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The Global Roots of the Financial Crisis and Regulatory Implications

This paper discusses the reasons for over-exposure of banks, alternative principles for capital regulation, and a specific proposal for capital regulation. It also explores the idea of capital insurance for banks.

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The Global Roots of the Financial Crisis and Regulatory Implications

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  1. Comments on ”The global roots of the current financial crisis and its implications for regulation” Seppo Honkapohja Bank of Finland (includes a few oral comments from presentation)

  2. 0. Introduction This is a very useful paper with three main themes: • Analysis of the reasons for the over-exposure of banks. • Discussion of alternative principles for capital regulation. • A specific proposal for capital regulation.

  3. 1. Over-exposure of banks • Crisis due to a combination of two factors: • Substantial amounts of MBS’s remained in the commercial and investment banks. • Why did MBSs become popular? Some reasons are: - Low interest rates and savings glut shifted the focus of investors on housing markets. • These risky assets were financed by short-term borrowing.

  4. The deep explanation comes from agency problems in banks: • In incentive schemes it is difficult to separate genuine excess return from increased risk-taking (outcomes realized after a lag). • Short-term debt finance of banks is a natural response to agency problems in equity and to high liquidity of assets held by banks. • The downturn in housing prices exposed the implicit risks and led to asset price decline. • Banks forced to ”fire sales”, which created further price declines and thus a negative externality on other banks.

  5. The previous externality is associated with adjustments that use a lot of capital => cuts in lending to businesses. (A credit crunch externality) • I think that there is a further externality and market failure: • The losses led to liquidity problems for and solvency concerns about individual banks. • This created a ”lack of trust externality” between banks, which in dried up interbank-funding markets.

  6. 2. Principles for regulatory reform • Improvements to bank governance: • Employee compensation should be tied to longer-term performance. • Profit measures should be risk-adjusted. • Authors suggest that these are not regulation issues, but belong to internal governance. Comments: • Employee compensation is a major public concern, but not a regulation issue. However, some regulatory guidelines might be given. • Risk-adjusted performance measures might be subjected to regulatory inspection.

  7. Higher capital requirements (good criticisms): • These are costly because of high costs of equity. • Higher capital requirements do not avoid the fire-sale externality. • Traditional regulation forms do not deal with the viral nature of financial innovation. • Cyclically-adjusted requirements would offer some help. • Government (and private) recapitalization of banks is a response to fixe-sale and credit crunch externalities. • Issue of weak banks is difficult. In the Nordic crises in 1990s the governments had to make heavy-handed restructurings of the banking systems • Recapitalization and public guarantees of bank debt are a response to interbank market failures.

  8. 3. Capital Insurance • Banks to buy insurance that pays off in states of the world in which the overall banking system is in trouble. • Insurer buys treasury bills and puts them in a ”lock box”. • Insurance money returned to insurer with premia by banks and interest on treasuries if no systemic event occurs. • If the event occurs, then agreed sums of funds transferred to bank’s balance sheet. • A trigger mechanism invoked to decide on insurance payments. • Thresholds and caps to payments and also staggering of contracts to ensure smooth functioning.

  9. Comments and questions on the KRS proposal: • The proposal would largely be a ”private solution” to recapitalization. • In some earlier crises private solutions were emphasized, but in big crises (e.g. Nordic countries) they were usually insufficient. • The supply side of capital insurance is not discussed. • Pension funds usually have requirements or restrictions on forms of asset holdings. => They cannot provide the insurance. Which institutions can? • ”High water marks” based on the aggregate of banks mean that insurance paid out only in a sufficiently big crisis. • Such crises are systemic with most banks in trouble. • High aggregate losses arise from correlated portfolios and realized systemic risks. => Is supply of capital insurance available in such situations?

  10. Capital insurance can have its own moral hazard concerns: • Reduced incentives to hedge against crisis. • Possible incentives for excessive risk-taking. • Global aspects of the KRS proposal: • It is suggested that banks obtain insurance separately in the different countries in which they operate. • This can be cumbersome for international banks (e.g. HSBC in 88 countries). • A lot of coordination and probably public regulation would be required. • A very thoughtful and inspiring paper. However, the KRS proposals require quite a bit of further analysis. • Supply side • Proper assessment of benefits and costs using a GE framework

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