Aspects of Financial Aspects of Financial RegulationRegulation

MSc Financial EconomicsMSc Financial Economics

Anne SibertAnne Sibert

Spring 2014Spring 2014

International Aspects of Financial Regulation

Purpose of financial regulationPurpose of financial regulation

To protect consumersTo protect consumers To ensure competitionTo ensure competition To lessen the likelihood of instabilityTo lessen the likelihood of instability

I will mainly focus on the last of I will mainly focus on the last of thesethese

Three aspects of retaining and Three aspects of retaining and restoring stability:restoring stability:

Lowering the likelihood of crisesLowering the likelihood of crises• Lowering the likelihood of a liquidity Lowering the likelihood of a liquidity

crisiscrisis• Lowering the likelihood of a solvency Lowering the likelihood of a solvency

crisiscrisis Warning of crisesWarning of crises Managing a crisisManaging a crisis I will consider these three things in I will consider these three things in

turnturn

Lowering the likelihood Lowering the likelihood of a liquidity crisisof a liquidity crisis

Old-style depositor runsOld-style depositor runs New-style wholesale creditor runsNew-style wholesale creditor runs Speculative attacks on fixed Speculative attacks on fixed

exchange ratesexchange rates Adverse selection shutting down Adverse selection shutting down

marketsmarkets I will consider the first two of theseI will consider the first two of these

Averting old-style bank runsAverting old-style bank runs It is difficult for small retail investors to monitor It is difficult for small retail investors to monitor

the health of a bank.the health of a bank. The government wants to protect these The government wants to protect these

consumers while still creating an incentive for the consumers while still creating an incentive for the private sector to monitor banks.private sector to monitor banks.

Provide deposit insurance with a ceiling and, Provide deposit insurance with a ceiling and, perhaps, exclude wholesale investors.perhaps, exclude wholesale investors.

Public or private funds can insure deposits in the Public or private funds can insure deposits in the event of a failure of a medium-size bank.event of a failure of a medium-size bank.

How does this work in practice?How does this work in practice?

In the United StatesIn the United States

In EuropeIn Europe

In the United StatesIn the United States The Federal Deposit Insurance Corporation The Federal Deposit Insurance Corporation

(FDIC) insures deposits in banks and thrift (FDIC) insures deposits in banks and thrift institutions for at least $250,000. Standard institutions for at least $250,000. Standard insurance will return to $100,000 in 2014.insurance will return to $100,000 in 2014.

It is funded by premiums that banks and It is funded by premiums that banks and thrift institutions pay for deposit insurance thrift institutions pay for deposit insurance coverage and from earnings on coverage and from earnings on investments in U.S. Treasury securities. investments in U.S. Treasury securities.

The FDIC is also a bank supervisor.The FDIC is also a bank supervisor. Backed by the Federal Reserve.Backed by the Federal Reserve.

In Europe:In Europe: The EU faces the problem of who is to insure the depositors The EU faces the problem of who is to insure the depositors

of a member country’s multinational bank branches that of a member country’s multinational bank branches that are located in other member countries. are located in other member countries.

The provision of deposit insurance in the EU (and also in the The provision of deposit insurance in the EU (and also in the EEA countries Norway, Switzerland and Iceland) is governed EEA countries Norway, Switzerland and Iceland) is governed by a directive. by a directive.

Directives are legislative acts that specify a result that Directives are legislative acts that specify a result that Member States must achieve, leaving the form and method Member States must achieve, leaving the form and method up to the Member States. This directive requires that up to the Member States. This directive requires that Member States are to have and monitor a deposit Member States are to have and monitor a deposit guarantee scheme that protects most depositors up to EUR guarantee scheme that protects most depositors up to EUR 100,000. 100,000.

Member States are allowed to choose among different Member States are allowed to choose among different types of schemes and the idea is that these schemes are to types of schemes and the idea is that these schemes are to be funded by charging resident banks.be funded by charging resident banks.

CyprusCyprus On 15 Mar 2013 the ECB ordered the On 15 Mar 2013 the ECB ordered the

President of Cyprus to come up with President of Cyprus to come up with 5.8 billion euros without increasing his 5.8 billion euros without increasing his country’s indebtedness as part of country’s indebtedness as part of Cyprus’s contribution to a ESM rescue Cyprus’s contribution to a ESM rescue package.package.

Without such an agreement borrowing Without such an agreement borrowing from the ECB would be cut off and the from the ECB would be cut off and the Cypriot banking system would Cypriot banking system would collapse.collapse.

CatastropheCatastrophe

As it nice to have a banking system, As it nice to have a banking system, Cyprus would likely have been forced to Cyprus would likely have been forced to leave the Euro Area (and probably the EU).leave the Euro Area (and probably the EU).

It would issue its own currency and use it It would issue its own currency and use it to recapitalize its banking system.to recapitalize its banking system.

Consequently the value of the new Consequently the value of the new currency would plummet, as would the currency would plummet, as would the value of residents’ bank accounts, value of residents’ bank accounts, pensions and wages.pensions and wages.

The president looked to the only The president looked to the only source of available cashsource of available cash

The president proposed a levy on all The president proposed a levy on all bank accounts.bank accounts.

Although it was not accepted, the Although it was not accepted, the proposal had the approval of EU proposal had the approval of EU policy makers at the time.policy makers at the time.

EFTA Court RulingEFTA Court Ruling

The EFTA court ruled that Iceland The EFTA court ruled that Iceland was not legally required to was not legally required to compensate UK and Dutch depositors compensate UK and Dutch depositors who had placed their money in who had placed their money in Icesave accounts.Icesave accounts.

EFTA court rulingEFTA court ruling The intent of the directive was to eliminate restrictions on The intent of the directive was to eliminate restrictions on

the establishment and provision of financial services within the establishment and provision of financial services within the EEA while supporting the stability of the area’s banking the EEA while supporting the stability of the area’s banking system and providing insurance for its savers. system and providing insurance for its savers.

The directive was intended to prevent EEA Member States The directive was intended to prevent EEA Member States from impeding the activities of credit institutions licensed in from impeding the activities of credit institutions licensed in other Member States by invoking depositor protection.other Member States by invoking depositor protection.

The directive was not intended to protect depositors in all The directive was not intended to protect depositors in all instances. instances.

Forcing the banking system to provide the funding Forcing the banking system to provide the funding necessary to cover depositors in a systemic crisis would necessary to cover depositors in a systemic crisis would undermine the objective of promoting the stability of the undermine the objective of promoting the stability of the banking system.banking system.

EFTA court rulingEFTA court ruling

If the state were required to provide the funding If the state were required to provide the funding that the banking system this this would have a that the banking system this this would have a negative effect on competition.negative effect on competition.

It also interpreted the wording of the directive to It also interpreted the wording of the directive to suggest that it was meant only to cover the suggest that it was meant only to cover the failure of individual banks and not the failure of a failure of individual banks and not the failure of a large part of the banking system that would occur large part of the banking system that would occur in a systemic crisis.in a systemic crisis.

Finally, the Court ruled that it was permissible for Finally, the Court ruled that it was permissible for Iceland to treat depositors at home differently Iceland to treat depositors at home differently than depositors in foreign branches.than depositors in foreign branches.

Are deposits safe?Are deposits safe?

German Finance Minister Wolfgang German Finance Minister Wolfgang Schäuble recently stated that, Schäuble recently stated that, ‘[deposits] are safe, though only on ‘[deposits] are safe, though only on the proviso the states are solvent.’the proviso the states are solvent.’

The Cypriot bank deposits had the The Cypriot bank deposits had the highly enticing feature (from the highly enticing feature (from the Cypriot point of view) that non-EU Cypriot point of view) that non-EU residents owned a large fraction of residents owned a large fraction of them, perhaps a third or even a half. them, perhaps a third or even a half.

Are deposits safe?Are deposits safe? Moody's estimated that there were about USD 31 Moody's estimated that there were about USD 31

billion of Russian money in Cypriot bank accounts.billion of Russian money in Cypriot bank accounts. Moreover, there was a widespread suspicion that Moreover, there was a widespread suspicion that

the Russian investment in Cyprus was driven by the Russian investment in Cyprus was driven by corruption-linked money laundering.corruption-linked money laundering.

The initial proposal to tax small as well as large The initial proposal to tax small as well as large deposits may have been in part a result of a belief deposits may have been in part a result of a belief that much of the Russian money in Cyprus had that much of the Russian money in Cyprus had been broken up and put into small, insured been broken up and put into small, insured deposits. Thus, the only way to access it was to deposits. Thus, the only way to access it was to tax both small and large accounts. tax both small and large accounts.

However, ultimately even Cyprus in its dire However, ultimately even Cyprus in its dire circumstances spared its insured depositors.circumstances spared its insured depositors.

Are deposits safe?Are deposits safe? In practice, small deposit holders around the world have In practice, small deposit holders around the world have

been well protected.been well protected. In the United States, the Federal Deposit Insurance In the United States, the Federal Deposit Insurance

Corporation (FDIC) was established in 1933 and no one has Corporation (FDIC) was established in 1933 and no one has ever lost a cent in an FDIC-insured deposit since then.ever lost a cent in an FDIC-insured deposit since then.

Not a single small deposit holder in an advanced economy Not a single small deposit holder in an advanced economy has lost their money since the financial crisis arose. has lost their money since the financial crisis arose.

Perhaps the most recent example of a sovereign of what is Perhaps the most recent example of a sovereign of what is now a euro area state not fully protecting its deposit now a euro area state not fully protecting its deposit holders is the Italian government’s levying a paltry 0.6 holders is the Italian government’s levying a paltry 0.6 percent tax on bank accounts as part of its attempt to stave percent tax on bank accounts as part of its attempt to stave off the collapse of the lira in July 1992. off the collapse of the lira in July 1992.

