MACROECONOMIC SHOCKS AND BANKING SUPERVISION Jean-Charles ROCHET

1. MACROECONOMIC SHOCKS AND BANKING SUPERVISION Jean-Charles ROCHET (IDEI, Toulouse University, France) PREPARED FOR THE 2nd WORKSHOP OF THE LATIN AMERICAN FINANCE NETWORK, Cartagena, December 2004

2. 1-INTRODUCTION • Many Latin American countries (and more generally emerging countries) have recently been hurt by severe banking and financial crises but they do not have a monopoly for such crises • In the last 25 years, an impressive number of countries (developed, developing and emerging) have also been involved in such crises: • Among IMF member countries: more than 130 out of 180 have experienced crises or serious banking problems • Let us not forget that the cost of Savings and Loans debacle in the USA (late 1980s) was probably much superior to the cumulated loss of all failed US banks during Great Depression (in real terms)

3. No significant banking problem/Insufficient information Banking crisis Significant banking problems

4. PRUDENTIAL INSTITUTIONS HAVE BEEN REFORMED TO AVOID OR MITIGATE FURTHER CRISES • DEPOSIT INSURANCE FUNDS: • USA: FDIC (created in 1934) still quite generous ($100,000) but now funded by risk-sensitive premiums • UK: more recent and less generous: 75% of the first £ 20,000 • EU: minimum harmonization: have to be explicit, funded by premiums • Minimum coverage: Euros 20,000 • Explicit schemes have been introduced in many countries (Garcia 1999) • It has been argued that they provoke moral hazard: bankers could be incited to take too much risks since they are not disciplined by small depositors. Demirguc-Kunt and Detragiache (1997) find evidence in this direction.

5. SOLVENCY REGULATIONS • Basel accord (1988): minimum capital requirement ( 8% of the sum of risk weighted assets) for all internationally active banks of G-10 countries. Later amended to incorporate interest rate risk and market risk. • USA: FDICIA ( 1991)= capital requirement plus Prompt Corrective Action: reform introduced after the Saving and Loans crisis: supervisors are forced to intervene before it is too late (CAMELS ratings) • EU: Capital Adequacy Directives: similar to the Basel accord, which has also been adopted in many countries • OTHER REFORMS • Creation of integrated supervisory authorities (FSA), independent from central banks, in the UK and other countries

6. The Basel Committee on Banking Supervision has elaborated a reform of the Basel accord (Basel 2) • This reform relies on three “pillars”: • A refined capital requirement with very complex weights • A more pro-active role of banking supervisors • An increased recourse to market discipline • The problem is that supervisors have a tendency to interfere too much when the banks are wellrun and intervene too less when they have problems

7. In fact, empirical evidence on the resolution of bank defaults suggests that failing banks are more often rescued than liquidated. • Goodhart and Schoenmaker (1995):effective methods of resolving banking problems vary a lot from country to country but in most cases result in bail outs • Out of a sample of 104 failing banks they find that 73 resulted in rescue and 31 in liquidation • Santomero and Hoffman (1998): in the USA, the discount window was often used (improperly) to rescue banks that subsequently failed

8. OBJECTIVES OF THIS PRESENTATION: • Show that deposit insurance and capital requirements are not enough to deal with macro-shocks • Study how regulatory/supervisory systems should be reformed, • so as to deal properly not only with individual bank failures (micro- prudential regulation) but also with systemic crises( macro-prudential regulation) • Try to see whether these conclusions also apply to Latin America • PUNCH LINE: • Central bank independence for monetary policy should be extended to lender of last resort activities • Liquidity assistance to the banks in trouble should be provided under the strict control of independent supervisory authorities

9. STRUCTURE OF THIS PRESENTATION: 1 INTRODUCTION 2 A SIMPLE MODEL OF PRUDENTIAL REGULATION 3 HOW TO DEAL WITH MACRO SHOCKS? 4 IS MARKET DISCIPLINE USEFUL? 5 AN AGENDA FOR MACRO-PRUDENTIAL REGULATION

