banks, regulation, and the case of contingent capital_by richter_17 apr 12

8/19/2019 Banks, Regulation, And the Case of Contingent Capital_by RICHTER_17 Apr 12

1/101

B ANKS, REGULATION, AND THEC ASE OFCONTINGENTC APITAL

Jürgen Richter April 2012

Abstract

The recent experiences of financial institutions highlight the shortcomings of the currentcapital regulatory regime. The shortcomings of that regime include that it fails to protect theeconomy from spillover effects related to the distress of financial firms. In the aftermath of thelatest crisis, regulators are seeking ways to reduce such spillovers to protect taxpayers. Thisstudy examines – after explaining the economic reasons for banks and the basics of bankregulation – one specific issue of the proposed solutions: contingent capital in the form ofdebt that converts to equity when a bank faces financial distress. The work analyzes thepotential of contingent capital structures in order to enhance financial stability and avoidcostly government rescues. Therefore all relevant papers about contingent capital since 2002are taken into account. To verify the academic view, market participant comments are alsoconsidered. Although the case of contingent capital remains a heterogeneous one andregulators so far have not stated their exact requirements on contingent capital structures, Icome to the conclusion that CoCo-bonds bear the potential to play its part in a strengthenedfinancial system.


2/101

ii

Of al l the beings th at have existenc eonly in the minds of men, noth ing i smore fan tas t ica l and n ice than c redi t ;i t i s never to be forced; i t hangs uponopin ion; i t depends upo n our pass ionsof hope and fear ; i t comes many t im esunsou ght - for, and of ten goes awaywi thout reason; and onc e los t , it i s

hardly to be quite recovered.

[Charles Davenant]

Althoug h l i fe is no t easy in the wor ld of K,i t is easier in K than in u , and easier in uthan in U. Hence , one ga ins by m ovinglef tward through KuU tow ard knowledge ,tha t i s , form U to u to K. The ques t ion , then ,i s how to do i t : How to inves t in know ledge?Not surpr i s ingly g iven our taxonom y ofknow ledge as measurement and know ledgeas theory, two routes emerge: bettermeasurement and be t te r theory. The twoare mutua l ly re inforc ing , mo reover, asbe t ter measurement provides gr i s t for thetheory mi l l , and be t te r theory s t imu la tesimproved measurement .

[Francis Diebold, Neil Doherty, and Richard Herring]


3/101

iii

ACKNOWLEDGEMENTS

Several factors have contributed to this work’s development. First and foremost the peoplewho directly supported me: Teresa Weiss who did a great editorial job and who helped

eliminate most of my errors. Anton Stelzmüller supported me greatly with a constant

inquisitorial discussion on the functioning of the banking industry – hopefully we can keep this

discussions going on and on. Guido Schäfer, my academic supervisor, had always an open

door policy and helped to find a proper structure for the subject and gave important feedback

on every single chapter – many thanks in advanced for continuing the work with me on mydissertation thesis. Also mentioned should be Christian Spanberger, Johannes Stelzhammer,

and Tom Rohrer for proofreading. Furthermore all friends and colleagues should be thanked

which helped with uncountable issues but whose specific input I am not able to specifically

associate with single subjects anymore. Thank you all for your help without this work wouldnot be the same. Another important factor was the great infrastructure from the Vienna

University of Economics and Business which made the research and the writing for this work

possible in the first place.

I apologize in advance for the many errors that surely remain. They are my, and onlymy, responsibility. Despite such errors, I hope that the work’s content will help expand thereaders understanding of the banking industry, financial regulation and contingent capital. I

always do appreciate critical remarks; therefore, please write to [email protected].

Vienna, 2012

mailto:[email protected]:[email protected]:[email protected]:[email protected]


4/101

iv

Content

ACKNOWLEDGEMENTS ...................................................................................................................... III

ACRONYMS .......................................................................................................................................................... VI

T ABLES ................................................................................................................................................................. IX

1. INTRODUCTION .......................................................................................................................... 1

2. THE BANKING BUSINESS ...................................................................................................... 3

2.1 BANKS AND THEIR ROLE IN THE F INANCIAL S YSTEM .......................................................... 3

2.1.1 M ATCHINGBORROWERS ANDLENDERS ....................................................................................... 4

2.1.2 TRANSACTIONCOSTS .......................................................................................................................... 7

2.1.3 LIQUIDITYINSURANCE ....................................................................................................................... 10

2.1.4 ASYMMETRY OFINFORMATION ...................................................................................................... 112.1.5 OPERATION OF THE P AYMENTSMECHANISM .......................................................................... 15

2.1.6 DIRECT BORROWING FROM THEC APITALM ARKET ............................................................... 16

3. BANK REGULATION ...............................................................................................................17

3.1 THE J USTIFICATION FOR BANK REGULATION ......................................................................18

3.1.1 THE SOURCES ANDCONSEQUENCES OF RUNS, P ANICS, ANDCRISES ........................ 19

3.1.2 A M ARKET FORLEMONS .................................................................................................................. 21

3.2 THE GOVERNMENT S AFETY NET .................................................. ...........................................22

3.2.1 PRUDENTIALREGULATION ANDSUPERVISION: INSTRUMENTS AND AIMS .................... 24

3.2.2 DEPOSITORY INSTITUTIONS ANDFORMS OF DEPOSITOR PROTECTION........................ 26

3.2.3 THE GOVERNMENT ASLENDER OF L AST RESORT ................................................................. 28

3.2.4 PROBLEMSCREATED BY THEGOVERNMENTS AFETYNET ................................................ 28

3.3 REGULATION AND S UPERVISION .............................................................................................29

3.3.1 RESTRICTIONS ONCOMPETITION ................................................................................................. 31

3.3.2 RESTRICTED ASSET HOLDINGS ANDMINIMUMC APITALREQUIREMENTS .................. .. 32

3.3.3 DISCLOSURE REQUIREMENTS ....................................................................................................... 33

3.3.4 SUPERVISION ANDEXAMINATION ................................................................................................. 34

3.4 REGULATORY RESPONSE TO THE F INANCIAL CRISIS OF 2007-09 ..................................34

4. THE BASEL COMMITTEE ................................................. .....................................................36

4.1 THE REFORM AGENDA ..............................................................................................................36

4.2 HISTORY AND ORGANIZATION OF THE BASEL COMMITTEE ...............................................37

4.3 A P RIMER ON BASEL III.............................................................................................................39


5/101

v

5. CONTINGENT CAPITAL .........................................................................................................44

5.1 DEFINITIONS , FORMS AND FUNCTION OF CONTINGENT CAPITAL ....................................45

5.2 THE TRIGGER ..............................................................................................................................51

5.3 P

RICING OFC

ONTINGENTC

APITAL ........................................................................................55

5.4 ECONOMIC RATIONALE OF CONTINGENT CAPITAL ...................................................... .......57

5.5 WHY CONTINGENT CAPITAL INSTEAD OF EQUITY ? ............................................................59

5.6 ANOTHER REGULATORY APPROACH : BAIL-INS .................................................. ................62

5.7 LEGAL , ACCOUNTING , AND TAX ISSUES ...............................................................................64

5.8 WHERE ARE WE NOW ? ............................................................................................................65

6. CONCLUSION ...................................................... ....................................................... ................67

APPENDIX 1: CONTINGENTC APITALLITERATUREOVERVIEW ...................................................... 70 APPENDIX 2: SELECTEDFEATURES OF OUTSTANDINGLOSS-ABSORBING SECURITIES .... 79

BIBLIOGRAPHY .............................................................................................................................80


6/101

vi

ACRONYMS

AIRB Advanced Internal Ratings-Based Approach

ALM Asset Liability Management

BAKred Federal Banking Supervisory Office BCN Buffer Capital Notes

BIS Bank for International SettlementsBCBS Basel Committee on Banking Supervision (or the Basel Committee)

BCCS Buffer Convertible Capital Securities

bn Billion

bp Basis Point (1bp = 0.01%)CAB Capital Access Bond

CAMELS US supervisory rating of a bank´s overall condition

CAPM Capital Asset Pricing ModelCC Contingent CapitalCCB Contingent Convertible Bond