Does depositor insurance Does depositor insurance promote financial stabilitypromote financial stability

In the canonical story of depositor runs each In the canonical story of depositor runs each depositor believes that all other depositors will depositor believes that all other depositors will run and, thus, the bank will fail. Thus it is optimal run and, thus, the bank will fail. Thus it is optimal for each depositor to run and a bank that would for each depositor to run and a bank that would otherwise be solvent can fail solely as a result of otherwise be solvent can fail solely as a result of self-fulfilling expectations. self-fulfilling expectations.

This financial fragility argument has been used to This financial fragility argument has been used to justify deposit insurance. If it is known that justify deposit insurance. If it is known that deposits are safe and that consumers will always deposits are safe and that consumers will always have access to their money, then no depositor have access to their money, then no depositor has an incentive to run. has an incentive to run.

Deposit insurance and Deposit insurance and moral hazardmoral hazard

The problem with using deposit insurance to The problem with using deposit insurance to avert bank runs, however, is that depositavert bank runs, however, is that deposit

insurance also promotes moral hazard. insurance also promotes moral hazard. If depositors have no incentive to monitor the If depositors have no incentive to monitor the

activities of banks, then banks will engage in activities of banks, then banks will engage in riskier behavior. riskier behavior.

As an empirical matter, it is not clear whether As an empirical matter, it is not clear whether deposit insurance promotes financial stability. deposit insurance promotes financial stability. There are fewer runs but the quality of bank There are fewer runs but the quality of bank assets is likely to deteriorate. assets is likely to deteriorate.

An empirical studyAn empirical study Demergüç-Kunt and Detragiache (2002) use data from a Demergüç-Kunt and Detragiache (2002) use data from a

large panel of countries from 1980 – 1997 and find large panel of countries from 1980 – 1997 and find evidence that offering explicit deposit insurance is evidence that offering explicit deposit insurance is detrimental to bank stability. detrimental to bank stability.

Deposit insurance is not necessary to prevent bank runs. Deposit insurance is not necessary to prevent bank runs. For countries in the euro area, the Eurosystem can act as For countries in the euro area, the Eurosystem can act as lender of last resort in the event of a depositor run. lender of last resort in the event of a depositor run.

In other countries as long as banks’ deposits are not In other countries as long as banks’ deposits are not allowed to become too large, the central bank can act as allowed to become too large, the central bank can act as the lender of last resort. the lender of last resort.

If it is fully credible that the central bank will always loan to If it is fully credible that the central bank will always loan to illiquid, but fundamentally solvent, banks then depositor illiquid, but fundamentally solvent, banks then depositor runs based solely on self-fulfilling expectations should not runs based solely on self-fulfilling expectations should not occur.occur.

Should large depositors be Should large depositors be protected?protected?

A Widows and Orphans argument for A Widows and Orphans argument for large depositors? A lesson from large depositors? A lesson from Cyprus: large depositors can be Cyprus: large depositors can be firms, households and institutional firms, households and institutional investors. Or, they can be criminals.investors. Or, they can be criminals.

The differential treatment of insured The differential treatment of insured and uninsured deposits is less and uninsured deposits is less relevant in the United States than in relevant in the United States than in Europe.Europe.

Who should foot the bill?Who should foot the bill? Banks should pay insurance premiums and the amount could depend upon Banks should pay insurance premiums and the amount could depend upon

readily measurable features that indicate its riskiness or how likely it is to readily measurable features that indicate its riskiness or how likely it is to contribute to systemic risk. The EU has favored this ex ante approach. contribute to systemic risk. The EU has favored this ex ante approach.

The US has favored a bank tax. If Bank A fails the shareholders and some or The US has favored a bank tax. If Bank A fails the shareholders and some or most of the uninsured creditors should lose their money before the taxpayers most of the uninsured creditors should lose their money before the taxpayers step in. But why should Bank B should be assessed before the taxpayers? step in. But why should Bank B should be assessed before the taxpayers? • For a country with a small number of banks is that it gives each banks an For a country with a small number of banks is that it gives each banks an

incentive to monitor each other.incentive to monitor each other.• If Bank A failed for systemic reasons or if Bank A’s failure causes systemic If Bank A failed for systemic reasons or if Bank A’s failure causes systemic

problems then Bank B has to come up with additional liquidity at a time it problems then Bank B has to come up with additional liquidity at a time it might be pinched itself. might be pinched itself.

   The current crisis was, to a great extent, the result of governments’ policy The current crisis was, to a great extent, the result of governments’ policy

blunders, the failure of policy makers to design institutions properly and failures blunders, the failure of policy makers to design institutions properly and failures of supervisors and regulators to adequately oversee their charges. In the of supervisors and regulators to adequately oversee their charges. In the democratic North Atlantic nations that experienced the financial crisis, the democratic North Atlantic nations that experienced the financial crisis, the electorate bears much of the blame. For it to share the burden is only fair and electorate bears much of the blame. For it to share the burden is only fair and encourages it to ensure that the same errors are not repeated.encourages it to ensure that the same errors are not repeated.

Rules vs. discretionRules vs. discretion A legal system that does not spell out how much of a haircut each A legal system that does not spell out how much of a haircut each

type of unsecured debtor is supposed to take benefits only type of unsecured debtor is supposed to take benefits only lawyers. lawyers.

Banks could issue securities such as contingent convertible bonds Banks could issue securities such as contingent convertible bonds (“Cocos”) that are clearly (“Cocos”) that are clearly not not protected. These are bonds which protected. These are bonds which are automatically converted into equity at a pre-specified price are automatically converted into equity at a pre-specified price when some trigger point is reached. when some trigger point is reached.

The Basel Committee wants the regulators to decide when the The Basel Committee wants the regulators to decide when the trigger point is reached. The benefit is flexibility but it eliminates trigger point is reached. The benefit is flexibility but it eliminates one of the main advantages of Cocos: the rules of the game are one of the main advantages of Cocos: the rules of the game are clear to all in advance. clear to all in advance.

An alternative is for the conversion to be triggered by some An alternative is for the conversion to be triggered by some readily observable and verifiable event. Credit Suisse, Rabobank readily observable and verifiable event. Credit Suisse, Rabobank and Lloyds have all issued Cocos that are triggered if their Tier-1 and Lloyds have all issued Cocos that are triggered if their Tier-1 capital falls below some specified levelcapital falls below some specified level..

The future of deposit insurance in the EUThe future of deposit insurance in the EU

There is going to be a single supervisory There is going to be a single supervisory mechanism for the Euro area.mechanism for the Euro area.

Once there is a single resolution regime, the EU Once there is a single resolution regime, the EU can begin work on a single, harmonized deposit can begin work on a single, harmonized deposit insurance scheme.insurance scheme.

Averting new-style bank runsAverting new-style bank runs

The central bank can act as lender of last The central bank can act as lender of last resort, providing domestic currency loans.resort, providing domestic currency loans.

There is a problem of determining whether There is a problem of determining whether the financial institution is insolvent or the financial institution is insolvent or merely illiquid.merely illiquid.

Countries that do not have an important Countries that do not have an important international reserve currency should not international reserve currency should not let their financial sectors become too let their financial sectors become too large.large.

Famous Example:Famous Example:The Bank of New YorkThe Bank of New York

In 1985 the Bank of New York played a key In 1985 the Bank of New York played a key role in the market for US government role in the market for US government securities. It acted as a clearing house: securities. It acted as a clearing house: buying bonds and reselling them.buying bonds and reselling them.

On 20 Nov 1985 a software mistake On 20 Nov 1985 a software mistake caused it to lose track of its transactions caused it to lose track of its transactions and at the end of the day it owed $23 and at the end of the day it owed $23 billion that it did not have.billion that it did not have.

The Federal Reserve Bank of NY stepped in The Federal Reserve Bank of NY stepped in and made a loan.and made a loan.

An international An international lender of last resort?lender of last resort?

An international lender of last resort may seem like an An international lender of last resort may seem like an appealing reform measure, but it has never proved feasible appealing reform measure, but it has never proved feasible in practice. in practice.

One reason is that distinguishing solvent but liquid One reason is that distinguishing solvent but liquid borrowers from insolvent borrowers is difficult, particularly borrowers from insolvent borrowers is difficult, particularly if the lender of last resort is not also (or does not also have if the lender of last resort is not also (or does not also have a close relationship with) the supervisor and regulator of a a close relationship with) the supervisor and regulator of a financial institution in need of a loan. financial institution in need of a loan.

If a loan is made to a financial institution that turns out to If a loan is made to a financial institution that turns out to be insolvent and cannot repay, then the tax payers of the be insolvent and cannot repay, then the tax payers of the countries who fund the international lender of last resort countries who fund the international lender of last resort must pay. must pay.

To fund an international lender of last resort requires deep To fund an international lender of last resort requires deep pockets and a willingness to transfer money from tax pockets and a willingness to transfer money from tax payers in one country to the creditors of a defaulting payers in one country to the creditors of a defaulting financial institution in another country when an financial institution in another country when an ex postex post incorrect decision is made.incorrect decision is made.

The IMF asThe IMF aslender of last resort?lender of last resort?

The IMF has not been especially successful at The IMF has not been especially successful at playing the role of lender of last resort. playing the role of lender of last resort.

Traditional IMF loans -- with conditionality and funds Traditional IMF loans -- with conditionality and funds disbursed in tranches -- are not suited to a liquidity disbursed in tranches -- are not suited to a liquidity crisis. crisis.

Recently, however, the IMF has expanded its limited Recently, however, the IMF has expanded its limited role as international lender of last resort (to role as international lender of last resort (to countries, rather than to specific financial countries, rather than to specific financial institutions) by introducing a flexible credit line institutions) by introducing a flexible credit line (FCL).(FCL).

