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1. Aspects of Financial Regulation MSc Financial Economics
Anne Sibert
Spring 2011
3. Purpose of financial regulation To protect consumers
To ensure competition
To lessen the likelihood of instability
We will focus on the last of these
4. Three aspects of retaining and restoring stability: 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
5. Lowering the likelihood of a liquidity crisis Old-style depositor run
New-style wholesale creditor run
Speculative attacks on fixed exchange rates
Adverse selection shutting down markets
I will consider the first two of these
6. 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.
Ultimately, only a guarantee backed by the central bank is sufficient to withstand a run on all banks.
7. How does this work in practice? In the United States
In Europe
8. 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 securities.
The FDIC is also a bank supervisor.
Backed by the Federal Reserve.
9. In Europe: 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. This issue was originally addressed by Directive 94/19/EC of the European Parliament and of the Council of 30 May 1994. This Directive is now updated in the European Commission’s 12 July 2010 proposal for a Directive on Deposit Guarantee Schemes (DGSs).
The proposed Directive requires member countries to set up a DGS (Article 3(1)) with coverage up to 100,000 euros (Article 5(1)). The DGSs are to hold a target amount of funds equal to 1.5 percent of eligible deposits; this is to be funded by collecting mandatory insurance payments from member banks. In the event of a shortfall, surviving member banks may be taxed to collect an amount equal to 0.5 percent of eligible deposits.
10. The Recital and the Operative Provisions The problem with the proposed Directive is that, while it deals clearly with the case of the collapse of a small to medium-bank, it does not say what should happen if the DGS does not have and cannot borrow sufficient funds to cover the depositors of a failed bank or banks.
Indeed, it appears to allow the obvious party to make up the shortfall off the hook. Recital 24 of the old Directive remains (now as Recital 30): the Directive may not result in a member state’s sovereign being liable “if they have ensured that one or more schemes guaranteeing deposits … have been introduced and officially recognized”.
11. Lack of Clarity Despite the Recital, it is currently accepted (at least outside of Iceland) that the sovereign is indeed ultimately liable for providing any necessary funding to reimburse depositors.
However, the acrimony and delay in bank restructuring caused by the Icesave dispute suggests that it would be preferable for this to be clearly statutory, rather than merely conventional.
12. Who has priority claim on a failed banked assets? In the US the order is: Administrative expenses of the receiver: the firm’s last payroll, guard services, data processing services, utilities, leased facilities. Generally not severance claims, golden parachutes.
Deposit holders. The FDIC assumes the rights of insured deposit holders.
Claims from vendors, suppliers, contractors, claims from repudiated contracts, employee obligations, tax claims.
Subordinated debt holders.
Share holders.
13. 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 illiquid.
Countries that do not have an important international reserve currency should not let their financial sectors become too large.
14. Famous Example: The 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 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.
15. 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.
16. The IMF as lender 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 understandings.
17. Preventing Solvency Crises 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
18. 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.
19. 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 company.”
20. 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.
21. Rajan, Raghuram, “A better way to reduce financial sector risk,” Financial Times, 25 Jan 2010. 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. While there are always concerns about whether regulators will use these sorts of powers arbitrarily, they are no more difficult for legislators and courts to oversee than are powers based on anti-competitive considerations.
Willem Buiter: Penalise size through capital requirements that are progressive in size.
22. 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 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.
23. 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.
24. Regulating Off-Balance-Sheet Banking: securitisation 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.
25. 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.
26. 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 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.
27. 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 Johnson
Supertaxes on bonuses
Are these good ideas?
28. Bill of attainder 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.
29. 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 regulated.”
30. 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
31. 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 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.
32. Why didn’t 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 it.
33. 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.
34. Previously economists have tried to predict when and where crises will occur 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.
35. 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.
36. 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
37. Results are disappointing 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.
38. 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.
39. Measuring systemic risk 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 domino-like collapse, given the failure of one big firm.
40. 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.
41. Interlinkages 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.
42. 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 regulation.
43. 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.
44. 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.
45. 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.
46. 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.
47. 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.
48. 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.
49. 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.