CCC Contingent Capital Certificates

CCR Counterparty Credit RiskCDO Collateralized Debt Obligation

CDS Credit Default Swap

CET1 Common Equity Tier 1

CHIPS Clearing House Interbank Payments System

CLO Collateralized Loan ObligationCMS Constant Maturity Swap

CoCo Contingent Convertible Capital Bond

CRC Contingent Reverse Convertible

CRD Capital Requirements DirectiveCT1 Core Tier-1 Capital

CSFI Centre for the Study of Financial Innovation

CVA Credit Valuation AdjustmentDM Deutsche Marke.g. For example (from Latin exempli gratia )

EBA European Banking Authority

EPC Event-driven Process ChainEPE Expected Positive Exposures

ECB European Central Bank

ECN Enhanced Capital NotesEMU European Monetary Union

EUR Euro

FASB Financial Accounting Standards BoardFedwire Federal Reserve Wire Network


7/101

vii

FDIC Federal Deposit Insurance Corporation

FINMA Swiss Financial Market Supervisory AuthorityFIRB Foundation Internal Ratings Based Approach

FMA Financial Market Authority

FSA Financial Services AuthorityFSB Financial Stability BoardFSF Financial Stability Forum

FSOC Financial Stability Oversight Council

FSPP Financial Services Practitioners Panel

FX Foreign ExchangeG-SIBs Global Systemically Important Banks

G-SIFIs Global Systemically Important Financial Institutions

G20 Group of Twenty Finance Ministers and Central Bank Governors

GBP Pound SterlingGDP Gross Domestic Product

IADI International Association of Deposit Insurers

IASB International Accounting Standards Board

IFRS International Financial Reporting StandardsIMF International Monetary Fund

IR Interest Rate

LCFI Large, Complex, Cross Border Financial InstitutionLFI Large Financial Institution

LLR Lender of Last Resort

LYON Liquid Yield Option Note

LT2 Lower Tier 2LTV Loan to Value, usually Loan to Value Ratio

MAG Macroeconomic Assessment Group (established by the Financial Stability

Board and the Basel Committee on Banking Supervision)

MCB Mandatory Convertible Bond

MM Modigliani-Miller

NA Not Applicablemn Million

MPT Modern Portfolio TheoryNPL Nonperforming Loan

NPV Net Present Value

NOPAT Net Operating Profit after Tax

OeNB Oesterreichische NationalbankOTS Office of Thrift Supervision

PwC PricewaterhouseCoopers, a Global Professional Services Firm

RCD Reverse Convertible Debenture


8/101

viii

REPO Repurchase Agreement

ROA Return on AssetsROE Return on Equity

ROIC Return on Invested Capital

RWA Risk Weighted AssetsSA Standardized ApproachSIFI Systemically Important Financial Institution or Systemically Important

Financial Intermediaries

SWF Sovereign Wealth Fund

TBTF Too Big To Failtn Trillion

USD US-Dollar

GAAP U.S. Generally Accepted Accounting Principles

UST U.S. Treasury NoteUT2 Upper Tier 2

WACC Weighted Average Cost of Capital

WIPO World Intellectual Property Organization

yr Year


9/101

ix

TABLES

Table 1: Implications of bank´s target returns on equity.................................................. ................... 3

Table 2: The regulatory reform agenda post-lehman ................................... ..................................... 37

Table 3: Basel IIi and the impanct on european banking .......................................................... ........ 42

Table 4: Pre- and Post-Crisis Contingency Planning .................. ...................................................... 43

Table 5: Contingent Convertible Capital in a Nutshell ...................................................... ................. 46

Table 6: Instruments Providing Common Equity in Distress .................................................... ........ 51

Table 7: Types of Triggers ................................ .......................................................... ......................... 52

Table 8: After the trigger-event ...................................................... ...................................................... 54


10/101

1

1. Introduction

The recent financial crisis has highlighted, inter alia, that not only the absolute amount of a bank’sequity position, but also the quality of the capital it holds available to absorb losses, is important. In

response to this, the Basel Committee on Banking Supervision (BCBS or the Basel Committee) has

tightened up its requirements of the quality and quantity of core capital, promoted the build-up ofcapital buffers that can be drawn down in periods of severe market conditions, improved the risk

coverage of the capital framework and introduced a non-risk based supplementary measure.Hybrid forms of capital were meant to combine the cost-efficiency of debt with the support that

equity offers to banks in times of crisis. Yet they ultimately proved to be less well constructed than

originally thought. When extra capital was needed to protect depositors and other creditors, these

hybrid instruments did not provide it without the bank first defaulting (The Economist, 2009). Due tothe fact that hybrid capital did not support banks in the way they were originally thought of, only very

few of the old hybrid capital instruments are to be recognized as regulatory capital (Zähres, 2011).

With regulators pressing for higher loss absorbency for hybrid forms of capital 1, here, the case ofcontingent capital applies.

The new BCBS measures are designed to have subordinated creditors participate in the cost

of recapitalization, just like providers of equity capital, to prevent socially not desired outcomes (e.g.

that investors in subordinated debt were held liable only in the event of a gone concern) (Zähres,2011). The moral hazard problem to which such flawed risk-responsibility connection gave rise is now

being addressed by involving subordinated creditors at an early stage. It is intended to reflect the risks

entailed in subordinated bonds adequately in their pricing and to close the door on investors benefiting

from the assumption of risk taking by the government. Only then will creditors have more appropriate

incentives to price, monitor, and limit the risk-taking of the firms to which they lend (Bernanke, 2010).

Bernanke told the U.S. Congress: “The right response is to put extra cost, extra supervision on these

[financial] firms that will give them an incentive to eliminate unnecessary size, to eliminate

unnecessary activities and to reduce their risk- taking.” (Wessel, 2011)

Driven by the conclusions of the latest financial crisis, two fundamental approaches haveevolved to improve bondholder liability. The first is a hybrid capital instrument in the form of fixed

income securities serving as an equity buffer in times of financial distress and known as contingent

convertibles (CoCo-bonds); the second tool would be a so called bond creditor “ bail-in” . The two ideas

differ fundamentally: CoCos are market-based fixed income instruments, while bail-in ’s rest on theprinciple of discretionary intervention. Together they share the goal to strengthen the stability of the

financial system (Zähres, 2011).

CoCo-bonds look like the perfect post-crisis panacea. Swiss regulators (FINMA) backed themas an ordinary equity supplement (Schweizerische Eidgenossenschaft, 2010). Credit Suisse

successfully sold USD 2bn of Tier 2 Buffer Capital Notes (BCN) 2 in February 2011. But the Basel

Committee on Banking Supervision is not convinced: it wants the world’s 30 too -big-to-fail lenders or

G-SIFIs/G-SIBs to use only common equity to meet its proposed core equity tier one capital surcharge

1 Hybrid capital has certain properties of debt but is treated as equity as far as depositors are concerned (subordinated todepositors). Prior to the financial crisis many banks issued hybrid capital as a cost-effective means of meeting their Tier 1 andTier 2 capital requirements.2 USD 2bn 7.875 per cent Tier 2 Buffer Capital Notes due 2041.


11/101

2

of between 1 per cent and 3.5 per cent (BCBS, 2011). Common Equity Tier 1 is the highest quality

component of a bank’s capital as it is capable of fully absorbing losses whilst the bank remains a

going concern. For the financial institution, Common Equity Tier 1 is the most costly form of capital to

raise.

The case of contingent capital is to support banks with sufficient capital to comply with

regulatory capital requirements. Therefore, this form of structured credit instruments has to provide theoriginally intended function of hybrid capital to protect depositors, other creditors and in the end thetaxpayers. The aim of this study is to evaluate the possibilities of contingent capital instruments to

strengthen the financial system. The regarding research questions are:

A) Is contingent capital a useful regulatory tool to strengthen the financial system?

B) If question A is to answer positively how will the specific CoCo-bond features have to bedesigned to ensure that A is given?

To reach an appropriate conclusion, all the issued academic research on contingent capital will be

reviewed. To support the findings, expert comments from market participants, broker research,newspapers and magazine articles will also be considered. Finally, the empirical findings will be

compared to the contingent capital securities issued so far.