Access to the Access to the Flexible Credit LineFlexible Credit Line (FCL) is limited (FCL) is limited to countries with very strong fundamentals, to countries with very strong fundamentals, policies, and track records of policy implementation. policies, and track records of policy implementation. Disbursements under the FCL are not phased or Disbursements under the FCL are not phased or conditioned to policy understandings.conditioned to policy understandings.

Preventing Solvency CrisesPreventing Solvency Crises

Restructure supervision and Restructure supervision and regulationregulation

Prevent financial firms from Prevent financial firms from becoming too big to failbecoming too big to fail

Prevent financial firms from Prevent financial firms from becoming too leveragedbecoming too leveraged

Limit the activities of financial firmsLimit the activities of financial firms Prevent bankers from having an Prevent bankers from having an

incentive to take on too much riskincentive to take on too much risk

Restructuring Restructuring supervision and regulationsupervision and regulation

Many countries – such as the United States – have Many countries – such as the United States – have an an institutionalinstitutional system of regulation. That is, system of regulation. That is, supervision is organised according to types of supervision is organised according to types of financial institutions. financial institutions.

In a world where the difference between types of In a world where the difference between types of financial institutions is diminishing this makes financial institutions is diminishing this makes little sense and it has allowed some financial little sense and it has allowed some financial institutions to be lightly regulated, or in the case institutions to be lightly regulated, or in the case of hedge funds, to be not regulated at all. of hedge funds, to be not regulated at all.

The solution to this is to have a regulatory system The solution to this is to have a regulatory system that is based instead upon that is based instead upon objectivesobjectives, such as , such as financial stability, consumer protection and financial stability, consumer protection and adequate competition.adequate competition.

Horrible example of what can go Horrible example of what can go wrong with an institutional systemwrong with an institutional system

Perhaps even more than the 14 September 2008 collapse Perhaps even more than the 14 September 2008 collapse of Lehman Brothers, it was the failure of American of Lehman Brothers, it was the failure of American International Group (AIG) two days later that marked the International Group (AIG) two days later that marked the beginning of the global financial crisis. beginning of the global financial crisis.

AIG (the subject of the largest government bailout of a AIG (the subject of the largest government bailout of a private company in US history) is a global insurance private company in US history) is a global insurance company with a balance sheet of more than a trillion dollars company with a balance sheet of more than a trillion dollars – the 18th largest publicly owned company in the world in – the 18th largest publicly owned company in the world in 2008. 2008.

Regulated by the New York State Regulator of Insurance, it Regulated by the New York State Regulator of Insurance, it developed a rogue investment banking unit that sold credit developed a rogue investment banking unit that sold credit default swaps out of sight of the Fed, the FDIC or the SEC. default swaps out of sight of the Fed, the FDIC or the SEC.

As Fed Chairman Bernanke, commented, “A.I.G. exploited a As Fed Chairman Bernanke, commented, “A.I.G. exploited a huge gap in the regulatory system. There was no oversight huge gap in the regulatory system. There was no oversight of the financial products division. This was a hedge fund, of the financial products division. This was a hedge fund, basically, that was attached to a large and stable insurance basically, that was attached to a large and stable insurance company.”company.”

Preventing financial firms from Preventing financial firms from becoming too bigbecoming too big

Some financial firms are too big to Some financial firms are too big to fail.fail.

This causes them to take on too This causes them to take on too much risk.much risk.

They receive better interest rates They receive better interest rates and put smaller banks at a and put smaller banks at a competitive disadvantage.competitive disadvantage.

Rajan, Raghuram, “A better way to reduce financial sector Rajan, Raghuram, “A better way to reduce financial sector risk,” Financial Times, 25 Jan 2010.risk,” Financial Times, 25 Jan 2010.

Are size limits a good idea?Are size limits a good idea? How should size be defined? Whether you use assets, How should size be defined? Whether you use assets,

capital or profits there will be problems – banks will try to capital or profits there will be problems – banks will try to economise on whatever measure is limited.economise on whatever measure is limited.

Limits on asset size: Banks would attempt to hide financial Limits on asset size: Banks would attempt to hide financial activities from regulators off balance sheet. activities from regulators off balance sheet.

Limit capital: Banks will economise on it as much as Limit capital: Banks will economise on it as much as possible, increasing risk.possible, increasing risk.

Limit profits: Reward sickly banks by allowing them to Limit profits: Reward sickly banks by allowing them to expand indefinitely. expand indefinitely.

Being large is neither necessary or sufficient for an entity to Being large is neither necessary or sufficient for an entity to be a systemic risk. be a systemic risk.

Instead of imposing a blanket ban on institutions growing Instead of imposing a blanket ban on institutions growing beyond a certain size, regulators should use more subtle beyond a certain size, regulators should use more subtle mechanisms such as prohibiting mergers of large banks or mechanisms such as prohibiting mergers of large banks or encouraging the break-up of large banks that seem to have encouraging the break-up of large banks that seem to have a propensity for getting into trouble. a propensity for getting into trouble.

But there are always concerns about whether regulators But there are always concerns about whether regulators will use these sorts of powers arbitrarily. will use these sorts of powers arbitrarily.

Capital Requirements: preventing firms Capital Requirements: preventing firms from becoming too leveragedfrom becoming too leveraged

The Basel II accord sets out international standards for The Basel II accord sets out international standards for banking regulators seeking to reduce excessive risk taking banking regulators seeking to reduce excessive risk taking by banks by imposing the amount of capital that banks are by banks by imposing the amount of capital that banks are required to hold. required to hold.

It is widely believed that these capital requirements are It is widely believed that these capital requirements are pro-cyclical. During an economic downturn, banks’ pro-cyclical. During an economic downturn, banks’ estimates of the likely losses on their loans rise and, under estimates of the likely losses on their loans rise and, under the Basel II rules this increases their required capital. As a the Basel II rules this increases their required capital. As a result, their ability to make further loans is impaired and result, their ability to make further loans is impaired and this worsens the downturn further. this worsens the downturn further.

It is argued that the Basel II accord places an insufficient It is argued that the Basel II accord places an insufficient emphasis on liquidity management and too much reliance emphasis on liquidity management and too much reliance on internal risk management models and on ratings on internal risk management models and on ratings agencies. agencies.

Satisfactory solutions to the inadequacies of Basel II are not Satisfactory solutions to the inadequacies of Basel II are not obvious, but resources should be devoted to developing obvious, but resources should be devoted to developing them.them.

Regulate the scope: Regulate the scope: United StatesUnited States

The Glass-Steagall Act prohibited banks from owning shares The Glass-Steagall Act prohibited banks from owning shares of stock in corporations.of stock in corporations.

The main objection was the stock is too risky.The main objection was the stock is too risky. In 1987, J.P. Morgan found a loophole: banks may not be In 1987, J.P. Morgan found a loophole: banks may not be

affiliated with any firm engaged affiliated with any firm engaged principallyprincipally in underwriting in underwriting and dealing in firm securities. So, J.P. Morgan, Bankers and dealing in firm securities. So, J.P. Morgan, Bankers Trust and Citicorp set up affiliates that engaged in Trust and Citicorp set up affiliates that engaged in underwriting and dealing with firm securities in a underwriting and dealing with firm securities in a limitedlimited fashion.fashion.

In 1999 the Gramm-Leach-Bliley Financial Services In 1999 the Gramm-Leach-Bliley Financial Services Modernisation Act eliminated the contraints.Modernisation Act eliminated the contraints.

In the United Kingdom and many other countries In the United Kingdom and many other countries universal universal bankingbanking has been the norm. has been the norm.

Regulating Off-Balance-Sheet Regulating Off-Balance-Sheet Banking: securitisationBanking: securitisation

Securitisation involves pooling loans with similar risk Securitisation involves pooling loans with similar risk characteristics and selling the loan pool as a tradable financial characteristics and selling the loan pool as a tradable financial instrument.instrument.

While allowing the diversification of idiosyncratic risk, While allowing the diversification of idiosyncratic risk, securitisation perverts the incentives of commercial banks. securitisation perverts the incentives of commercial banks. Commercial banks exist as intermediaries between borrowers and Commercial banks exist as intermediaries between borrowers and lenders because they can mitigate asymmetric information lenders because they can mitigate asymmetric information problems in credit markets by collecting information about problems in credit markets by collecting information about potential borrowers (thus reducing adverse selection problems) potential borrowers (thus reducing adverse selection problems) and by monitoring their behaviour (thus reducing moral hazard and by monitoring their behaviour (thus reducing moral hazard problems). problems).

A commercial bank that intends to securitise its loan portfolio has A commercial bank that intends to securitise its loan portfolio has little incentive to either gather information about potential little incentive to either gather information about potential borrowers or to oversee the behaviour of borrowers once the loan borrowers or to oversee the behaviour of borrowers once the loan is made. is made.

Regulatory reform need not eliminate securitisation, but it must Regulatory reform need not eliminate securitisation, but it must restore the proper central bank incentives. One way that this restore the proper central bank incentives. One way that this could be done is to insist that a commercial bank or other financial could be done is to insist that a commercial bank or other financial institution that securitises its loans retain some fraction of the institution that securitises its loans retain some fraction of the subordinate, or riskiest, tranche.subordinate, or riskiest, tranche.

Changing Bankers’ IncentivesChanging Bankers’ Incentives Huge upside potential to taking on Huge upside potential to taking on

risk; little downside risk.risk; little downside risk. Many executives at financial firms Many executives at financial firms

that had to be bailed out lost large that had to be bailed out lost large amounts of money, but they remain amounts of money, but they remain very wealthy. very wealthy.

Sir Win Bischoff presided over the Sir Win Bischoff presided over the failure of Citigroup. Alistair Darling failure of Citigroup. Alistair Darling supported his appointment as supported his appointment as chairman of Lloyds.chairman of Lloyds.

