Regulation and Competition in Banking

1. Regulation and Competition in Banking Mathias Dewatripont Solvay Brussels School and ECARES Universite Libre de Bruxelles ACE Conference Madrid – November 16, 2017 Panel on ‘The Limits to Competition – When is Regulation the Right Instrument?’

2. Introductory remarks • Presentation based on experience as contract theorist who has looked at prudentialregulation (Dewatripont-Tirole, 1994). • Involved also in 2010 CEPR Report for DG Comp on bank bailouts. • Also based on 6 years spent at National Bank of Belgium, where I represented Belgium at Basel Committee, and then at ECB Supervisory Board. • Therefore, presentation tilted towards prudential re-gulation and State Aid control, even though consu-mer protection is also important, and (cross-border) bank mergers will probably become important soon.

3. Introductory remarks (2) One focus here: how do we restore health to a Euro-area sector with excess capacity and there-fore low profitability (+ high level of NPLs)? As Vives’ (2016) very good book says: more competition should require more capital to guard against potentially adverse risk-taking incentives. Not obvious though in a non-Modigliani-Miller world, with cost-of-equity estimates for banks today in range of 8-10% and ROE below this level. Adjustment therefore needed fast enough because of adverse growth consequences. With or without public money? 3

4. The challenges of banking Banking is risky (maturity transformation). Almost century-old ‘cycling’ between 3 objectives: productively efficient banking; financial stability (no bank runs); fighting moral hazard (‘no bailouts’). Until 1930’s: sacrifice financial stability, but many bank runs, in particular in the Great Depression. From mid-1930’s to early 1970’s: sacrifice efficien-cy, with strict limits on competition (on entry, size, prices & activities); & introduce deposit insurance. No more bank runs & no bailouts but low product-ive efficiency in banking (e.g. overbranching) + development of nonbank competitors. 4

5. The challenges of banking (2) • As a result, gradual deregulation since 1970s, on prices and entry, & on size and set of activities. • But deposit insurance maintained (against financial instability) and focus on (risk-based) bank solvency (against moral hazard): Basel I and II capital ratios. • Impact: since 70s, very few runs, but many banking crises (147 worldwide (Laeven-Valencia, IMF, 2012)), many linked to macro imbalances, but also to bank behavior (moral hazard), especially when underca-pitalized (Basel I/II insufficient) and ‘gamble for resur-rection’ (in banking, financial distress often does notreduce activity). Culminated in 2007-8 crisis.

6. Responses to the 2007-8 crisis • Crisis significantly worsened after fall of Leh-man: first big-bank bankruptcy, that triggered « move to another equilibrium » (à la Diamond-Dybvig 1983) but for wholesale funding). • Double response: (i) « no more Lehmans », instead, significant rise of (retail) deposit insurance and massive bail-outs; (ii) re-regulation (more and better capital, liqui-dity ratios, recovery and resolution planning, macroprudential regulation).

7. Assessment of reregulation Reform agenda makes sense given previous crisis. Does involve a partial U-turn w.r.t. laisser-faire approach to banking activities. Impact of new approaches (liquidity, recovery & resolution, macroprudential / systemic approach to regulation) still untested. Debate continues on 'excessively low Basel III capital ratios' (e.g. Admati-Hellwig, 2013) vs 'difficulty of finding the money & risks to real-economy lending'. What to think about new trend: bail-in rather than bailout, in a European landscape plagued by overcapacity and a challenging environment? 7

8. Stylized facts on bailouts • Gross fiscal cost of bailout is only a fraction of debt increase (rest due to lower growth). • Procrastination really costly (Japan, US S&L). • Instead, swift bailout intervention may pay for taxpayer, possibly fully US 2009, Sweden 1991 (even if ex-post net-cost computations fail to take into account risk premia). • Conclusion: Tradeoff current/future crisis: fighting moral hazard good, but NOT worth delaying restructuring, because lower GDP growth will raise final cost for taxpayer ! • See Laeven-Valencia, 2012, Dewatripont, 2014a.

9. State Aid control in Europe • Specificity of our jurisdiction. • Two justifications: (i) externalities across Member States; (ii) ‘paternalism’: ‘protect national taxpayers against capture of national Governments by special interests’. • (i) straightforward; (ii) more delicate, esp. in times of euroskepticism. To be balanced w.r.t. subsidiarity principle. • And then, specificity of banking, with financial stability concerns (and the fact that State Aid may then help rather than hurt competitors).