A good state of the art textbook on money, banking, and financial markets is usually based on

a few core principles (see, for example, Ceccetti (2008)). Knowledge of these principles is the basisfor learning how the financial system is organized. To better understand the case of contingent capital,

we will adopt a similar approach. Applying a proper structure to this study, we will first explain how the

banking business works and which economic functions it provides. In the following chapter, aframework for bank regulation is explained in detail, with a primer on the new Basel III rules closingthe focus on regulation. Finally, after we are aware of all the issues modern banking has to deal with,

we will review the features of contingent capital to evaluate their possible contribution for a

strengthened financial system.


12/101

3

2. The Banking Business

Banking plays the major role in channelling funds to borrowers with productive investment

opportunities. Therefore, the provided activities are important in ensuring that the financial system and

the economy run smoothly. In this section, we will examine the role of financial institutions within the

economy in detail and set the preconditions for the necessary knowledge of the following chapters on

bank regulation, the Basel Accord and contingent capital.

2.1 B ANKS AND THEIR R OLE IN THE F INANCIAL S YSTEM

Financial institutions come in various forms and offer an extensive product range. Although around for

centuries, the banking landscape has changed dramatically over the last decades; and with it, ourworld: in the 1980s, deal making shifted to a new focus on trading. Firms such as Merrill Lynch or

Drexel Burnham Lambert who became prominent as investment banks earned an increasing amount

of their profits from trading for their own account. Trading with the firm´s money, proprietary trading

(also dubbed as "prop trading"), occurs when a firm trades stocks, bonds, currencies, commodities,derivatives, or any other financial instruments to make a profit for itself. This “search for yield ”3

became one of the most important drivers for the industry and bank CEO´s competed globally with

their yearly ROE-targets. See Table 1 for an analysis of the meaning of bank´s target returns on

equity.

TABLE 1: IMPLICATIONS OF BANK´S TARGET RETURNS ON EQUITY

What banks’ t arget returns on equity tell us According to a company statement from September 2011, Lloyds’ bank announced a target return on equity of 14.5 per cent. Another famous example would be Deutsche Bank, where CEO Josef Ackermann targeted a more demanding return onequity of 25 per cent, something the bank achieved in 2005. Bank managers like to argue that this is the necessary level ofreturn on equity they need to earn, in order to gain funding from the markets. Usually, the variable compensation part ofexecutive employees is linked to achieving such objectives. But is it really useful to target such objectives? Regarding toMartin Wolf, chief economist of the Financial Times, the brief answer is: no.

Consider the following: someone is offering you an investment with a promised real return of 15 per cent (referring to theLloyds target return on equity). You might instantly reply (as a person who is aware of the correlation between risk/reward andrecalling a current risk free yield of close to zero ): “What is the catch?” If you come to the conclusion that you were beingoffered a reliable real return at such an exalted level, you would buy as much as your finances allow. So what is the catch?The obvious answer has to be that the real return in question must be extremely risky and has the chance of a total wipe-out.

Obviously, these cannot be sustainable safe returns in economies growing at a rate of about 2 per cent a year, for such awell-established industry as the banking industry is. At a 15 per cent real return, the value of cumulative retained earningswould double in five years and increase 16-fold in 20 years. As a consequence, bank equity would be the most desired realasset in the world.

If you were really confident that banks could earn 15 per cent real returns, no one would ask for distributions, since the returnswould be so much higher than anywhere else. Therefore, the example of compound growth of bank equity, underreinvestment of profits, is not unreasonable if the returns were themselves plausible. But they are clearly not. If these reallywere plausible returns, there would also be no problem for banks obtaining much more capital; they would just have toprevent distributions for a few years. We can therefore summarize that these returns must represent the result of extremerisk-taking. Just how big that risk must be emerged during the latest crisis, when real returns became significantly negativeand several institutions failed.

Turner et al. (2010) made exactly this point regarding to the UK banking sector: trends in return on equity are divided into twoperiods. Until around 1970, return on equity in banking was around 7 per cent with a low variance – in other words, returns tothe financial sector were in line with the economy as a whole. But the 1970s mark a regime shift, with return on equity inbanking roughly trebling to over 20 per cent. During much of the latter period, banks internationally were engaged in a highly

3 Actually, the term “search for yield” – lately the reference to the industry’s excessive risk taking – refers to a more technicalissue within the asset management industry: investors may underestimate risk if their investment managers take risks that arenot evident, or are purposely concealed. For example, some investment managers promise to pay a relatively high nominal rateon a long-term contract. However, when expected inflation falls, as it did in the U.S. for nearly two decades after 1982, nominalinterest rates fall too. In these circumstances, the investment manager may for a time try to continue making high nominalinterest payments by taking greater risks: a so-called search for yield (Cecchetti, 2011).


13/101

4

competitive return on equity race.

There are other reasons why banks might earn 15 per cent returns on equity (besides the fact that these highly leveragedbalance sheets are risky and pose a real threat to society): one is that they can earn monopoly profits, the other is that theyare subsidised, mainly because taxpayers provide a safety net. Both are related. Without entry barriers, subsidies would bearbitraged away. So when banks tell us that they target an ambitious high return on equity figure, they are saying that theirbusinesses are very risky and/or protected against competition and/or well subsidised and probably a bit of all three.

The question we need to ask ourselves is: can we afford to have financial institutions that are both so large and so essential

and yet run such enormous risks? Wolf suggests the answer is (again): no. “Make them safer. It really is not going to hurt.” Source: Wolf (2011)

Today, the importance of the banking industry is obvious and goes hand in hand with other

developments: debt to GDP ratios increased somewhat dramatically, worldwide trading volumes

exploded 4, and financial products have become highly complex since Wall Street embraced financial

engineering 5. Stephen Cecchetti, advisor to the BIS, puts it as follows: “For most of the 20 th century,defining money and banks was straightforward. Money was currency or a checking account balance;

banks were institutions that took deposits and made loans. Then the invention of computers and the

resulting revolution in information technology changed everything. […] The changes have been sosweeping that if a banker of the 1960s or 1970s were transported to the present day, he or she wouldhardly recognize our current financial system. The way we use money, financial instruments, financial

markets, and financial institutions is completely different from the way our grandparent’s generation

used them.” (Cecchetti, 2008, p. vii)

Until the recent crisis, this increased surge in financial products and their complexity werebelieved to enhance stability as well as efficiency. That assumption was, to put it mildly, not correct.

Financial innovation has allowed market participants to share risk more effectively than before. At the

same time, the financial industry has introduced a large number of highly complex securities 6, which

investors and risk managers have to deal with.In summary, “complexity matter s” (Brunnermeier & Oehmke, 2009, p. 4) in financial markets.

Investors, and therefore also regulators, need to find ways to deal with it. In 2011, three years after the

near collapse of the global financial system, former U.S. Federal Reserve chief Alan Greenspan seesthe possibilities for regulators limited (Greenspan, 2011) : “The problem is that regulators, and for thatmatter everyone else, can never get more than a glimpse at the internal workings of the simplest of

modern financial systems. Today’s competitive markets, whether we seek to recognise it or not, are

driven by an interna tional version of Adam Smith’s invisible hand that is unredeemable opaque. ”

So what should financial market regulation try to achieve to stop the on-going uncertainty? We

will deal with this and other questions in later sections. First, to start with, we have to think about why

we need financial intermediaries (if ever) and what functions they have within an economy.

2.1.1 MATCHING B ORROWERS AND LENDERS

4 Worldwide total merchandise (exports, USD in current prices) grew by 4,707 per cent from 1970 to 2010 (World TradeOrganization, 2011).5 Financial engineering is a multidisciplinary field related to the creation of new financial instruments and strategies, typicallyexotic options and specialized interest rate or debt derivatives. Today, all full service institutional finance firms employ financialengineering professionals in their banking and finance operations. JPMorgan Chase & Co. was one of the first firms to create alarge derivatives business, which employs computational finance (Tett, 2010, p. 3 f.).6 One interpretation is that complexity emerged from financial institutions’ desire to sidestep regulation (Brunnermeier &Oehmke, 2009).


14/101

5

What does the financial system do, and how does it deliver economic value added? This section will

provide us with the economic rationale about why banks exist.

There are different ways of categorizing activities within the financial system – for the purposeof this work, referring to Adair Turner 7, we will distinct between following four activities (Turner, et al.,

2010):

Provisions of payment services;

Provisions of pure insurance services, which enables economic entities to lay off exposure torisks by pooling their exposure with others;

Creation of markets in spot or futures instruments in, for instance, commodities;

Financial intermediation between surplus units (borrowers) and deficit units (lenders), or

generally speaking an intermediation, which plays a crucial role in capital allocation within theeconomy.