What can be done?What can be done? Charles Krauthammer: “I would be for an Charles Krauthammer: “I would be for an

exemplary hanging or two.”exemplary hanging or two.” Keith Olbermann: "Certainly, we can screw these Keith Olbermann: "Certainly, we can screw these

guys out of these bonuses the way they screwed guys out of these bonuses the way they screwed us.”us.”

Thomas Sowell: “If members of Congress can't be Thomas Sowell: “If members of Congress can't be bothered to read the laws they pass, then they bothered to read the laws they pass, then they have no basis for whipping up lynch mob outrage have no basis for whipping up lynch mob outrage against people who did read the law and acted against people who did read the law and acted within the law.”within the law.”

Larry Summers: "The easy thing would be to just Larry Summers: "The easy thing would be to just say, you know, ‘Off with their heads,’ and violate say, you know, ‘Off with their heads,’ and violate the contracts. the contracts.

What can be done?What can be done? Much of salary could be paid in stock that has to Much of salary could be paid in stock that has to

be held for a significant period of time. This has be held for a significant period of time. This has the drawback that it makes wage income and the drawback that it makes wage income and non-wage income highly correlated.non-wage income highly correlated.

““We must stop sending the message to our We must stop sending the message to our bankers that they can win on the rise and also bankers that they can win on the rise and also survive the downside. This requires legislation survive the downside. This requires legislation that recoups past earnings and bonuses from that recoups past earnings and bonuses from employees of banks that require bailouts.” Boone employees of banks that require bailouts.” Boone and Johnsonand Johnson

Supertaxes on bonusesSupertaxes on bonuses Are these good ideas? Are these good ideas?

Bill of attainderBill of attainder A A bill of attainderbill of attainder is a legislative act that punishes a is a legislative act that punishes a

person or group for a crime without a trial.person or group for a crime without a trial. The Irish rebel, Lord Edward Fitzgerald, had had his The Irish rebel, Lord Edward Fitzgerald, had had his

property confiscated in 1798 by a bill of attainder. Denied property confiscated in 1798 by a bill of attainder. Denied medical treatment, he had died before a trial. medical treatment, he had died before a trial.

In 1779 the New York legislature confiscated the property In 1779 the New York legislature confiscated the property of suspected loyalist Parker Wickham and banished him of suspected loyalist Parker Wickham and banished him under threat of death. He claimed to be innocent, but was under threat of death. He claimed to be innocent, but was denied a trial.denied a trial.

The UK had stopped passing bill of attainders after 1798 The UK had stopped passing bill of attainders after 1798 and they are banned by the US constitution.and they are banned by the US constitution.

An An ex post facto lawex post facto law retroactively changes the legal retroactively changes the legal consequences of actions committed prior to the enactment consequences of actions committed prior to the enactment of the law. These are unconstitutional in the United States, of the law. These are unconstitutional in the United States, but technically possible in the UK.but technically possible in the UK.

Regulatory CaptureRegulatory Capture

The famous University of Chicago The famous University of Chicago economist and judge Richard Posner economist and judge Richard Posner said, “Regulation is not about the said, “Regulation is not about the public interest at all, but is a process, public interest at all, but is a process, by which interest groups seek to by which interest groups seek to promote their private interest ... Over promote their private interest ... Over time, regulatory agencies come to be time, regulatory agencies come to be dominated by the industries dominated by the industries regulated.” regulated.”

Famous exampleFamous example In the 1880s the US Interstate Commerce Commission (ICC) In the 1880s the US Interstate Commerce Commission (ICC)

was set up to regulate the prices of railroad freight. was set up to regulate the prices of railroad freight. Richard Olney, a lawyer for the railroads was then Richard Olney, a lawyer for the railroads was then

appointed US attorney general. appointed US attorney general. Olney's former boss, a railroad president, asked him if he Olney's former boss, a railroad president, asked him if he

could get rid of the ICC. Olney replied, "The Commission . . . could get rid of the ICC. Olney replied, "The Commission . . . is, or can be made, of great use to the railroads. It satisfies is, or can be made, of great use to the railroads. It satisfies the popular clamor for a government supervision of the the popular clamor for a government supervision of the railroads, at the same time that that supervision is almost railroads, at the same time that that supervision is almost entirely nominal. Further, the older such a commission gets entirely nominal. Further, the older such a commission gets to be, the more inclined it will be found to take the business to be, the more inclined it will be found to take the business and railroad view of things. . . . The part of wisdom is not to and railroad view of things. . . . The part of wisdom is not to destroy the Commission, but to utilize it.“destroy the Commission, but to utilize it.“

Thomas Frank, “Obama and 'Regulatory Capture‘: It's time Thomas Frank, “Obama and 'Regulatory Capture‘: It's time to take the quality of our watchdogs seriously,” to take the quality of our watchdogs seriously,” WSJWSJ, JUNE , JUNE 24, 2009 24, 2009

Warning of a crisisWarning of a crisis Economists have been widely reviled in the popular press for Economists have been widely reviled in the popular press for

failing to predict the current financial crisis. failing to predict the current financial crisis. To some extent, this criticism is unfair. Future economic To some extent, this criticism is unfair. Future economic

outcomes are functions of future fundamental random outcomes are functions of future fundamental random variables. Even if economists could perfectly model the world variables. Even if economists could perfectly model the world and even if they knew all of the potential fundamental random and even if they knew all of the potential fundamental random variables and their distributions, they could at most describe variables and their distributions, they could at most describe the statistical distribution of future economic outcomes. the statistical distribution of future economic outcomes.

However, even if economists could not have predicted the However, even if economists could not have predicted the timing of the current collapse, it might be argued that they timing of the current collapse, it might be argued that they should have realised the extent of the should have realised the extent of the systemic risksystemic risk in the in the financial sector. financial sector.

If economists had properly assessed the systemic risk in the If economists had properly assessed the systemic risk in the global financial system in early 2007, the vulnerability of global financial system in early 2007, the vulnerability of financial institutions would have been recognised, and it would financial institutions would have been recognised, and it would have been understood that if events triggered the collapse of have been understood that if events triggered the collapse of just one or a few important financial firms, then an entire just one or a few important financial firms, then an entire national, or even the international, financial system could be national, or even the international, financial system could be endangered. endangered.

Why didn’t economists Why didn’t economists warn of systemic risk?warn of systemic risk?

Yet, few – if any – economists sounded a widely heard Yet, few – if any – economists sounded a widely heard alarm on this point. In the period prior to the credit crisis of alarm on this point. In the period prior to the credit crisis of August 2007, many economists voiced concerns about the August 2007, many economists voiced concerns about the rise in US house prices and the size of global imbalances. rise in US house prices and the size of global imbalances. Not many, however, argued that systemic risk was Not many, however, argued that systemic risk was excessively high in the financial sector. excessively high in the financial sector.

One reason for this is that systemic risk is not yet well One reason for this is that systemic risk is not yet well understood. Another reason is that, while housing and understood. Another reason is that, while housing and balance of payments data is widely available, few balance of payments data is widely available, few economists knew that financial firms had become so economists knew that financial firms had become so leveraged or comprehended the nature of the real-estate-leveraged or comprehended the nature of the real-estate-backed assets that these firms held. backed assets that these firms held.

Most economists had little incentive to analyse systemic Most economists had little incentive to analyse systemic risk; they were rewarded for doing other things. Identifying risk; they were rewarded for doing other things. Identifying systemic risk in the financial sector will require having the systemic risk in the financial sector will require having the data to measure it and rewarding some body of research data to measure it and rewarding some body of research economists and related professionals for spotting it. economists and related professionals for spotting it.

Definition of systemic riskDefinition of systemic risk G10 definition: “the risk that an event will trigger G10 definition: “the risk that an event will trigger

a loss of economic value or confidence in, and a loss of economic value or confidence in, and attendant increases in uncertainty about, a attendant increases in uncertainty about, a substantial portion of the financial system that is substantial portion of the financial system that is serious enough to quite probably have adverse serious enough to quite probably have adverse effects on the real economy”effects on the real economy”

Or, it is the risk that one or a few financial Or, it is the risk that one or a few financial institutions might fail, at least partially because of institutions might fail, at least partially because of institution-specific factors. Then, because of the institution-specific factors. Then, because of the size of the failed entities or the interlinkages size of the failed entities or the interlinkages between these entities and other financial between these entities and other financial institutions, additional financial firms would begin institutions, additional financial firms would begin collapsing until entire markets or even the whole collapsing until entire markets or even the whole financial system is endangered.financial system is endangered.

Previously economists have tried to Previously economists have tried to predict when and where crises will occurpredict when and where crises will occur

Unfortunately, we haven’t been very good Unfortunately, we haven’t been very good at it.at it.

A recent paper by Rose and Spiegel (2009) A recent paper by Rose and Spiegel (2009) illustrates the difficulties. They try to do illustrates the difficulties. They try to do something simpler. They ask given that something simpler. They ask given that the financial crisis occurred, can they the financial crisis occurred, can they come up with a model that predicts the come up with a model that predicts the incidence across countries.incidence across countries.

Rose, Andrew and Mark M. Spiegel, “Cross-Rose, Andrew and Mark M. Spiegel, “Cross-Country Causes and Consequences of the Country Causes and Consequences of the 2008 Crisis: Early Warning,” unpublished 2008 Crisis: Early Warning,” unpublished paper, Sept. 2009.paper, Sept. 2009.

Extent of the crisisExtent of the crisis

First task: measure the extent of the First task: measure the extent of the crisis in 107 countriescrisis in 107 countries

Use data from 2008 and early 2009.Use data from 2008 and early 2009. The authors use real GDP growth, The authors use real GDP growth,

variance financial market indicators variance financial market indicators such as stock market growth and such as stock market growth and exchange rate appreciation, the exchange rate appreciation, the country ratings from Institutional country ratings from Institutional Investor.Investor.

