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Aspects of Financial Regulation


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Title: Aspects of Financial Regulation

Aspects of Financial Regulation
  • MSc Financial Economics
  • Anne Sibert
  • Spring 2014

International Aspects of Financial Regulation
Purpose of financial regulation
  • 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
  • Lowering the likelihood of crises
  • Lowering the likelihood of a liquidity crisis
  • Lowering the likelihood of a solvency crisis
  • Warning of crises
  • Managing a crisis
  • I will consider these three things in turn

Lowering the likelihood of a liquidity crisis
  • 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
  • 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?
  • In the United States
  • In Europe

In the United States
  • 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
  • The FDIC is also a bank supervisor.
  • Backed by the Federal Reserve.

In Europe
  • The EU faces the problem of who is to insure the
    depositors of a member countrys multinational
    bank branches that are located in other member
  • 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.

  • On 15 Mar 2013 the ECB ordered the President of
    Cyprus to come up with 5.8 billion euros without
    increasing his countrys indebtedness as part of
    Cypruss 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.

  • 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
  • The president proposed a levy on all bank
  • Although it was not accepted, the proposal had
    the approval of EU policy makers at the time.

EFTA Court Ruling
  • 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
  • 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 areas 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
  • 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?
  • German Finance Minister Wolfgang Schäuble
    recently stated that, deposits are safe,
    though only on the proviso the states are
  • 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?
  • Moody's estimated that there were about USD 31
    billion of Russian money in Cypriot bank
  • 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?
  • 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
    governments 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
  • 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
  • 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
  • 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?
  • 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
  • The differential treatment of insured and
    uninsured deposits is less relevant in the United
    States than in Europe.

Who should foot the bill?
  • 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
    As 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
  • 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
  • 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
  • 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
  • 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
  • Countries that do not have an important
    international reserve currency should not let
    their financial sectors become too large.

Famous ExampleThe Bank of New York
  • 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
  • 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?
  • 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 aslender of last resort?
  • 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

Preventing Solvency Crises
  • Restructure supervision and regulation
  • Prevent financial firms from becoming too big to
  • Prevent financial firms from becoming too
  • Limit the activities of financial firms
  • Prevent bankers from having an incentive to take
    on too much risk

Restructuring supervision and regulation
  • 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
  • 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

Preventing financial firms from becoming too big
  • 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
  • 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
  • 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

Capital Requirements preventing firms from
becoming too leveraged
  • 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
  • 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
  • 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 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
  • 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?
  • 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
  • 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?
  • 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
  • Supertaxes on bonuses
  • Are these good ideas?

Bill of attainder
  • A bill of attainder is a legislative act that
    punishes a person or group for a crime without a
  • 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
  • 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
  • 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

Famous example
  • 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
  • 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
  • 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

Why didnt economists warn of systemic risk?
  • 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-estate-backed
    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

Definition of systemic risk
  • 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
  • Unfortunately, we havent 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
  • 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
  • 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
  • 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
  • Only a few variables have even weak predictive
  • 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

What went wrong?
  • Maybe the crisis arose in just one or a few
    countries and spread to the rest via contagion.
  • Maybe the crisis was caused by different factors
    in different countries.
  • 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
  • Maybe measuring systemic risk is an easier and
    better way of providing an early warning system.
  • We cant predict when a big financial firm will
    fail, but maybe we can predict the likelihood of
    a domino-like 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
  • 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.

  • We would like to measure how relationships
    between financial institutions contribute to
  • 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
  • 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

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
  • 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

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
  • 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
    members 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

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 macro-prudential 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 ones 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
  • 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
  • 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
  • rank the claims of different types of creditors
  • provide an orderly process for realizing these
  • 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
  • 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
    adminis-tration 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
  • 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

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 sectors
    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

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
  • Fortiss Belgian banking operations were sold to
    the French bank BNP Paribas (while its Dutch
    ABN-Amro operations were sold to the Dutch
  • 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
  • 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
  • The FDIC auctioned off a package including most
    of the WaMus 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, WaMus
    business operations proceeded without
    interruption after its demise.
  • Its branches opened as usual on the morning of
    Friday 26 September, albeit as JP Morgan
  • ts ATMs continued to operate and its online
    services remained available.

  • 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 banks 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
  • 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 FDICs job is easy compared to that of EU
  • 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
  • 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
  • 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

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
  • 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

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
    bare-bones chapter 11 petition ever filed by 200
    the next morning.
  • The lack of forethought contributed to the global
    financial chaos that ensued.
  • Lawyers and accountants have since been paid
    about 3 billion to resolve matters and almost
    1000 counterparties have yet to agree claims.

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
  • More mechanical definitions that rely less on
  • negative net worth under accepted accounting
  • 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 assets
    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
  • 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
  • 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 FDICs 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 FDICs 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.

  • 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
  • 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

Banks should be taken over before they fail
  • To insure that a banks 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

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
  • 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
  • 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