Of course, different banking products and activities span these four categories, but the conceptual

separation remains valuable. The last category (financial intermediation) deserves special attention:linking surplus units/lenders with deficit units/borrowers. 8 The claims between borrowers and lenders

can take the form of debt, equity or a combination of the two (hybrid), and appears with a variety of

different maturities. One function of financial institutions is simply to help match surplus and deficit

units. This straightforward matchmaking function is only a small part of the financial service industry.The more interesting part, the core of what the financial system does, is to intermediate non-matching

borrowers and lenders of funds, enabling the pattern of lender’s assets to differ from the pattern of

borrower’s liabi lities.

7 Jonathan Adair Turner is a British businessman, academic and chairman of both the Financial Services Authority and theCommittee on Climate Change in the U.K.8 Here the problems arose in the latest financial crisis and most past financial crisis (for an historical overview see, for example,Reinhart and Rogoff’s work on financial crises over the last eight centuries (Reinhart & Rogoff, 2009)).


15/101

6

This intermediation of non-matching assets and liabilities provides four functions (Turner, et al., 2010):

Risk transformation: through the pooling of risks, with each depositor of a bank having an

indirect claim on all obligations owed to the bank rather than a claim on a specific loan;

Maturity transformation (through balance sheet intermediation): an inherent feature of a bank’sbusiness is maturity transformation. This is accomplished through lending at longer average

maturities compared to the maturities of a bank’s borrowings. The risk herein lies in themanagement of the equity cushion, but also in the holding of a reserve of highly liquid assets 9.

Normally, liquidity insurance is achieved through the interbank market but also by the centralbank (in providing the lender-of-last-resort function). Through this process, savers are enabled

to hold short-time deposits, while borrowers can take out long-term debt;

Maturity transformation (via provision of market liquidity): gives the holder of a long-term asset

the option of selling his asset anytime he wants to in a liquid market 10;

Risk return transformation: banks offer a mix of debt and equity investment options for savers,

which arise naturally from the liabilities of the borrowers. A banks balance sheet takes a set ofdebt liabilities from final users and tranches them. This credit tranching refers to creating a

multi-layered capital structure that includes senior and subordinated tranches (classes)(Nomura, 2004). Essentially, depositors and senior debt holders possess a (debt) claim of

lower risk than the average pooled quality of the asset side of the banks’ balance sheet. Butthis comes with a lower return, while equity holders have a higher risk with an assumed higherreturn on their investment.

Now we are able to analyse, how banks add value to the economy. Based on the four transformation

functions above, banks can provide value added to the economy in three different ways (Turner, et al.,

2010):

Pooling: the intermediary allocates capital to specific projects. The pooling process is

important, since a more efficient allocation of capital will tend to produce higher income

levels;11

Asset/Liability maturity mix: a maturity mix of assets and liabilities provides assurance ofaccess to liquid assets in the face of either fluctuating consumption or (unanticipated) income

shocks. Therefore it enables individual economic units a smoothing of consumption across

their life cycle. In summary, it can deliver welfare benefits independent of any impact on

aggregate savings rates, investment levels, the efficiency of capital allocation, or economicgrowth;

9 The Basel III rulebook addresses this issue with the Liquidity Coverage Ratio (LCR). The 30-day liquidity coverage ratio isdesigned to ensure short-term resilience to liquidity disruptions.10 This form of liquidity provision comes with uncertainty compared to maturity transformation on the balance sheet, where thedepositors are enabled to enjoy both liquidity and capital certainty. But it is still recognized as a form of maturity transformation,giving the fund provider a different set of assets options that is inherent in the maturity of the liabilities faced by fund users(Turner, et al., 2010).11 A significant amount of capital allocation occurs de facto within firms, which make decisions about the use of retainedearnings. But still, intermediaries play an important role when it comes to capital allocation (Turner, et al., 2010).


16/101

7

Transformation: all above stated functions inherent to the intermediation of non-matching

assets and liabilities together enable individual household sector savers to hold an asset-mix

(as defined by risk, return and liquidity), which is different from the liability-mix owed by

business users of funds. This transformation may produce a higher savings rate, moreinvestments and, temporarily, higher growth (Levine, Loayza, & Beck, 2000).

These above stated functions increase the range of options for investments in different

risk/return/maturity combinations beyond the possibilities, which would exist if investors had only the

opportunity of direct investments in untransformed liabilities of businesses or households, or in poolsof these untransformed liabilities. It may be useful to note that the wave of credit securitization, which

played an important part in the recent crisis, was not in its economic function entirely new, but rather a

stepping up of the four financial system transformations described by Turner, et al. (2010).

As illustrated above, financial intermediaries can engage in asset transformation as regardssize/maturity/risk to accommodate the utility preferences of lenders and borrowers (first explained by

Gurley and Shaw (1960)). We have to consider if this explanation for the existence of banks iscomplete.

One question is obvious: why are firms themselves not committed to direct borrowing (cuttingout the middleman)? Prima facie, the shorter transaction chain involved in direct lending-borrowing

would be less costly than the longer chain involved in indirect lending-borrowing. This leads to the

(theoretically correct) conclusion that, in a world with perfect knowledge, transaction costs and

indivisibilities would not exist and therefore financial intermediaries would be of no use. Of course,

these conditions are usually not present in the real world. Any business venture is subject to

uncertainty and consequently risky. Both project finance and lending are not perfectly divisible, and

transaction costs most certainly exist. To consider the reasons why borrowers and lenders prefer the

services of financial intermediaries we have to think of the following (Matthews & Thompson, 2008):

One reason for the dominance of financial intermediation over direct lending-borrowing refersto transaction costs; Benston and Smith (1976) argue that the “raison d’ être” for this industry

is the existence of transaction costs;

Other reasons include liquidity insurance (Diamond & Dybvig, 2000), information-sharing

coalitions (Leland & Pyle, 1977) and delegated monitoring (Diamond, 1984 and 1996).

We will discuss these topics in the following sections.

2.1.2 TRANSACTION C OSTS

As a first stage in the analysis of the role of costs in an explanation of financial intermediation, we

need to examine the nature of costs involved in transferring funds form surplus to deficit units. The

following broad categories of cost can be discerned (Matthews and Thompson, 2008):

Search costs: these involve economic units searching out agents willing to take an oppositeposition, e.g. a borrower seeking out one or more lenders who is willing to provide the

required amount. Additionally, beside the search for a counterparty, it would also be


17/101

8

necessary for the agents to obtain information about the opposite party to the transaction and

then negotiate and finalize relevant contract(s);

Verification costs: these arise from the need of the surplus unit to evaluate the proposal for

which the funds are required;

Monitoring costs: once a loan is made, the lender will wish to monitor the progress of the

deficit unit and ensure that the funds are used in accordance with the purpose agreed; 12

Enforcement costs: such costs will be incurred by the surplus unit should the deficit unit

violate any of the contractually agreed conditions.

The role of costs can be examined more formally. In the absence of a bank, the cost-return structure

of the two parties involved is depicted below, denoting the rate of interest as R, the various costs

incurred by the borrower as T B and those incurred by the saver as T S (Matthews & Thompson, 2008):

Return to the saver (R S) = R - TS

Cost to the borrower (R B) = R + TBThen the spread is equal to: R B – RS = TB + TS

The spread provides a profit opportunity, which can be exploited by the introduction of an

intermediary, a bank. The bank books transaction costs denoted by C. For simplicity, we will assume

that this cost is borne solely by the borrower. Following the introduction of a bank, the cost-returnstructure of the two parties will be amended to (the prime indicates the costs after the introduction of a

bank):

Return to the saver (R S) = R – T’SCost to the borrower (R B) = R + T’ B + C

Then the spread is equal to: R B – RS = T’B + T’S + C

The introduction of a bank will lower the cost of the financial transaction provided the borrower’s and

saver’s cost fall by more than the amount of the charge raised by the intermediary, i.e. provided

(TB + TS) – (T’B + T’S) > C

We can now consider the reasons for the assumption that the fall in the total costs incurred by

borrowers and lenders will be greater than the charge levied by a bank. As far as search costs are

concerned, banks are nowadays located within every city and the growth of Information Technology

has permitted direct access to financial institutions. Access can be easily accomplished. Thecontractual arrangements are carried through standard forms of contract, which again lowers

transaction costs. Costs are also lowered for borrowers through size and maturity transformation.