Predict the incidencePredict the incidence

Explanatory data is from 2006 or Explanatory data is from 2006 or beforebefore

Country size, country income, Country size, country income, measures of financial policies, measures of financial policies, condition of the financial sector, condition of the financial sector, asset price appreciation, asset price appreciation, international imbalances, international imbalances, macroeconomic policies, state of macroeconomic policies, state of economic institutions, geographyeconomic institutions, geography

Results are disappointingResults are disappointing

Only a few variables have even weak Only a few variables have even weak predictive powerpredictive power

Countries with large stock market Countries with large stock market increases relative to GDP, large current increases relative to GDP, large current account deficits relative to GDP, or few account deficits relative to GDP, or few reserves relative to short-run debt were reserves relative to short-run debt were more apt to have crises than other more apt to have crises than other countries.countries.

Real estate price increases were Real estate price increases were statistically insignificant.statistically insignificant.

What went wrong?What went wrong? Maybe the crisis arose in just one or a few countries and Maybe the crisis arose in just one or a few countries and

spread to the rest via contagion.spread to the rest via contagion.

Maybe the crisis was caused by different factors in different Maybe the crisis was caused by different factors in different countries.countries.

Maybe it is not individual variables, but combinations of Maybe it is not individual variables, but combinations of variables, that matter. An example from Lo (2009): higher variables, that matter. An example from Lo (2009): higher real estate prices, falling interest rates and increased real estate prices, falling interest rates and increased availability of financing may not be bad on their own. But, availability of financing may not be bad on their own. But, together they are associated with home owners becoming together they are associated with home owners becoming more leveraged with no way of reducing their exposure more leveraged with no way of reducing their exposure when house prices drop.when house prices drop.

Maybe the crisis depends on things we cannot measure: Maybe the crisis depends on things we cannot measure: say, business ethics.say, business ethics.

Measuring systemic riskMeasuring systemic risk

Maybe measuring systemic risk is an Maybe measuring systemic risk is an easier and better way of providing an easier and better way of providing an early warning system.early warning system.

We can’t predict when a big financial We can’t predict when a big financial firm will fail, but maybe we can firm will fail, but maybe we can predict the likelihood of a domino-predict the likelihood of a domino-like collapse, given the failure of one like collapse, given the failure of one big firm.big firm.

To predict systemic risk in the euro area, To predict systemic risk in the euro area, we need to know the balance sheet for we need to know the balance sheet for

the euro area as a wholethe euro area as a whole Small changes in financial prices can have devastating Small changes in financial prices can have devastating

consequences for highly financial firms. How leveraged is consequences for highly financial firms. How leveraged is the euro area?the euro area?

If a financial firm is in trouble, it may have to sell its illiquid If a financial firm is in trouble, it may have to sell its illiquid financial assets at fire sale prices. So, how liquid is the euro financial assets at fire sale prices. So, how liquid is the euro area?area?

How correlated are the prices of euro-area assets? How How correlated are the prices of euro-area assets? How sensitive are they to changes in conomic conditions?sensitive are they to changes in conomic conditions?

We want market prices on on- and off-balance sheet assets We want market prices on on- and off-balance sheet assets and liabilities of all euro area financial firms, including those and liabilities of all euro area financial firms, including those in the shadow banking sector.in the shadow banking sector.

See Lo, Andrew, “The Feasibility of Systemic Risk See Lo, Andrew, “The Feasibility of Systemic Risk Measurements: Written Testimony for the House Financial Measurements: Written Testimony for the House Financial Services Committee on Systemic Risk Regulation,” Oct. Services Committee on Systemic Risk Regulation,” Oct. 2009.2009.

InterlinkagesInterlinkages We would like to measure how relationships between We would like to measure how relationships between

financial institutions contribute to risk.financial institutions contribute to risk. Are some financial institutions, such as AIG, too Are some financial institutions, such as AIG, too

interconnected to fail?interconnected to fail? Economists are using network theory to consider this Economists are using network theory to consider this

question.question. Some results: Increased connectivity may ensure more risk Some results: Increased connectivity may ensure more risk

sharing, but can amplify shocks. If a larger than expected sharing, but can amplify shocks. If a larger than expected number of institutions are more connected than average, number of institutions are more connected than average, than the system may be less vulnerable to random shocks, than the system may be less vulnerable to random shocks, but more vulnerable to shocks to the hubs.but more vulnerable to shocks to the hubs.

Soramaki et al (2007) use a network map of the US Fedwire Soramaki et al (2007) use a network map of the US Fedwire interbank payment system to look at connectedness in the interbank payment system to look at connectedness in the US financial system.US financial system.

Soramaki, K., Bech, M. Arnold, J., Glass, R. and W. Beyeler, Soramaki, K., Bech, M. Arnold, J., Glass, R. and W. Beyeler, “The Topology of Interbank Payment Flows,” “The Topology of Interbank Payment Flows,” Physica APhysica A 379, 379, 2009, 317-333.2009, 317-333.

Problems with a Problems with a systemic risk data setsystemic risk data set

It would need new laws to get firms to comply.It would need new laws to get firms to comply. It would be very expensive to collect the data, It would be very expensive to collect the data,

store it and turn it into something usable. A new store it and turn it into something usable. A new agency would probably be required.agency would probably be required.

As many financial firms are multinational As many financial firms are multinational enterprises, international coordination, say enterprises, international coordination, say through the BIS or IMF, would desirable, but that through the BIS or IMF, would desirable, but that may be politically difficult. may be politically difficult.

The data will, at most, allow policy makers to The data will, at most, allow policy makers to observe the observe the symptoms symptoms of financial vulnerability. of financial vulnerability. Using a systemic risk data set in an early warning Using a systemic risk data set in an early warning system is no substitute for sensible economic system is no substitute for sensible economic policy and good supervision and regulation. policy and good supervision and regulation.

Connectedness is Connectedness is not well understoodnot well understood

A key feature of a crisis caused by systemic risk factors is A key feature of a crisis caused by systemic risk factors is the domino-like collapse of a chain of financial institutions the domino-like collapse of a chain of financial institutions after the demise of a just one or a few. This may be after the demise of a just one or a few. This may be because of the size of the first institutions to go, or it may because of the size of the first institutions to go, or it may be because they were too interconnected to fail without be because they were too interconnected to fail without damaging the entire system. But, neither size nor damaging the entire system. But, neither size nor conventional connectedness may be necessary for a conventional connectedness may be necessary for a financial crisis to propagate. financial crisis to propagate.

A new or old-style bank run or speculative attack in one A new or old-style bank run or speculative attack in one market may make a similar run or attack a focal outcome.market may make a similar run or attack a focal outcome.

Recent research by Stephen Morris and Hyun Song Shin Recent research by Stephen Morris and Hyun Song Shin (2009) demonstrates that a tiny amount of contagious (2009) demonstrates that a tiny amount of contagious adverse selection can shut down a market. adverse selection can shut down a market.

Morris, Stephen, and Hyun Song Shin, “Contagious Adverse Morris, Stephen, and Hyun Song Shin, “Contagious Adverse Selection,” unpublished paper, 2009.Selection,” unpublished paper, 2009.

A systemic risk warning boardA systemic risk warning board

The data set cannot be used The data set cannot be used mechanisticallymechanistically

Thus, along with an agency to collect and Thus, along with an agency to collect and manage the data, the Eurozone must have manage the data, the Eurozone must have a systemic risk assessment committee to a systemic risk assessment committee to interpret this and other relevant data, in interpret this and other relevant data, in light of the current macroeconomic and light of the current macroeconomic and regulatory and supervisory environment. regulatory and supervisory environment.

Designing a systemic risk boardDesigning a systemic risk board

The board should be small and diverse. I suggest The board should be small and diverse. I suggest that ideally it should be composed of five people: that ideally it should be composed of five people: a macroeconomist, a microeconomist, a financial a macroeconomist, a microeconomist, a financial engineer, a research accountant, and a engineer, a research accountant, and a practitioner. practitioner.

The reason for diversity is that spotting systemic The reason for diversity is that spotting systemic risk requires different types of expertise. A board risk requires different types of expertise. A board composed of entirely of macroeconomists might, composed of entirely of macroeconomists might, for example, see the potential for risk pooling in for example, see the potential for risk pooling in securitisation, whereas a microeconomist would securitisation, whereas a microeconomist would see the reduced incentive to monitor loans. see the reduced incentive to monitor loans.

Why five members?Why five members? The reason for the small size is that, consistent with the The reason for the small size is that, consistent with the

familiar jokes, it is a stylised fact that the output of familiar jokes, it is a stylised fact that the output of committees is not as good as one would expect, given their committees is not as good as one would expect, given their members. members.

Process losses due to coordination problems, motivational Process losses due to coordination problems, motivational losses, and difficulty sharing information are well losses, and difficulty sharing information are well documented in the social psychology literature; not documented in the social psychology literature; not everyone can speak at once; information is a public good everyone can speak at once; information is a public good and gathering it requires effort; no one wants to make a and gathering it requires effort; no one wants to make a fool of themselves in front of their co-members. fool of themselves in front of their co-members.

As the size of a group increases so does the pool of human As the size of a group increases so does the pool of human resources, but motivational losses, coordination problems, resources, but motivational losses, coordination problems, and the potential for embarrassment become more and the potential for embarrassment become more important. important.

The optimal size for a group that must solve problems or The optimal size for a group that must solve problems or make judgements is an empirical issue, but it may not be make judgements is an empirical issue, but it may not be much greater than five. much greater than five.

It should be independentIt should be independent The committee should be composed of researchers outside of The committee should be composed of researchers outside of

government bodies and international organisations; career government bodies and international organisations; career concerns may stifle the incentive of a bureaucrat to express concerns may stifle the incentive of a bureaucrat to express certain original ideas. It is of particular importance that the certain original ideas. It is of particular importance that the board not include supervisors and regulators. This is for two board not include supervisors and regulators. This is for two reasons. reasons. • First, it is often suggested that supervisors and regulators First, it is often suggested that supervisors and regulators

can be captured by the industry that they are supposed to can be captured by the industry that they are supposed to mind, and this may make them less than objective and mind, and this may make them less than objective and prone to the same errors. prone to the same errors.