10. State Aid control in Europe since 2008 • Phase 1: immediately after the crisis: good ba-lance between financial stability and ‘punishing the outliers’. DG Comp played essential role (Beck et al. 2010). • Phase 2: 2013 State Aid guidelines: understand-able desire to toughen conditionality (bail-in of equity and junior claims). OK w.r.t. financial insta-bility (LT claims). Overreach?: 2015 case of four very small Italian banks did NOT play well … • Phase 3: BRRD (see EC, 2014): much more challenging !

11. Banking Recovery & Resolution Directive • BRRD insists on 8% bail-in even under systemic stress, as of January 1, 2016, for access to common resolution fund or (even national) public money. • Beyond secured liabilities, it exempts very short-term interbank debt (up to 7 days). • It gives priority to natural persons and SMEs over other unsecured claims. • At this point, no hard targets yet for bail-inable securities (« MREL »). To be determined by SRB.

12. Assessment Current situation NOT without dangers (see Dewatripont, 2014b). To avoid bank runs (especially with volatile wholesale deposits), need to have 8% long-term junior liabilities. Instead, including senior claims in MREL does NOT protect other claimholders ! 12

13. Assessment (2) Aversion to bailouts understandable: taxpayer money, moral hazard, … Remember however the cost of financial instabi-lity: the costliest bank failure for taxpayers in last 10 years was Lehman, despite lack of bail-out, while TARP bailout has almost been fully repaid (CBO 2013: more than 400 Billion $ out of 428). Remember also that « orderly » resolution will not prevent depositors from running if they can and feel their money is at risk. 13

14. Assessment (3) Several Member States aware of the problem, and are trying to tackle it. For example: Germany: make senior bank bonds junior, retro-actively (also used for Greek banks in 2015). France: same as Germany, but NOT retroactive, and more granular. Conclusion: useful initiatives, but better to have a ‘European solution’. And the key is to have 8% junior long-term claims for all banks asap ! 14

15. Assessment (4) General idea: requiring x% of bail-in before bailout ideally requires x% of long-term junior claims to absorb bail-in and reassure senior claimholders. Problem: this would imply a big shock to an already challenged EA banking sector. Other ideas: (i) go for x < 8% (note: TLAC = 6.75% in 2022, and only for G-SIBs), at least for bailouts with national money; or (ii) BRRD holiday to clean up weak banks. Seems politically infeasible, so chosen route is ‘precautionary recap’ + compensation for retail subordinated claimholders. Or even ‘national bankruptcy’. OK maybe, but not first-best. 15

16. General conclusion Search for ‘ideal policy’ has not converged yet. While banks are on average safer than in 2007-8, no reason to be overconfident. Danger of forgetting lessons of crisis and em-barking on ‘regulatory stimulus’. Harder to be tough with banks that are weak, for example because of a challenging macro environ-ment. Do not forget macro cost of procrastination. Challenge: ‘when bailout is out and bail-in is not in, denial is the only option left’ … In steady state, only way to have proper competi-tion is sufficient capital + LT junior debt. 16

17. References • Admati, A. & M. Hellwig (2013), The bankers' new clothes: What's wrong with banking & what to do about it, Princeton UP. • Beck, T., D. Coyle, M. Dewatripont, X. Freixas & P. Seabright (2010), Bailing out the banks: Reconciling stability and competition, London: CEPR. • Congressional Budget Office (2013), Report on the Troubled Asset Relief Program - May 2013. • Dewatripont, M. (2014a), “European banking: Bailout, bail-in and State Aid control”, Inter-national Journal of Industrial Organization.

18. References (2) • Dewatripont, M. (2014b), “Banking regulation and lender-of-last-resort intervention”, European Central Bank, ECB Forum on Central Banking, Conference Proceedings: Monetary Policy in a Changing Financial Landscape, Sintra. • Dewatripont, M. and J. Tirole (1994), The Prudential Regulation of Banks, MIT Press. • Diamond, D. & P. Dybvig (1983), “Bank Runs, Deposit Insurance, and Liquidity”, Journal of Political Economy.

19. References (3) • European Commission (2014), “EU Bank Recovery and Resolution Directive (BRRD): Frequently Asked Questions”, available at http://europa.eu/rapid/press-release_MEMO-14-297_en.htm • Laeven, L. & F. Valencia (2012), "Systemic banking crises database: An update," IMF WP-12-163. • Vives, X. (2016), Competition and Stability in Banking, Princeton University Press.