12 A moral hazard problem could arise here: the borrower may be tempted to use the funds for purposes other than thosespecified in the loan contract (Matthews & Thompson, 2008). To cover these risks the lender may demand an insurance(Zimmermann, Henke, & Broer, 2009).


18/101

9

Consider the scale of costs likely to be incurred negotiating a series of small loans and their

subsequent renegotiation as and when each individual loan matures. In fact, economies of scale arelikely to be present, particularly in the banking industry. Costs of monitoring n loans carried out by q

investors are likely to be far more than the costs if monitoring were carried out by a single financialintermediary.

In addition to economies of scale, scope economies are also likely to be present.13

Economiesof scope arise from diversification of the corresponding asset portfolio including loans. Clearly, given

the geographical dispersion of agents and the resulting transport costs, some economies can arisefrom the concentration of lending and deposit acceptance facilities. Pyle (1971) argues that economies

of scope can be explained within a portfolio framework. Deposits earn a negative return; loans and

advances earn a positive return. If these two returns were positively correlated (which would be

expected), then the financial intermediary would – for optimization purposes – hold a short position inthe first category and a long position in the second. In other words, the financial intermediary will issue

deposits and make loans.

It is therefore fairly certain that the introduction of financial intermediaries lowers the cost of

transferring funds from deficit to surplus units. Nevertheless, reasons for caution are appropriate

(Matthews & Thompson, 2008):

Economies of scale seem to be exhausted relatively early. The increased value of banks can

arise from two potential sources: increased efficiency and, of course, increased market power.

The first source is beneficial to society and originates from economies of scale (and also due

to economies of scope). As most banks offer a wide range of services, further large-scope

economies are not very likely;

There seems to be a quite general agreement that there is little potential for economies ofscope – see, for example, Clark (1988) and Mester (1987);

Large firms with excellent credit ratings find it cheaper to obtain direct finance through equity,

bonds or money markets. This would be a case for disintermediation.

There is clear evidence that banks do generally lower the aggregate cost of financial intermediation;but this appears to be an incomplete story of why financial intermediation occurs. It seems to suggest

that the level of transaction costs is exogenous without examination as to why these costs varybetween direct and indirect borrowing/lending. Further analysis is required to investigate the nature of

these costs.

13 Economic efficiency can be defined as the firm’s combining its inputs in a manner such that its costs are at a minimum: it istherefore a combination of pure technical and allocative efficiencies (Matthews & Thompson, 2008).


19/101

10

2.1.3 LIQUIDITY INSURANCE

In the absence of perfect information, consumers are unsure when they will require funds to finance

consumption. Therefore consumers will desire a pool of liquidity to offset the adverse effects of shocksto the economy. Provided these shocks to individual consumers are not perfectly correlated, modern

portfolio theory (MPT) suggests that the total liquid reserves needed by a bank will be less than the

aggregation of the reserves required by individual consumers acting independently. This is the basis

of the argument put forward by Diamond and Dybvig (1983) to explain the existence of financialintermediaries. The existence of banks obviously enables consumers to alter the pattern of their

consumption in response to unexpected events compared with the pattern that would have existed in

a base scenario (Matthews & Thompson, 2008). The value of this service justifies a fee to be raised by

the intermediary.Diamond and Dybvig illustrate the case of liquidity insurance in form of a three-period model.

Decisions are made in period 0 to run over the next two periods. Technology is assumed to require

two periods to be productive. As a result, every interruption of the process to finance consumptionleads to a lower return. Consumers are split into two categories: those who consume early in period 1and those who consume late at the end of period 2. Early consumption imposes a cost in the form of

lower output and consumption in period 2.

Diamond and Dybvig point out that business investment often requires expenditures in the

present to obtain returns in the future. Therefore, when deficit units need to borrow to finance theirinvestments, they wish to do so on the understanding that the surplus unit will not demand

repayment(s) until some agreed upon time in the future, in other words they prefer loans with a long

maturity (low liquidity). The same principle applies to individuals seeking financing to purchase large-ticket consumer goods. On the other hand, individual savers may have unpredictable need for cash,

due to unforeseen expenditures or broader shocks to the economy. Therefore they demand liquid

accounts, which permit them immediate access to their deposits (they value short maturity deposit

accounts). Regarding to the introduced model, the existence of a bank offering fixed money claimsovercomes this problem by pooling resources and making larger payments to early consumers and

smaller payments to later consumers than would be the case in the absence of a financial

intermediary. For this reason the financial intermediary acts as an insurance agent.

Diamond and Dybvig's crucial point about how banking works is that under ordinary

circumstances, savers' unpredictable needs for cash are unlikely to occur at the same time. Thus abank can make loans over a long horizon, while keeping only relatively small amounts of cash on hand

to pay any depositors that wish to make withdrawals. It should also be noted that the key point is that

the existence of uncertainty provides the underlying rationale for the model (Matthews & Thompson,2008). There is also the critical assumption that the division of agents between the two classes of

consumers is certain. Finally, the explanation is not independent of transaction costs as the role of the

bank does depend on possessing a cost advantage, otherwise individuals would introduce their own

contracts, which would be able to produce a similar outcome.


20/101

11

2.1.4 ASYMMETRY OF INFORMATION

A large literature (see, for example, Bhattacharya and Thakor (1993), or van Damme (1994) for an

overview) has identified asymmetric information as the decisive element of credit markets. The basicrationale underlying the asymmetry of information argument is that the borrower is likely to have more

information about the project that is the subject of a loan than the lender. In any case, the borrower

should be aware of the degree of risk attached to the project (Matthews & Thompson, 2008). These

asymmetries lead to a credit rationing equilibrium (see, for example, Stiglitz and Weiss, 1981), andmay invalidate other competitive market results (Ariccia, 1998). But lenders are able to resolve part of

these informational problems over time. In the process of lending, financial intermediaries gather

valuable proprietary information about borrowers creditworthiness. Banks gather market power by

acquiring some degree of informational monopoly about their clients (Greenbaum, Kanatas, &Venezia, 1989). In essence, it is simply all about the cost of figuring out whether a borrower is

trustworthy.

Special attention should be drawn upon moral hazard and adverse selection. The phrasemoral hazard originated when economists who were studying the insurance business noted that an

insurance policy changes the behaviour of the insured person (Cecchetti, 2008). In our context, moral

hazard is the risk that the borrower may engage in activities that reduces the probability of the loanbeing repaid. Prior to the credit line granted, the borrower may well have inflated the probable

profitability of the project either by exaggerating the profit if the venture is successful or by minimizing

the chance of failure. It goes without saying that it is difficult for the lender to assess the true situation.

After a loan is negotiated, moral hazard may occur because the borrower acts not as agreed upon. Onthe other hand, adverse selection may occur because the lender is not sure of the precise

circumstances surrounding the loan and associated project. Given this lack of information, the lender

may select the wrong projects to finance. Apparently, the result of the existence of asymmetric

information between borrower and lender reduces the efficiency of the transfer of funds from surplusto deficit units (Matthews & Thompson, 2008). What can the introduction of an intermediary do to

circumvent these problems? Three answers are given in the literature (Matthews & Thompson, 2008):

Banks are subject to economies of scale in their borrowing/lending activities so that they can

be considered as information-sharing coalitions;

Banks monitor the projects that they finance, i.e. they operate as delegated monitors ofborrowers;

Banks provide a mechanism for commitment to a long-term relationship.

In all these cases a bank may overcome the pitfalls of moral hazard and adverse selection. The nextsubsections will explain the above-mentioned answers against the asymmetry of information problems

in greater detail.


21/101


22/101

13

Examples, to name a few, of such monitoring-tasks are:

Screening the application of loans to sort out the good from the bad to reduce the probability

of financing too risky loans;

Examining the creditworthiness of the counterparty;

Implementing control mechanisms to keep track of the borrower’s behaviour if he sticks to the

terms of the contract; etc.