• Second, a prominent cause of the recent crisis was Second, a prominent cause of the recent crisis was supervisory and regulatory failures, and these are more apt supervisory and regulatory failures, and these are more apt to be spotted and reported by independent observers than to be spotted and reported by independent observers than the perpetrators.the perpetrators.

Finally, it is important that the board be made sufficiently Finally, it is important that the board be made sufficiently visible and prominent that a member’s career depends on his visible and prominent that a member’s career depends on his performance. Given the importance of the task, pay should be performance. Given the importance of the task, pay should be high to attract the best qualified, and the members should not high to attract the best qualified, and the members should not have outside employment to distract them.have outside employment to distract them.

The European Systemic Risk The European Systemic Risk Board (ESRB)Board (ESRB)

The Eurozone has already swung into action, creating the The Eurozone has already swung into action, creating the European Systemic Risk Board (ESRB), set to begin this European Systemic Risk Board (ESRB), set to begin this year. Unfortunately, this board, responsible for macro-year. Unfortunately, this board, responsible for macro-prudential oversight of the EU financial system and for prudential oversight of the EU financial system and for issuing risk warnings and recommendations, is far from the issuing risk warnings and recommendations, is far from the ideal. It is to be composed of the 27 EU national central ideal. It is to be composed of the 27 EU national central bank governors, the ECB President and Vice-President, a bank governors, the ECB President and Vice-President, a Commission member and the three chairs of the new Commission member and the three chairs of the new European Supervisory Authorities. In addition, a European Supervisory Authorities. In addition, a representative from the national supervisory authority of representative from the national supervisory authority of each EU country and the President of the Economic and each EU country and the President of the Economic and Financial Committee may attend meetings of the ESRB, but Financial Committee may attend meetings of the ESRB, but may not vote. may not vote.

This lumbering army of 61 central bankers and related This lumbering army of 61 central bankers and related bureaucrats is a body clearly designed for maximum bureaucrats is a body clearly designed for maximum inefficiency; it is too big, it is too homogeneous, it lacks inefficiency; it is too big, it is too homogeneous, it lacks independence, and its members are already sufficiently independence, and its members are already sufficiently employed. employed.

Could the IMF Could the IMF provide early warnings?provide early warnings?

The IMF is intensely bureaucratic. Its culture may result in The IMF is intensely bureaucratic. Its culture may result in staff who are socialised to think in a particular way. To see staff who are socialised to think in a particular way. To see a looming crisis before others typically requires thinking in a looming crisis before others typically requires thinking in a highly independent and unconventional way. a highly independent and unconventional way.

The IMF is an exceedingly political organisation; to argue The IMF is an exceedingly political organisation; to argue one’s unusual and possibly sensitive view may not be a one’s unusual and possibly sensitive view may not be a career-enhancing move for a staff member. career-enhancing move for a staff member.

While the IMF has the expertise to analyse financial account While the IMF has the expertise to analyse financial account crises, its emphasis on macroeconomics may mean that it crises, its emphasis on macroeconomics may mean that it does not have the expertise to predict financial sector does not have the expertise to predict financial sector crises based on microeconomic failures. crises based on microeconomic failures.

The objections raised to the IMF as provider of early The objections raised to the IMF as provider of early warnings apply to a great extent to other international warnings apply to a great extent to other international organisations and central banks.organisations and central banks.

It is vital to have a good resolution It is vital to have a good resolution regime for banksregime for banks

Because of systemic risk factors that are not Because of systemic risk factors that are not yet well understood, there is the fear that yet well understood, there is the fear that the demise of just one or a few sufficiently the demise of just one or a few sufficiently large or interconnected banks could lead to large or interconnected banks could lead to the domino-like collapse of a chain of banks the domino-like collapse of a chain of banks and even an entire national or the global and even an entire national or the global financial sector. financial sector.

Because the real economy is so dependent Because the real economy is so dependent upon the orderly functioning of the financial upon the orderly functioning of the financial system, this could be a damaging or even system, this could be a damaging or even devastating blow that could lead to years of devastating blow that could lead to years of recession or worse. recession or worse.

Conventional bankruptcy regimes Conventional bankruptcy regimes are not enoughare not enough

We need a special regime for banks. Conventional We need a special regime for banks. Conventional bankruptcy regimes are too slow and cumbersome bankruptcy regimes are too slow and cumbersome and can interact badly with foreign countries’ regimes and can interact badly with foreign countries’ regimes in the case of multinational banksin the case of multinational banks. .

The regime needs to The regime needs to • specify when and how a bank is to be declared bankruptspecify when and how a bank is to be declared bankrupt• rank the claims of different types of creditors rank the claims of different types of creditors • provide an orderly process for realizing these claimsprovide an orderly process for realizing these claims• provide a mechanism for allowing the parts of the bank provide a mechanism for allowing the parts of the bank

that are to be kept on as going concerns to continue to that are to be kept on as going concerns to continue to operate. operate.

Designing and implementing a bankruptcy regime for Designing and implementing a bankruptcy regime for banks is challenging!banks is challenging!

Using conventional Using conventional insolvency lawsinsolvency laws

Lehman Brothers filed for Chapter 11 bankruptcy protection Lehman Brothers filed for Chapter 11 bankruptcy protection on 15 September 2008. on 15 September 2008.

At Lehman, all spare cash held by the London subsidiary – a At Lehman, all spare cash held by the London subsidiary – a corporate entity subject to British bankruptcy legislation – corporate entity subject to British bankruptcy legislation – was sent to the New York parent at the close of each was sent to the New York parent at the close of each business day. business day.

When the directors of this subsidiary realised on Sunday 14 When the directors of this subsidiary realised on Sunday 14 September 2008 that their US parent was going to file for September 2008 that their US parent was going to file for bankruptcy protection the next day, they realised they no bankruptcy protection the next day, they realised they no longer had the cash to fund their operations. longer had the cash to fund their operations.

Under British law the firm had to be put into adminis-Under British law the firm had to be put into adminis-tration: its access to exchanges and clearing systems was tration: its access to exchanges and clearing systems was

frozen with a large number of trades left open.frozen with a large number of trades left open.

Lehman illustrates the problems with using Lehman illustrates the problems with using conventional bankruptcy lawsconventional bankruptcy laws

Putting the British subsidiary into administration created a Putting the British subsidiary into administration created a further problem as well. further problem as well.

The British subsidiary used a bewildering array of complex The British subsidiary used a bewildering array of complex legal structures to hold its client assets. legal structures to hold its client assets.

The Lehman Brothers group had a group-wide IT system The Lehman Brothers group had a group-wide IT system that was operated out of New York and, after the that was operated out of New York and, after the bankruptcy filing, it ceased to be updated for British bankruptcy filing, it ceased to be updated for British subsidiary. subsidiary.

This made it difficult for the administrators to return the This made it difficult for the administrators to return the client assets – worth about $35 billion – held by this client assets – worth about $35 billion – held by this subsidiary. subsidiary.

The resulting delay greatly increased the market disruption The resulting delay greatly increased the market disruption caused by the failure of Lehman Brothers.caused by the failure of Lehman Brothers.

Taxpayer-funded bailoutsTaxpayer-funded bailouts

United States: American International United States: American International Group (AIG)Group (AIG)

Germany: Hypo Real and CommerzbankGermany: Hypo Real and Commerzbank United Kingdom: Royal Bank of Scotland United Kingdom: Royal Bank of Scotland

Group and the TSB-HBOS GroupGroup and the TSB-HBOS Group Netherlands, Belgium and Luxembourg: Netherlands, Belgium and Luxembourg:

Fortis Bank Fortis Bank Ireland: Anglo Irish Bank. Ireland: Anglo Irish Bank.

These are not politically popularThese are not politically popular

In Ireland, parties campaigning against In Ireland, parties campaigning against the continued use of tax payers’ the continued use of tax payers’ money to repay the senior unsecured money to repay the senior unsecured bondholders of Irish banks gained a bondholders of Irish banks gained a large majority in the Irish large majority in the Irish parliamentary elections of 25 February parliamentary elections of 25 February 2011. 2011.

Moral hazard problem?Moral hazard problem? If financial firms believe they are likely to be bailed out if If financial firms believe they are likely to be bailed out if

they run into difficulties then this would tend to cause them they run into difficulties then this would tend to cause them to engage in excessively risky behaviour. to engage in excessively risky behaviour.

But, if the market also believes that insolvent financial firms But, if the market also believes that insolvent financial firms are likely to be bailed out, then these firms can borrow at are likely to be bailed out, then these firms can borrow at more favourable rates than they otherwise could. This more favourable rates than they otherwise could. This raises the value of solvency and might, in principle, raises the value of solvency and might, in principle, mitigate this problem to some extent. mitigate this problem to some extent.

A recent study of German banks during the period 1996 – A recent study of German banks during the period 1996 – 2006 does not support this. It was found that the removal of 2006 does not support this. It was found that the removal of public guarantees significantly reduced risk taking. public guarantees significantly reduced risk taking.

They might not be possibleThey might not be possible

The failed banks may be too large for tax payer The failed banks may be too large for tax payer bailouts to be feasible. bailouts to be feasible.

The size of the Icelandic banking sector’s balance The size of the Icelandic banking sector’s balance sheet was about 11 times the size of Icelandic sheet was about 11 times the size of Icelandic GDP before it collapsed. Fortunately, the Icelandic GDP before it collapsed. Fortunately, the Icelandic government did not attempt to save its banks, as government did not attempt to save its banks, as this would have dragged the sovereign into this would have dragged the sovereign into insolvency along with the banks. insolvency along with the banks.