50. Resolving failed financial institutions In the current financial crisis, policy makers appeared to see themselves as having only three options for dealing with a failed bank:
Use conventional bankruptcy legislation
Bail out the bank with tax payer funds
Sell the financial institution to another financial institution
All three of these solutions had problems
51. 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 adminis-tration: its access to exchanges and clearing systems was frozen with a large number of trades left open.
52. 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.
53. 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.
54. 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.
55. 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.
56. 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.
57. 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”.
58. 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.
59. 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).
60. 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.
61. 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.
62. 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.
63. 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.”
64. 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.
65. 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.
66. 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.
67. 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.
Claims against assets are largely the same order as they are for depository institutions, but the compensation claims of all senior executives are subordinate to those of all junior creditors.
68. Limitations Unfortunately, however, the problem of multiple jurisdictions is not addressed: the Act does not apply to foreign subsidiaries.
It is also not entirely credible that the United States has committed itself to never using taxpayer money.
69. Designing a Bank Resolution Regime Who should bear the cost of the institution’s failure or restructuring?
Increasing a resolution regime’s operational efficiency limits systemic risk, but potentially at the expense of trampling on property rights.
How much efficiency does society want and what is the least costly way to get it?
How can society resolve the problem of financial institutions operating in multiple jurisdictions?
70. Who should bear the cost of a bank failure? When a financial firm fails, many parties have claims against its assets: its workers and suppliers, tax authorities, depositors, secured debt holders, senior debt holders, junior debt holders and shareholders.
There is wide agreement that if the assets are insufficient to meet these claims, that the depositors should be protected, at least up to a point, and that the shareholders should lose their money.
There is less agreement over whether or not other creditors should be protected and if so whether society or other financial institutions should foot the bill.
71. Why protect deposit holders? Fragility argument (can also be applied to other creditors if there is no credible lender of last resort)
It may be unreasonable to expect small depositors to monitor the health of complex financial organisations, and hence, they should be protected.
72. 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.
73. 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.
74. Lack of legal clarity leads to acrimony Partial solution to a lack of political will to clarify matters: firms can issue securities that are clearly not protected.
An example is a contingent convertible bond, or Coco. Such bonds vary in nature, but the ones that are relevant here are bonds which are automatically converted into equity at a pre-specified price when some trigger point is reached.
Basel Committee: let regulators decide when the trigger is reached. This gives flexibility in dealing with novel situations, but does away with one of the main advantages of Cocos: the rules of the game are clear to all in advance.
Attractive alternative: the trigger is 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.
75. Taxpayers vs. Banks If a failed financial firm’s assets are insufficient to protect the claimants that society wishes to protect then the question of who should cover a shortfall arises: the taxpayers or the financial services industry.
It is not necessary to point out the political implications of taxpayer-funded bailouts.
In the US the Dodd-Frank act specifically precludes spending taxpayer money to rescue a systemically important institution.
Taking the more realistic view that there may be instances where some public funding is inevitable, the UK Banking Act of 2009 allows for this.
76. Taxing the financial services industry It is generally accepted that the owners, creditors or customers of the financial services industry should pay at least some of the short fall. In addition to being popular with taxpayers, this might lessen the moral hazard problem associated with bailouts, especially in countries with just a few large financial firms. If financial institutions provide the funding, then they have an incentive to monitor each other.
Funds could be collected by taxing institutions (and possibly deposit holders or other insured creditors) either ex post or ex ante. The EU has favoured an ex ante approach. In this case the payment can be viewed as an involuntary insurance payment that is collected from financial firms and it might depend upon readily measurable features that indicate its size or contribute to its riskiness.
77. Insurance vs. Taxation The US has favoured an ex post approach. This is a tax, not an insurance payment.
If Bank A fails, it is widely perceived as fair that the shareholders and the uninsured creditors should lose their money before the taxpayers step in to pay off the insured creditors. It is not, however, reasonable that Bank B, whose managers behaved prudently and which did not fail, should also be assessed before the taxpayers.
It is fair to tax financial institutions and their customers for the provision of insurance, but if reasonable ex ante insurance payments and recovered assets do not cover the insured creditors of a failed financial institution then it is the tax payers who are the natural candidates to contribute.
78. 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.
79. 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.
80. 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.
81. 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.
82. 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.
83. EU law EU law provides stronger protection for bank shareholders than does US law.
EU law: shareholders of firms must vote on acquisitions and mergers and on whether or not the company is to be liquidated.