A bank has a special advantage in the monitoring process as it will often be operating the client’s

current acco unt and will therefore have private information concerning the client’s flows of income andexpenditure. This factor is very important in the case of small- and medium-sized companies and

arises from the fact that banks are the main operators in the payments mechanism.

A bank will require a firm to produce a business plan before granting a loan. Given the number

of such plans examined, a bank will have developed special expertise in assessing such plans and willtherefore get more competent in judging the plausibility of a plan over time. Further controls exist inthe form of credit scorings whereby a client’s creditworthiness is assessed by certain rules ( for

example, the best-known and most widely used credit score model in the U.S. is the FICO score

(named after the Fair Isaac Corporation, a provider of analytics and decision managementtechnology).14 The FICO score is calculated statistically, with information from personal credit files.

Other, more public information is available in respect of firms. Rating agencies exist that provide credit

ratings for firms and also sovereign debt, where country ratings are a necessary by-product (ratingagencies are not being paid for country ratings, but are a factor to evaluate for firms based in the

regarding jurisdiction). The most well-known rating agencies are Standard & Poor, Moody ’s and Fitch.

This information becomes available to the general public via reports in the media. Finally, monitoring is

also relevant after a loan has been granted. Banks will set conditions in the loan contract that can beverified over time. For a firm these typically will include the adherence to certain accounting ratios and

a restraint over further borrowing while the loan is outstanding. The bank is able to check that such

conditions are being adhered to. In addition, collateral security will often be required. Failure to adhere

to the terms of the agreement will cause the loan to be cancelled and the collateral forfeited (Matthews& Thompson, 2008).

The information obtained from borrowers is also confidential, which is not the case whenfunds are obtained from the capital market. In the latter situation, a firm raising funds must provide a

not inconsiderable amount of detail to all prospective investors. There is a second advantage to firmsraising bank loans. The fact that a firm has been able to borrow from a bank and meet its obligations

regarding repayment provides a seal of approval as far as the capital market is concerned. It shows

that the firm has been satisfactorily screened and absolves the capital market form repeating the

process. The role of banks, in particular, provides a means for the problems associated withasymmetric information to be ameliorated. For monitoring to be beneficial, it is necessary to show that

14 Credit scores are widely used because they are inexpensive and largely reliable, but are not without any problems. Oneproblematic issue, for example, is the piggyback problem. Because a significant portion of the U.S. FICO score is determined bythe ratio of credit used to credit available on credit card accounts, one way to increase the score is to increase the credit limitson one's credit card accounts (Foust & Pressman, 2008).


23/101


24/101

15

2.1.4.3 MECHANISM FOR C OMMITMENT

Another reason for the existence of banks given asymmetric information is that they provide amechanism for commitment (Matthews & Thompson, 2008). Contracts cannot be drawn up and

agreed upon in a manner that specifies all possible outcomes; this means that there is an absence of

complete contracts.

Mayer (1988) suggests that a close relationship with borrowers may provide an alternativemeans of commitment. It is argued that German and Japanese banks do have a close relationship

with their clients and often are represented on the firms’ governing bodies. Banks are therefore

enabled to stay well informed about investment prospects and the future outlook for the firm. Despite

of foreclosure, remedial actions can help in case of the firm experiencing problems. This close

relationship to the clients may help to ease the problems of moral hazard and adverse selection.

Supporting Mayer’s arguments, Hoshi et al. (1991) provides evidence that firms with close banking

ties perform more efficiently than firms without such ties.

2.1.5 O PERATION OF THE P AYMENTS MECHANISM

The operation of a payments mechanism provides banks with an advantage over competing financial

intermediaries. Money provides different functions to the economy: "Money," Scitovsky (1969, p. 1)

said, "is a difficult concept to define, partly because it fulfils not one but three functions, each of them

providing a criterion of moneyness […] those of a unit of account, a medium of exchange, and a store

of value." The two main purposes money serves in the economy are the medium of exchange and the

store of value function. Bank deposits are unique because they serve both purposes at the same time

- they are a package of services. The difference between a bank deposit and other assets serving as astore of value is that bank deposits also provide the medium of exchange function. Usually, payments

are effected by a bookkeeping entry moving a balance between accounts without the necessity to

transfer actual cash amounts. We can say that it is always necessary for us to keep money balances,

i.e. a bank deposit, to conduct transactions. The deposits are important for banks because they canuse them to purchase interest-earning assets. Banks also protect this advantage. For example they

provide a free or nearly free service of transferring funds. Nevertheless, such services are expensive

to provide and that is why banks are trying to reduce costs by branch closure and greater operational

efficiency (Matthews & Thompson, 2008). We keep in mind that the payments mechanism by banks

gives them a great advantage over competitors in the role of financial intermediaries.


25/101

16

2.1.6 DIRECT B ORROWING FROM THE C APITAL MARKET

Even when it comes to direct borrowing by deficit units, banks have an important role to play - they

provide functions regarding to guarantees (Matthews & Thompson, 2008):

Loan commitments by way of note issuance facilities: these facilities consist of promises to

provide the credit in case the total issue will not be completely taken up in the market;

Debt guarantees: one obvious example of this is the guarantee of bills of exchange on behalf

of its customers;

Security underwriting: banks act as advisors on the issue of new securities and also they will

take up any quantity of the issue not taken up in the market.

It goes without saying that for all these activities the bank earns fee income rather than interest. This is

commonly known as “off balance sheet business” because it does not appear on the balance sheetunless the guarantee has to be exercised. To evaluate the activities outside traditional financial

intermediation we can compare two figures for the bank’s income calculation: first, net interest income

(gap between interest paid out on deposits and interest received from lending) and second, fee or

commission income. We instantly can get an impression of the importance of the activities outsidetraditional financial intermediation (Matthews & Thompson, 2008).

We have now shown the economic rationale for the existence of banks. In summary we

should keep in mind that financial institutions perform five functions (Cecchetti, 2008): (1) pooling the

resources of all the small savers; (2) providing safekeeping and accounting functions, as well as

access to the payments system; (3) supplying liquidity by converting saver’s balances directly into a

means of payment whenever needed; (4) providing ways to diversify risk; and (5) collecting and

processing information in ways that reduce information costs.Now we are aware of the economic reasons for the existence of banking. In Summary, closing

the chapter on banking business, we are now able to explain the (standard textbook) economic

reasons for intermediation and classify financial institutions within an economy. For critical remarks on

the standard textbook view see, for example, Graeber (2011). Having heard of the unquestionableimportance of the banking sector, the next chapter will put its focus on bank regulation.


26/101

17

3. Bank Regulation

Banking crises are not a recent phenomenon; the history of banking over the last centuries is replete

with periods of turmoil and failure. Many of the earliest crises were driven by currency debasements

that occurred when the monarch of a country reduced the gold or silver content of the coin 15 of the

realm to finance budget shortfalls often prompted by wars (Cecchetti, 2008).More timely, the last thirty years have seen an impressive number of worldwide banking and

financial crises. Caprio and Klingebiel (1997) identify 112 systemic banking crises in 93 countries and

51 borderline crises in 46 countries since the late 1970s. 16

The recent crises, which now appear to happen in shorter intervals than before, have renewed

interest of economic research about two questions (Rochet, 2008): the causes of fragility of banks and

the possible ways to remedy this fragility, and, as a result to this instability, the justifications and

organization of public intervention. As Rochet (2008) points out, public intervention can take several

forms:

Emergency liquidity assistance by the central bank acting as a lender of last resort (LLR);

Organization of deposit insurance funds for protecting the depositors of failed banks;

Minimum solvency requirements and other regulations imposed by banking authorities;

Supervisory systems, supposed to monitor the activities of banks and to close the banks that

do not satisfy these regulations.

The crisis of 2007-09 has been the result of the interaction of economic factors and financialinnovation (for an analysis see, for exam ple, Brunnermeier’s study “ Deciphering the Liquidity andCredit Crunch 2007 – 2008”, 2009). Wide global imbalances characterized the years before the crisis –

the International Monetary Fund (IMF) has written at length about the problem of global imbalances

since the early 2000s 17 (see, for example, Dunaway, 2009). The financial sector went through a period

of far-reaching changes caused by innovation and the development of credit risk transfer mechanisms.Thinking of the latest financial turmoil, the need for a more sophisticated regulatory framework seems

unquestionable.

