The bank will have until the next morning to prepare a
response. A hearing is held and the judge has what is left of the day to go
through the paperwork, to weigh the arguments presented at the hearing and
to arrive at a decision. Or, he can just let the clock run out.
An ex post appeal is allowed but by then the bank is likely irretrievable. The
only guilty party would be the US government and if a bank tried to sue it for a
monetary compensation it would likely claim sovereign immunity.
What about senior bondholders?




It has been argued (mainly by senior bondholders and their
lawyers) that senior bondholders should be protected.
Unlike equity holders, senior bondholders have no
possibility of an upside gain, thus they should not be
exposed to downside risk. If they were exposed to such risk
then they would require higher interest rates.
If the banks were forced to pay higher interest rates, they
would then pass this cost on to their consumers. As a
result, households would pay more for their mortgages and
other loans.
In addition, it is claimed, senior bondholders are not
typically hedge funds, but insurance companies and
pensions funds. If senior bonds become more risky, so do
these funds.
Counterarguments




If senior bonders were expected to take significant haircuts
in the event of insolvency, hey would have an incentive to
become more selective about which bonds they purchase.
Both they and society, because it cares about the health of
pension and insurance funds, would become more careful
about monitoring the behaviour of the issuers of the bonds.
Issuers of senior bonds would have an incentive to become
more transparent and to engage in less risky behaviour.
In the event of the failure of a sufficiently large bank,
protecting all senior bond holders may simply not be
feasible.
Society is partially to blame



The current banking crisis is to a large extent the
result of supervisory and regulatory failures, as
well as governments’ policy blunders.
In a democratic society, the ultimate
responsibility for much of the crisis then lies with
the electorate.
In addition to fairness issues, if the failure of an
institution causes significant systemic risk and
other financial firms must contribute to making
up the loss, then it forces financial firms to lose
liquidity just when they need it.
Fairness vs. Flexibility



The different spins on the handling of WaMu
result from the conflict between efficiency and
property rights that is inherent in the design of
bank resolution regimes.
Such regimes could in principle rely on statute,
and thus spell out the rules of the game in
advance, promoting fairness and protecting the
rights of property owners.
Or, they can rely on the discretion of regulators,
and thus allow the necessary flexibility to deal
with previously unforeseen events.
Banks should be taken over before they fail



To insure that a bank’s business continues
without interruption, it is best to take it over
before it becomes insolvent.
But, if the firm has not yet failed, then there may
be a chance that it might not fail and in this case,
seizing it amounts to confiscation.
The problem is further complicated by the
problem that it can be difficult to assess whether
or not a financial firm is solvent or likely to
become so.
Where is Europe going from here?




Euro Area and other EU policymakers hope to attain a Banking Union consisting
of three components. The first is a Single Supervisory Mechanism (SSM). Under
the SSM the important banks of the Euro Area and those of any other member
states of the EU that choose to participate would be supervised by the ECB.
Less important banks would be supervised by the national authorities with the
ECB having ultimate responsibility.
The details of the SSM were agreed on 19 Mar 2013, approved by the
European Parliament on 12 Sept 2013 and it is set to become operational in
late 2014. The ECB will have the enormous power of being able to license and
authorize credit institutions.
The not-yet-agreed-upon second component is a single deposit scheme.
The third, the most ambitious and perhaps the most important component is a
Single Resolution Authority (SRA). On 10 Jul 2013 the Commission proposed
the details of a possible SRA.
Single Resolution Mechanism


On 18 Dec 2013 the Council agreed
on a draft Single Resolution
Mechamism.
It is hopsed it will become
operational on 1 Jan 2015.