10. 2- A SIMPLE MODEL OF PRUDENTIAL REGULATION Adaptation to the banking sector of Holmström-Tirole (1997, 1998) (model of corporate financing) 2 dates t = 0,1; for the moment a single bank (micro view point), lends volume L of loans, financed by deposits D and equity E. Interest rate normalized to zero. Deposits insured by Deposit Insurance Fund (DIF) for a premium P . Banker gets E Returns Moral Hazard Lending Success t = 1 Failure t = 0 D 0 Banker repays depositors Bank pays P DIF repays depositors

11. Specificities of banks (w.r.t. corporations as in Holmström-Tirole) • A (large) fraction of loans is financed by deposits. • Deposits are insured • Loans have to be monitored by the banker (Moral Hazard): • “good” loans = high probability of success p • “bad” loans = probability ( p - p) + private benefit BL. • Social value of the bank > NPV loans • vL = additional social value (payment activities...). • (for the moment , could be 0). • Banking supervision • contract between banker and Deposit Insurance Fund (DIF) • specifies L and D (and insurance premium P) as a function of E

12. Assumptions (A1): (loans have positive social value only when monitored ) Banks play a crucial role by monitoring borrowers notice that (A1)  (A2): Banks can obtain large private benefits by “shirking” without A2 banks do not need capital, see below

13. Optimal contract • Specifies the volume of loans and the deposit insurance premium that maximize the economic value added by the bank under 2 constraints: • Bankers monitor the borrowers (MH) • The D.I.F. breaks its budget • Proposition 1: Optimal organization of the banking sector • Deposit insurance financed by fair ( risk- based) premiums: • Capital ratio: • Capital ratio k : >0 by A2,  in B (intensity of moral hazard) • and  in (pR - 1) (quality of assets).

14. Implementation • In the absence of macro shocks there are (in the model) 2 equivalent solutions: • Public authority regulates banks’ capital and DIF premiums • Banking supervisors close banks that do not comply with capital • requirements • Private contracting between competing DIFs and the bank: • deposits limited to a maximum of • insurance premiums set by competition between DIFs. • In practice there may be problems associated with private bank insurance, especially during systemic crises

15. 4- INTRODUCING MACROECONOMIC SHOCKS Crucial feature of banking = sensitivity to macro shocks, captured by risk of recession (devaluation): additional liquidity needs at t =1/2 specific to each bank: exposure to macro shocks, observable ex-ante by banking supervisors (dollarization ratio?) We now adopt banking system view point: distribution F( ) E t=0 t=1/2 Shock? t=1 Moral Hazard Success refinance Failure close Lending D 0 0 Additional question: which banks are bailed out (x=1) and which banks are closed (x=0) in the event of a shock at date t = 1/2 ?

16. Optimal regulation contract • For each bank, as a function of its exposure to macro shocks, it specifies: • the volume of loans the bank is allowed to grant, • the deposit insurance premium it has to pay and • whether it is eligible to the LLR or not • NB Liquidity requirements are suboptimal in this model • We show that • Banks have to be separated in two categories: in case of a macro shock, • those with a low macro exposure are rescued, • those with a high exposure are closed.

17. Proposition 2: • Optimal regulation in the presence of macroeconomic shocks: • Banks such that (small exposure to macro shocks) should not be closed in case of macro shock but should be subject to an additional capital charge or loan loss provision (increasing with macro exposure) • Banks such that (large exposure to macro shocks) should be closed if a recession occurs and should be subject to a flat capital ratio:

18. Implementation: different roles of private investors and public regulators • Private investors only interested by future cash flows: • refinance the bank (too many closures) • Public regulators subject to political pressure (efficient lobbying) • refinance the bank (too few closures). • Public intervention is needed to avoid too many bank closures • but it leads to forbearance and overinvestment

19. LLR SBC • Need for a Lender of Last Resort (LLR) • But risk of Soft Budget Constraint (SBC) Possible solutions: Market discipline: banks forced to issue subordinated debt held by private investors, who limit scope for moral hazard (Section 5) Independent regulatory agency and lender of last resort (Section 6)