As the BCBS (2006, p. 6) points out, an “effective system of banking supervision needs to be

based on a number of external elements, or preconditions . […] These preconditions, although mostlyoutside the direct jurisdiction of the supervisors, have a direct impact on the effectiveness of

supervision in practice. Where shortcomings exist, supervisors should make the government aware of

these and their actual or potential negative repercussions for the supervisory objectives. Supervisors

should also react, as part of their normal business with the aim to mitigate the effects of such

15 It is cheap to produce a coin or a banknote; the difference between what it costs the government to issue money and aneconomic unit to produce it is known as seignorage , after the right of the medieval lord, or seigneur, to coin money and keep forhimself some of the precious metal from which it was made (Eichengreen, 2011). In German, seignorage was therefore aptlydenoted as Münzgewinn or Schlagschatz .16 Many books have been written a bout the history of international financial crises, perhaps most famous Kindelberger’s (1989)book “Manias, Panics and Crashes” and more recently Reinhart and Rogoff’s (2009) book “This Time is Different”. Ferguson’s(2010) history of the foundations of cu rrency and finance “Der Aufstieg des Geldes: Die Währung der Geschichte” is also worthto be mentioned at this point.17 See world Economic outlook, International Monetary Fund, various issues.


27/101

18

shortcomings on the efficiency of regulation and supervision of banks. ” These external elements

include:

Sound and sustainable macroeconomic policies;

A well-developed public infrastructure;

Effective market discipline; and

Mechanisms for providing an appropriate level of systemic protection (or public safety net).

Continuing, Chapter 3 will address the topics of the justification for bank regulation, the government ’s

safety net, bank regulation and supervision, and, finally a brief look on the regulatory response to the

financial crisis of 2007-09.

3.1 T

HEJ

USTIFICATION FORB

ANKR

EGULATION

The strongest need for regulation arises in cases where physical danger is involved; obviously, bank

regulation does not fall into this category. Due to the absence of an immediate threat, it seemsappropriate to explain the need for bank regulation. For a detailed analysis of this topic regarding

specifically to the latest crisis, Bullard, Neely and Wheelock (2009), for example, explain in “SystemicRisk and the Financial Crisis: A Primer ” why the failures of financial firms are more likely to pose

systemic risks than the failures of nonfinancial firms.We could think of bank regulation as an application of a general theory of public regulation to

the specific problems of the banking industry. But in fact, as Freixas and Rochet (2008) argue, this

would be misleading. It is worth devoting some effort to understand why bank regulation raises some

questions that are not addressed within the general theory of public regulation. Although someinstruments and models of the theory of regulation can be adapted to cope with issues in bank

regulation, there are exceptions. The discussion here in Section 3.1 examines the justification for

regulation, considering first the general argument relating regulation and market failure, and then

analysing what is specific to banks as seen in Freixas and Rochet (2008).The case for regulation hinges on the argument from Ronald Coase 18 that unregulated, private

actions create outcomes whereby marginal social costs are greater than marginal private costs. The

marginal social costs occur because bank failure has a far greater effect – which is obvious when wethink of the topics we discussed in Chapter 2 (The Banking Business) – throughout the economy thanthe failure of other businesses. In comparison, the marginal private costs are borne by the

stakeholders of the company, and these are likely to be of a smaller magnitude than the marginal

social costs.

18 Ronald Harry Coase is a British-born, American-based economist. Coase is best known for two articles: “The Nature of theFirm” (1937), which introduces the concept of transaction costs to explain the nature and limits of firms, and “The Problem o fSocial Cost” (1960), which suggests that well -defined property rights could overcome the problems of externalities.


28/101

19

It should be kept in mind that regulation involves real resource costs, which arise from two sources

(Matthews & Thompson, 2008):

Direct regulatory costs;

Compliance costs, occurred at the regulated entities.

These costs are not trivial and have been characterized by Goodhart (1995, p. 2 f.) as representing

“the monstrous and expensive regiment of regulators” 19. Therefore we can see why, in general, public

regulation is justified by market failures. In terms of financial intermediation, contemporary banking

theory offers a series of explanations for the emergence of banks. But still, it is quite possible thatfinancial institutions do not completely solve the associated market failures or may even create new

market failures (Freixas & Rochet, 2008).

Banks emerge because they provide liquidity insurance solving the market failure owing to the

absence of contingent markets (e.g. markets, in which contracts will only be exercised under certaincircumstances). Still, regarding to Freixas and Rochet (2008), they create a new market failure

because a bank run equilibrium 20 exists, therefore requiring regulation.

The subsequent discussion establishes the existence of two market failures that make bank

regulation necessary: the fragility of banks is owed to their illiquid assets and liquid liabilities, and the

fact that depositors are not in the position to monitor the management of their bank.

3.1.1 THE S OURCES AND C ONSEQUENCES OF R UNS , P ANICS , AND C RISES

By their very nature, financial systems are fragile and vulnerable to crisis - as illustrated by

Kindelberger (1989) or Reinhart and Rogoff (2009) . Unfortunately, when a country’s financial systemcollapses, its economy goes with it (Calvo & Mendoza, 2000).

Considering the fact that there is empirical evidence (see, for example, Taylor 2008) that

government actions and interventions caused, prolonged, and worsened the latest financial crisis, it is

obvious that “the lack of coordination can be costly” (Gai, Hayes, & Shin, 2001, p. 7). Gai, Hayes &Shin (2001, p. 7) continue that “[…] in the event of a sovereign default, disorder in the workout processcan lead to the premature scrapping of longer-term investment projects and a protracted exclusion

from international capital markets”. Much of the policy debate has therefore focuse d on reducing the

costs of crisis. Keeping banks open and operating is therefore an essential to maintaining our way oflife. Because a functioning financial system benefits everyone, authorities are deeply involved in the

way banks and other financial intermediaries function. Referring to Cecchetti (2008), it is therefore

hard to exaggerate the importance of this government oversight in ensuring financial stability. “Banks’fragility arises from the fact that they provide liquidity to depositors .” (Cecchetti, 2008, p. 331) As we

19 Goodhart uses the phrase as an intentional misquote from a famous polemic of John Knox (1558) against Mary, Queen ofScots named “The First Blast of the Trumpet Against the Monstrous Regiment of Women”. The book was written against thefemale sovereigns of his day, particularly Mary of Guise, Dowager Queen of Scotland and regent to her daughter Mary, Queenof Scots, and Queen Mary I of England. Knox, a staunch Protestant Reformer, opposed the Catholic queens on religiousgrounds, and used them as examples to argue against female rule over men generally (but not about women in all roles orrespects).20 In a bank run equilibrium, the pure demand deposit contract is worse than direct ownership of assets (Diamond & Dybvig,2000).


29/101

20

all know, banks allow their depositors to withdraw their balances on demand. If a bank cannot meet

this promise because of insufficient liquid assets, it will fail.

It is important to mention that banks not only guarantee their depositors immediate cash on

demand, but they promise to satisfy depositors’ withdrawal requests on a first-come, first served basis- this has some important implications. We shall consider the following scenario: depositors who read

in the newspaper that their bank defaulted on one of its loans will lose conf idence in the bank’s abilityto make its payments . Hence, they think that the bank’s assets may no longer cover its liabilities.Thinking of the bank’s first -come, first-served policy, depositors may rush to the bank to convert theirbalances to cash before other customers arrive (Cecchetti, 2008).

As a bank run progresses, it turns into a self-fulfilling prophecy : as more and more people

withdraw their deposits, the likelihood of default increases, therefore encourages further withdrawals.

Clearly, this can destabilize a bank to the point where it faces bankruptcy (Diamond, 2007). The Britishbank Northern Rock 21, which needed state intervention to avoid a breakdown in September 2007, may

be named as a recent example (for more details on this see the report by the Treasury Committee

ordered by the House of Commons and published on January 26, 2008).

What matters during a bank run is not whether a bank is solvent, but whether it is liquid:

solvency means that the value of the bank’s assets exceeds the value of it s liabilities (the bank has a

positive net worth); on the contrary, liquidity means that the bank has sufficient reserves and

immediately mar ketable assets to meet depositors’ demand for withdrawals. Rumours, true or not, thata bank is insolvent can lead to a run that renders a bank illiquid (Cecchetti, 2008).