During the financial crisis, a need to avoid systemic risk led some nations to suspend these shareholder rights for financial firms.
UK: the Banking Act of 2009 gives the Treasury and the Bank of England wide powers to transfer shares from a failing bank to a government-owned bridge bank or to a private buyer.
84. Multinational Banks One of the most important and challenging problems in designing a bank resolution mechanism is how to deal with multinational banks.
An international banking group’s foreign branches are subject to the resolution regime of the country in which the group is licensed.
Its foreign subsidiaries, however, are subject to the resolution mechanism of their host country. As the Lehman Brothers bankruptcy illustrates, conflicts between these mechanisms have the potential to be disastrous.
85. Technical issues In addition to legal issues there are technical problems associated with the restructuring of a systemically important multinational financial institution.
For example, how does one transfer such a complicated organisation to new ownership over a weekend so that its operations are unaffected?
These technical issues are behind the proposals for all systemically significant cross-border institutions to have resolution plans or “living wills”.
86. European Commission Its 20 October 2011 communication is a careful and sensible assessment of the challenge.
It recommends national resolution regimes with well-defined powers and processes, safeguards for the property rights of creditors and resolution plans for financial groups that “would require detail on group structure, intragroup guarantees and service level agreements, contracts and counterparties, debt liabilities, custody arrangements, as well as operational information about IT systems and human resources.” It recognises the difficulties in specifying when the resolution mechanism for a firm is to be triggered. It discusses the design and use of resolution funds.
A formal proposal will be made by the Commission in the spring of 2011.
87. Cross-border groups The most serious problem the Commission faces is dealing with cross-border groups.
Without a harmonised European resolution regime and a single European regulator, there is no perfect way of dealing with systemically important financial groups with corporate entities in multiple European countries.
The existence of financial groups with corporate entities both inside and outside Europe further complicates the issue.
88. Resolution Colleges The Commission has made two recommendations for dealing with financial groups operating in multiple EU countries.
First: “resolution colleges” should be established for financial groups. These colleges would be chaired by the resolution authority responsible for the group’s parent company and would include the resolution authorities responsible for the group’s other corporate entities.
Such colleges would provide a forum for exchanging information and discussing coordinated solutions: a useful and relatively non-controversial idea, if limited in scope.
89. More controversially … The relevant authorities – presumably the resolution colleges – would prepare a group resolution plan in advance.
In the event of the failure of the group, the resolution authority responsible for the group’s parent company would have the right to decide whether the group resolution scheme is appropriate or whether national resolution regimes would be preferable.
This decision would have to be made quickly, but until made the authorities responsible for the group’s other corporate entities would be required to refrain from implementing national measures that would threaten the group resolution scheme. It is unclear whether such a scheme is currently politically feasible.
90. Managing a full-blown crisis Write off bad assets
Recapitalise viable firms
Provide short-term liquidity
In a global crisis, nations should coordinate to ensure the crisis does not propogate.
91. Removing bad assets The removal of bad assets from balance sheets requires first a mechanism for valuing assets.
Economists are good at devising auctions. Central banks should begin hiring people with the appropriate expertise and start experimenting.
A difficulty is that there is a tradeoff: firesale prices worsen the problem; too generous prices are a transfer from tax payers to possibly delinquent financial institutions.
International organisations can help provide technical expertise, but because of the political aspect and because the government may have to purchase some or all of the assets, national central banks in the main financial centres should probably implement the auction with national treasuries buying the assets if necessary.
92. Recapitalising The IMF can provide loans for recapitalisation and short-term liquidity needs to some small countries with large banking sectors.
However, the IMF does not have deep enough pockets to do anything but render technical assistance to large countries.
National treasuries, financed by their tax payers must borrow to finance this refunding. Countries should be discouraged from having banking systems that they are too small to recapitalise.
93. Global cooperation The Great Depression of the 1930s was made worse by competitive devaluations and tariffs.
The current crisis saw a round of enhancements of deposit insurance; it is likely that some of the motivation was to compete for funds.
In a global financial crisis international coordination is necessary to ensure that begger-thy-neighbour policies do not worsen matters.
The IMF can play a role in this by promoting cooperation.