20. 5- IS MARKET DISCIPLINE USEFUL? External monitor: Reduces private benefit of bankers B b = B -  Unit cost  Regulation contract: plus = remuneration of external monitor in case of success = financial involvement of monitor at t = 1 (subordinated debt)

21. OPTIMAL COMBINATION OF MARKET DISCIPLINE AND REGULATION • For each bank, as a function of its exposure to macro shocks, • the regulatory contract specifies • the minimum capital ratio, • the deposit insurance premium • whether it is eligible to the LLR, and • the volume of sub-debt it has to issue • the maximum interest rate on sub-debt Proposition 3: The presence of external monitors increases the optimal closure threshold (less closures) But in the absence of commitment power by the government, the effective closure threshold remains unchanged Capital requirements are reduced but the impact on social surplus is ambiguous.

22. If the supervisor can commit, the introduction of an external monitor • is not necessary beneficial (depends on cost of uninsured debt). • The consequences of using an external monitor are • to reduce the need for a LLR, • to reduce the commitment problem (Soft Budget Constraint) • of the public supervisor is unchanged, while SBC LLR

23. 6- AN AGENDA FOR MACRO PRUDENTIAL REGULATION • As a complement to market discipline I propose to solve the market failure associated with banks’ exposure to macro shocks by reforming prudential regulation. Two elements are needed for implementation of the optimal allocation: • · Intervention of the central bank as a lender of last resort for providing liquidity assistance ( in case of a recession) to the banks characterized by low macro exposure. • · Preventing extension of this liquidity assistance to other banks, with higher macro exposure. • For these banks ex post continuation value is positive (from a social point of view) but bailing them out would be welfare decreasing from an ex-ante perspective.

24. The optimal contract (characterized in Proposition 2) can be implemented by the following organization of the regulatory system: • · for each commercial bank, supervisory authorities evaluate the bank's exposure to macroeconomic shocks • ·Banks with a small exposure are backed by the DIF and receive liquidity assistance by the Central Bank in case of a macro shock. • They face a capital adequacy requirement and a deposit insurance premium that increase with macro exposure

25. · Banks with a large exposure to macro-shocks are not backed by the DIF: they are not eligible to receive liquidity assistance by the Central Bank. • · They face a flat capital requirement and a flat deposit insurance premium • · The lender of last resort activities of the central bank are made independent from political powers: the central bank only provides liquidity assistance to the banks that are backed by supervisory authorities. • Central bank loans are fully insured by the DIF.

26. CONCLUSIONS (1): • The main reason behind the frequency and magnitude of recent banking crises is not deposit insurance, bad regulation, or incompetence of supervisors. It is the commitment problem of political authorities, who are likely to exert pressure for bailing out insolvent banks and delay crisis resolution. • The remedy to political pressure on banks supervisors is not to substitute supervision by market discipline: market discipline can only be effective if absence of government intervention is anticipated. • Instead the way to restore credibility is to ensure independence and accountability of bank supervisors.

27. CONCLUSIONS (2): • The other key reform is to restrict liquidity assistance by the central bank to the banks with low exposure to macro shocks, that are backed by the independent supervisors (alternative: cap on macro exposure). • Supervisors should be in charge of selecting these banks, who then would face a capital requirement and a deposit insurance premium thatboth increase with their macro exposure • By contrast, banks with a too high macro exposure are not backed by the supervisors and do not receive liquidity assistance in case of macro shocks • Central bank loans should be insured by the DIF.

28. APPLICABILITY TO LATIN AMERICAN ECONOMIES? • Devaluation risk: major source of macro shock (but not the only one) • Full dollarization would trivially eliminate this risk but would prevent the action of the central bank as a LLR • Liquid asset requirements maybe useful but they are costly • A LLR is needed but neither a purely private solution (CCL) or a government controlled solution are good • Like everywhere else, independence and accountability of banking authorities (DIF, FSA and Central Bank) are fundamental • Solvency regulations and deposit insurance premiums should be modified to account for currency risk exposures of banks