When a bank fails, depositors may lose some or all of their deposits, and also their data – e.g.

information about borrowers’ creditworthiness – may disappear. The primary concern is that a single

bank’s failure might cause a small -scale bank run that could turn into a system wide bank panic. Thisphenomenon of spreading panic on the part of depositors is called contagion 22 (Cecchetti, 2008).

But we have to be aware of the trade-off that comes with a tight regulatory approach and thatis why government officials have to think about an optimal regulation and not about a regulatory

framework where single failures are minimized. But fortunately, there is empirical evidence that helps.Barth, Capiro, & Levine (2001) evaluated the efficacy of specific regulatory and supervisory policies

from an database of 107 countries and assessed two competing theories of government regulation: (1)

the helping-hand approach (governments regulate to correct market failures) and the (2) grabbing-

hand approach (governments regulate to support political constituencies). Their findings were that the

grabbing-hand theory predicts that countries with powerful supervisors, limits on bank activities, highlevels of government ownership of banks, and entry-restrictions will tend to have a higher level ofcorruption without the desired improvement in bank perfromance and/or stability. Their conclusion is

that governments that focus more on the empowerment of private-sector control of bank behaviour aremore likely to promote bank performance and stability than governments which take an interventionist

stance to regulation and supervision. On the contrary, the grabbing-hand view suggests that

21 On November 17, 2011 Virgin Money, Sir Richard Branson’s banking arm, announced to buy Northern Rock for GBP 747mn.The lender will be rebranded as Virgin Money. Speaking for the UK Treasury, George Osborne, chancellor of the exchequer,said (Financial Times, 2011) : “The sale of Northern Rock to Virgin Money is an important first step in getting the British taxpayerout of the business of owning banks. It represents value for money; will increase choice on the high street for customers; andsafeguards jobs in the north- east.” 22 For a detailed explanation of the term contagion , more specific bank contagion , and the interdependencies to systemic risksee, for example, Bandt and Hartmann (2000).


30/101

21

regulatory and supervisory practices that demand detailed disclosures from banks, empower the

private-sector corporate control of banks, and support incentives for private agents to exert corporate

control work best to reach a high level of banking performance and stability. Barth, Capiro, & Levine`s

(2001) research results are questioning strategies that place excessive reliance on direct, governmentoversight of and restrictions on banks; therefore, authorities should be aware of the tradeoff from a too

strict regulatory approach. Officials should be aware of such findings. Next up: the notorious Marketfor Lemons .

3.1.2 A MARKET FOR LEMONS

Information asymmetries are the reason that a run on a single bank can turn into a bank panic thatthreatens the entire financial system. Now we have to consider Akerlof’s famous market for lemonsproblem: if there is no way to differ a good used car from a bad one, there will only be lemons on the

market. And, regarding to Cecchetti (2008), what is true for cars is even truer for banks. Most of us 23 are clearly not in a position to assess the quality of a bank’s balance sheet (not to mention the off-

balance sheet activities). Hence, depositors are in the same position as uninformed buyers in the used

car market: t hey can’t tell the difference between a good bank and a bad bank. So when rumoursspread that a certain bank is in trouble, d epositors everywhere begin to worry about their own banks’financial condition. Concern about even one bank can create a panic that causes profitable banks

throughout the region to fail, leading to a complete collapse of the banking system (Cecchetti, 2008).

As we have shown, banking panics and financial crises can easily result from false rumours,

they can naturally also occur for more concrete reasons. Sinc e a bank’s assets are a combination ofloans and securities (plus physical assets and reserves), anything that affects entitled loan

repayments or reduces the market value of securities on a bank’s banking or trading book has thepotential to imperil the bank’s finances. Recessions, or at least a weak economy, have a negative

impact on a bank’s balance sheet. When business activity slows, all economic units have a harder

time paying their debts. As a result, default rates rise 24, bank assets lose value, and bank capital

suffers a slump. With less available capital, banks are forced to contract their balance sheets, handing

out fewer loans. This decline in loans, is followed by less business investment – the downturn

intensifies. If the economic situation gets really bad, banking institutions begin to fail (Cecchetti, 2008).Financial disruptions can also occur during a deflationary economic environment 25, where the

borrowers’ net worth falls. Companies borrow a fixed number of currency units to invest in real assets,

whose values fall with deflation. So a drop in price s reduces companies’ net worth – but not their loanpayments . This decline in firms’ net worth aggravates the adverse selection and moral hazardproblems caused by information asymmetries, and therefore making loans more difficult to obtain. If

the firms cannot get new financing, business investment will fall like during a recession, reducing

23 Even for professional financial analysts it is nearly impossible to evaluate the financial strength of banks (Mayo, 2011).24 This issue can be monitored over a bank’s financial statement, where it is referred to as nonperforming loans (NPLs), whichare defined as follows (IMF, 2005, p. 4): “A loan is nonperforming when payments of interest and/or principal are past due by 90days or more, or interest payments equal to 90 days or more have been capitalized, refinanced, or delayed by agreement, orpayments are less than 90 days overdue, but there are other good reasons —such as a debtor filing for bankruptcy —to doubtthat payments will be made in full. After a loan is classified as nonperforming, it (and, possibly, replacement loan(s)) shouldremain classified as such until written off or payments of interest and/or principal are received. “ Institutions holdingnonperforming loans in their portfolios may choose to sell them in order to get rid of risky assets and clean up their balancesheets. Sales of nonperforming loans must be carefully considered by the management since they can have numerous financialimplications, including affecting the company's profit and loss, and its tax situations.25 For an analysis of the disruptive effect of deflation on the financial system see, for example, Bernanke and James (1991).


31/101

22

overall economic activity and raising the number of defaults on loans. As more and more borrowers

default, banks’ balance sheets deteriorate, compounding information p roblems and intensifying the

economic stress (Cecchetti, 2008).

At the end of this section, and for a better illustration of the above stated threats for thefinancial industry, we will state the economic effects, which caused the financial crisis from 2007-09.

Following Brunnermeier’s (2009) arguments, four economic mechanisms amplified the latest U.S.mortgage crisis into a severe financial crisis:

The borrowers’ balance sheet: banks equity capital erodes through falling assetprices, forcing the institutions to sell positions at fire sale prices;

The lending channel: problems within the lending sector lead to less lending; this may

also be true if the creditworthiness of borrowers does not change. An uncertain

outlook on a bank’s future funding needs is enough to limit lending activity. Banks end

up hoarding funds, and as a consequence the lending market grinds to a halt;

Bank runs: runs can cause, as we already discussed above, a sudden erosion of bank

capital;

Counterparty risk: through the high grade of interconnectedness (financial institutionshave to be lenders and borrowers at the same time as Brunnermeier points out), an

increase in counterparty risk can cause network gridlock. In such a gridlock situation,

each individual institution is unwilling to sign netting agreements: each institution has

to shore up funds to insure against each other’s counterparty credit risk . Obviously,

the result is even more pressure on the funding side.

Having heard of all the bad things which can happen within the financial sector and therefore why it is

justified to regulate banks, we will now discuss the government safety net, which should enhance the

stability of the financial sector.

3.2 THE G OVERNMENT S AFETY NET

There are three reasons for the government to get involved in the financial system (Cecchetti, 2008):

To protect investors;

To protect bank customers from monopolistic exploitation; and

To safeguard the stability of the financial system.

First, the government is obligated to protect small investors. While market forces are supposed to

discipline the industry, in practice only the force of law can ensure a bank’s integrity (we already

mentioned above Greenspan’s misjudgement of the invisible hand ). Small investors rely on the

government to protect them from mismanagement and malfeasance. Second, the growing tendency


32/101

23

for small firms to merge into larger corporations reduces competition 26 , which could lead to

monopolies. Because monopolies are inefficient, the government intervenes – or should intervene – to

prevent such firms from becoming too large and to ensure that even large banks still face competition.

Also relevant in this context is the TBTF problem where the government faces five problems (Möschel,

2011):

Stability of the financial system: the stability of the financial system and the potential threatfrom the banking institutions to the real economy is an important focus of the government. The

mid-size investment bank Lehman Brothers elevated the financial crisis

banks, regulation, and the case of contingent capital_by richter_17 apr 12

Documents