The Irish attempt at bailing out banks that were The Irish attempt at bailing out banks that were too big to be saved is now threatening sovereign too big to be saved is now threatening sovereign

solvencysolvency. .

It might violate the TreatyIt might violate the Treaty State support of financial institutions may conflict with State support of financial institutions may conflict with

Article 107.1 of the Treaty on European Union (consolidated Article 107.1 of the Treaty on European Union (consolidated version) which says, “Save as otherwise provided in the version) which says, “Save as otherwise provided in the Treaties, any aid granted by a Member State or through Treaties, any aid granted by a Member State or through State resources in any form whatsoever which distorts or State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so undertakings or the production of certain goods shall, in so far as it affects trade between Member States, be far as it affects trade between Member States, be incompatible with the internal market.” incompatible with the internal market.”

However, Article 107.3 (b) may provide an exception in However, Article 107.3 (b) may provide an exception in sufficiently important cases as it allows aid “to remedy a sufficiently important cases as it allows aid “to remedy a serious disturbance in the economy of a Member State”.serious disturbance in the economy of a Member State”.

Selling Troubled FirmsSelling Troubled Firms

Fortis’s Belgian banking operations were Fortis’s Belgian banking operations were sold to the French bank BNP Paribas (while sold to the French bank BNP Paribas (while its Dutch ABN-Amro operations were sold its Dutch ABN-Amro operations were sold to the Dutch sovereign)to the Dutch sovereign)

Merrill Lynch was sold to the Bank of Merrill Lynch was sold to the Bank of AmericaAmerica

Bear Stearns was merged with JP Morgan Bear Stearns was merged with JP Morgan ChaseChase

HBOS was acquired by Lloyds TSB. HBOS was acquired by Lloyds TSB.

Problems with this approachProblems with this approach

It may require a taxpayer sweetener (Bear It may require a taxpayer sweetener (Bear Stearns) to get another firm to go along. Stearns) to get another firm to go along.

Negotiations can be acrimonious (as in the case Negotiations can be acrimonious (as in the case of Fortis) and lengthy. Shareholders may try to of Fortis) and lengthy. Shareholders may try to block the deal if it lowers the value of their shares block the deal if it lowers the value of their shares or reduces their control (Fortis and JP Morgan). or reduces their control (Fortis and JP Morgan).

It may weaken the institution that acquires the It may weaken the institution that acquires the failed firm. Lloyds TSB share values fell by about failed firm. Lloyds TSB share values fell by about a third in value after HBOs posted unexpectedly a third in value after HBOs posted unexpectedly high losses in early 2009. high losses in early 2009.

Some financial firms are too large to be digested Some financial firms are too large to be digested by another (RBS).by another (RBS).

The US Approach: FDICThe US Approach: FDIC Washington Mutual (WaMu) of Seattle was the 6th largest Washington Mutual (WaMu) of Seattle was the 6th largest

bank in the US, with assets valued at $328 billion in 2007.bank in the US, with assets valued at $328 billion in 2007. It suffered heavy losses in the US subprime mortgage It suffered heavy losses in the US subprime mortgage

market and the price of its shares plummeted from 30 market and the price of its shares plummeted from 30 dollars to two dollars between Sept 2007 and Sept 2008. dollars to two dollars between Sept 2007 and Sept 2008.

On 15 Sept 2008 its depositors began to run, withdrawing On 15 Sept 2008 its depositors began to run, withdrawing about $17 billion. On Thursday 25 Sept the US Office of about $17 billion. On Thursday 25 Sept the US Office of Thrift Supervision, which regulated WaMu, closed the bank Thrift Supervision, which regulated WaMu, closed the bank and appointed the Federal Deposit Insurance Corporation and appointed the Federal Deposit Insurance Corporation (FDIC) as receiver. (FDIC) as receiver.

The FDIC auctioned off a package including most of the The FDIC auctioned off a package including most of the WaMu’s assets and all of its deposits and secured debt. On WaMu’s assets and all of its deposits and secured debt. On Thursday 25 Sept, JP Morgan Chase was informed that it Thursday 25 Sept, JP Morgan Chase was informed that it was the winner. was the winner.

Seamless handlingSeamless handling

The collapse of WaMu was the largest bank The collapse of WaMu was the largest bank failure in US history and the 2nd largest failure in US history and the 2nd largest bankruptcy after Lehman Brothers.bankruptcy after Lehman Brothers.

Unlike in the collapse of Lehman Brothers, Unlike in the collapse of Lehman Brothers, WaMu’s business operations proceeded without WaMu’s business operations proceeded without interruption after its demise. interruption after its demise.

Its branches opened as usual on the morning of Its branches opened as usual on the morning of Friday 26 September, albeit as JP Morgan Friday 26 September, albeit as JP Morgan branches.Ibranches.I

ts ATMs continued to operate and its online ts ATMs continued to operate and its online services remained available.services remained available.

FDICFDIC

In the US the FDIC runs a receivership regime for In the US the FDIC runs a receivership regime for failed banks, selling their good assets and failed banks, selling their good assets and winding down their bad assets. winding down their bad assets.

It insures up to $250,000 per depositor per bank.It insures up to $250,000 per depositor per bank. If there are more than sufficient funds to pay If there are more than sufficient funds to pay

insured depositors from a bank’s recovered insured depositors from a bank’s recovered assets, then it uses the extra funds to pay, in assets, then it uses the extra funds to pay, in order, general unsecured creditors, subordinated order, general unsecured creditors, subordinated debt and stockholders. debt and stockholders.

If there are insufficient funds to pay insured If there are insufficient funds to pay insured depositors, then it makes up the difference with depositors, then it makes up the difference with its Deposit Insurance Fund. its Deposit Insurance Fund.

27 February 2009 press release from 27 February 2009 press release from the FDIC states: the FDIC states:

““Throughout the FDIC's 75-year history, no Throughout the FDIC's 75-year history, no depositor has ever lost a penny of insured deposits. depositor has ever lost a penny of insured deposits. While deposits insured by the FDIC are backed by While deposits insured by the FDIC are backed by the full faith and credit of the United States the full faith and credit of the United States Government, the FDIC is funded not with taxpayer Government, the FDIC is funded not with taxpayer money but with deposit insurance premiums money but with deposit insurance premiums imposed on banks. Though the FDIC has the imposed on banks. Though the FDIC has the authority to borrow from the Treasury Department authority to borrow from the Treasury Department to meet its obligations, it has never done so to to meet its obligations, it has never done so to cover losses.”cover losses.”

The FDIC’s job is easy compared to The FDIC’s job is easy compared to that of EU policymakersthat of EU policymakers

WaMu was a big bank by American WaMu was a big bank by American standards, but it was small compared standards, but it was small compared to behemoths such as BNP Paribas or to behemoths such as BNP Paribas or Royal Bank of Scotland which have Royal Bank of Scotland which have assets worth $3 trillion or more.assets worth $3 trillion or more.

Moreover, and crucially, WaMu was a Moreover, and crucially, WaMu was a domestic corporation with a domestic corporation with a relatively uncomplicated balance relatively uncomplicated balance sheet. sheet.

The FDIC has resolved plain vanilla The FDIC has resolved plain vanilla depository institutionsdepository institutions

They have not had complex contingent claims on their They have not had complex contingent claims on their balance sheets.balance sheets.

They have not combined principal and agent roles in their They have not combined principal and agent roles in their transactions, as do the US broker-dealers that act as transactions, as do the US broker-dealers that act as custodians and clearing agencies in OTC transactions as custodians and clearing agencies in OTC transactions as well as transacting in the same securities on their own well as transacting in the same securities on their own accounts. accounts.

They have not had complex cross-border structures of They have not had complex cross-border structures of branches and subsidiaries and, thus, they have not had the branches and subsidiaries and, thus, they have not had the coordination and technical problems associated with coordination and technical problems associated with multinational groups with corporate entities located in multinational groups with corporate entities located in several jurisdictions.several jurisdictions.

Banks can be large and Banks can be large and complexcomplex

They have complex contingent claims on their balance They have complex contingent claims on their balance sheetssheets

They can combine both principal and agent roles in their They can combine both principal and agent roles in their transactions, they act as custodians and clearing agencies transactions, they act as custodians and clearing agencies in OTC transactions and transact in the same securities on in OTC transactions and transact in the same securities on their own accounts. their own accounts.

They have complex cross-border structures of branches and They have complex cross-border structures of branches and subsidiaries and all of the coordination and technical subsidiaries and all of the coordination and technical problems associated with multinational groups with problems associated with multinational groups with corporate entities located in many countries.corporate entities located in many countries.

Over 14 banks around the world, two of them US banks, Over 14 banks around the world, two of them US banks, have assets valued at over two trillion dollars.have assets valued at over two trillion dollars.

Lehman BrothersLehman Brothers

Lehman Brothers Holdings, Inc. was a firm Lehman Brothers Holdings, Inc. was a firm with $639 bn in assets and $613 bn in with $639 bn in assets and $613 bn in liabilities. liabilities.

It consisted of over 7,000 legal entities in It consisted of over 7,000 legal entities in over 40 countries. over 40 countries.

At the time it filed for bankruptcy it had At the time it filed for bankruptcy it had almost a million derivative contracts with a almost a million derivative contracts with a notional value of $39 trillion outstanding. notional value of $39 trillion outstanding.

Within days of it filing for bankruptcy about Within days of it filing for bankruptcy about 80 foreign receiverships and insolvency 80 foreign receiverships and insolvency proceedings were brought against it.proceedings were brought against it.

And its chaotic demiseAnd its chaotic demise

On Sunday 14 September 2008 the Federal Reserve Bank of New York On Sunday 14 September 2008 the Federal Reserve Bank of New York directed Lehman Brothers to initiate a bankruptcy case by midnight. directed Lehman Brothers to initiate a bankruptcy case by midnight.

The bank was completely unprepared; it had had no intention of even The bank was completely unprepared; it had had no intention of even considering bankruptcy and had made no plans for this contingency.considering bankruptcy and had made no plans for this contingency.

It put together what is said to be the most bare-bones chapter 11 It put together what is said to be the most bare-bones chapter 11 petition ever filed by 2:00 the next morning. petition ever filed by 2:00 the next morning.

The lack of forethought contributed to the global financial chaos that The lack of forethought contributed to the global financial chaos that ensued.ensued.

Lawyers and accountants have since been paid about $ 3 billion to Lawyers and accountants have since been paid about $ 3 billion to resolve matters and almost 1000 counterparties have yet to agree resolve matters and almost 1000 counterparties have yet to agree claims. claims.

Living WillsLiving Wills The resolution authority must choose between the different The resolution authority must choose between the different

ways of resolving the bank: all of them can have large and ways of resolving the bank: all of them can have large and unpredictable costsunpredictable costs

It must act quickly: the longest it has to choose is the 36 or It must act quickly: the longest it has to choose is the 36 or 48 hours between close of business on Friday in Europe and 48 hours between close of business on Friday in Europe and North America to the opening of markets in Asia on Monday. North America to the opening of markets in Asia on Monday.

The bank must provide the authority with sufficient The bank must provide the authority with sufficient information to allow it to make the best choice. information to allow it to make the best choice.

8 US banks were covered by the G-20 agreement; the Dodd-8 US banks were covered by the G-20 agreement; the Dodd-Frank Act extends this by mandating that the more than Frank Act extends this by mandating that the more than 100 U.S. banks with over $50 billion in assets must prepare 100 U.S. banks with over $50 billion in assets must prepare living wills. The 4 biggest UK banks were covered by the G-living wills. The 4 biggest UK banks were covered by the G-20 agreement, 2 more were told to comply and now all UK 20 agreement, 2 more were told to comply and now all UK banks – about 250 of them – are to prepare living wills.banks – about 250 of them – are to prepare living wills.

Measuring insolvency is hardMeasuring insolvency is hard If insolvency occurs when the firm is unlikely to be able to If insolvency occurs when the firm is unlikely to be able to

repay its debts then declaring a firm to be insolvent repay its debts then declaring a firm to be insolvent requires the judgement of the regulators. requires the judgement of the regulators.

More mechanical definitions that rely less on judgement:More mechanical definitions that rely less on judgement:• negative net worth under accepted accounting principlesnegative net worth under accepted accounting principles• the firm would have a negative net value if it were liquidatedthe firm would have a negative net value if it were liquidated• the firm no longer has enough liquidity to continue to pay its billsthe firm no longer has enough liquidity to continue to pay its bills

These criteria are unreasonable when markets become These criteria are unreasonable when markets become dysfunctional and a financial asset’s price is far below its dysfunctional and a financial asset’s price is far below its reasonably expected DPV if it were held to maturity. reasonably expected DPV if it were held to maturity.

It is unrealistic to rely on a rules-based approach to It is unrealistic to rely on a rules-based approach to determining when a firm has failed. Regulators must be determining when a firm has failed. Regulators must be allowed discretion. But this entails a loss of security of allowed discretion. But this entails a loss of security of property rights and, hence, of government legitimacy. property rights and, hence, of government legitimacy. Shareholders, however, should have the opportunity to Shareholders, however, should have the opportunity to contest the regulators’ actions ex post in court. contest the regulators’ actions ex post in court.

Shareholder rights vs. efficiencyShareholder rights vs. efficiency To ensure that the operations of a financial institution are To ensure that the operations of a financial institution are

uninterrupted and to limit systemic risk, supervisors and uninterrupted and to limit systemic risk, supervisors and resolution authorities must act quickly when they suspect resolution authorities must act quickly when they suspect that a bank might be in danger of becoming insolvent. that a bank might be in danger of becoming insolvent.

Unfortunately, this raises the possibility that the authorities Unfortunately, this raises the possibility that the authorities might liquidate a bank that might have remained solvent if might liquidate a bank that might have remained solvent if left alone or for which a sale might have been arranged left alone or for which a sale might have been arranged that would not have wiped out the shareholders’ claims. that would not have wiped out the shareholders’ claims.

   The Fifth Amendment of the US constitution states, The Fifth Amendment of the US constitution states, “No “No

person shall be … deprived of life, liberty, or property, person shall be … deprived of life, liberty, or property, without due process of law; nor shall private property be without due process of law; nor shall private property be taken for public use, without just compensation.” taken for public use, without just compensation.” In the In the United States if a bankruptcy case is filed then the case United States if a bankruptcy case is filed then the case must be presented in a bankruptcy court and approved by must be presented in a bankruptcy court and approved by a judge. a judge.

Property rights vs. EfficiencyProperty rights vs. Efficiency Some tell a different story about the FDIC and WaMu.Some tell a different story about the FDIC and WaMu. In their version, WaMu had been looking for a buyer since In their version, WaMu had been looking for a buyer since

early Sept 2008. On 25 Sept the FDIC announced that JP early Sept 2008. On 25 Sept the FDIC announced that JP Morgan Chase had won an auction to buy the bank. Morgan Chase had won an auction to buy the bank.

So, the FDIC must have alerted potential purchasers that So, the FDIC must have alerted potential purchasers that the bank was going to be seized some time before the sale, the bank was going to be seized some time before the sale, making it impossible for WaMu to find a buyer: why buy a making it impossible for WaMu to find a buyer: why buy a bank from its shareholders and be required to take on all of bank from its shareholders and be required to take on all of its liabilities when you can purchase select parts of it in a its liabilities when you can purchase select parts of it in a government-run fire sale? government-run fire sale?

The resulting rumours might have provoked the bank run. The resulting rumours might have provoked the bank run. WaMu was solvent and might have remained so; the FDIC WaMu was solvent and might have remained so; the FDIC

provoked its liquidity crisis and the subsequent seizure provoked its liquidity crisis and the subsequent seizure amounted to confiscation.amounted to confiscation.

Does the FDIC trample on Does the FDIC trample on property rights?property rights?

On 20 Mar 2009 the shareholders of On 20 Mar 2009 the shareholders of WaMu, who were nearly wiped out in WaMu, who were nearly wiped out in the FDIC’s sale of WaMu to JP Morgan the FDIC’s sale of WaMu to JP Morgan Chase, filed suit against the FDIC. Chase, filed suit against the FDIC.

They are seeking damages for what They are seeking damages for what they view as the unjustified seizure they view as the unjustified seizure of the institution and its sale at an of the institution and its sale at an unreasonably low price.unreasonably low price.

Dodd-Frank ActDodd-Frank Act Until recently, the FDIC’s authority has been limited to Until recently, the FDIC’s authority has been limited to

depository institutions; this is why Lehman Brothers fell depository institutions; this is why Lehman Brothers fell outside of its scope. outside of its scope.

The Dodd-Frank Act of 21 Jul 2010 extends the reach of the The Dodd-Frank Act of 21 Jul 2010 extends the reach of the FDIC to financial firms whose potential collapse might FDIC to financial firms whose potential collapse might jeopardise the financial stability of the US.jeopardise the financial stability of the US.

Funding is to be provided by an Orderly Liquidation Fund Funding is to be provided by an Orderly Liquidation Fund that is to be set up by collecting risk-based assessment that is to be set up by collecting risk-based assessment fees from eligible financial firms. The fees are to be fees from eligible financial firms. The fees are to be adjusted as necessary so that any borrowing from the adjusted as necessary so that any borrowing from the Treasury is repaid within five years and, thus, no taxpayer Treasury is repaid within five years and, thus, no taxpayer money is used. money is used.

Dodd FrankDodd Frank If the Secretary of the Treasury decides a bank is insolvent or likely to become If the Secretary of the Treasury decides a bank is insolvent or likely to become

so, he notifies the bank. If the bank acquiesces, the FDIC is appointed the so, he notifies the bank. If the bank acquiesces, the FDIC is appointed the receiver and liquidation commences.receiver and liquidation commences.

If the bank objects then he petitions the District Court to appoint the FDIC as If the bank objects then he petitions the District Court to appoint the FDIC as receiver. The Court t has 24 hours to notify the bank, hold a hearing at which receiver. The Court t has 24 hours to notify the bank, hold a hearing at which the bank can oppose the petition and to reach a verdict. If the Court exceeds the bank can oppose the petition and to reach a verdict. If the Court exceeds the 24 hour limit, the FDIC is automatically appointed receiver and the the 24 hour limit, the FDIC is automatically appointed receiver and the liquidation begins. The result is final.liquidation begins. The result is final.

Suppose the Secretary files his petition and his vast amount of paperwork at the Suppose the Secretary files his petition and his vast amount of paperwork at the end of the day. The bank will have until the next morning to prepare a end of the day. The bank will have until the next morning to prepare a response. A hearing is held and the judge has what is left of the day to go response. A hearing is held and the judge has what is left of the day to go through the paperwork, to weigh the arguments presented at the hearing and through the paperwork, to weigh the arguments presented at the hearing and to arrive at a decision. Or, he can just let the clock run out.to arrive at a decision. Or, he can just let the clock run out.

An ex post appeal is allowed but by then the bank is likely irretrievable. The An ex post appeal is allowed but by then the bank is likely irretrievable. The only guilty party would be the US government and if a bank tried to sue it for a only guilty party would be the US government and if a bank tried to sue it for a monetary compensation it would likely claim sovereign immunity.monetary compensation it would likely claim sovereign immunity.

What about senior bondholders?What about senior bondholders?

It has been argued (mainly by senior bondholders and their It has been argued (mainly by senior bondholders and their lawyers) that senior bondholders should be protected. lawyers) that senior bondholders should be protected.

Unlike equity holders, senior bondholders have no Unlike equity holders, senior bondholders have no possibility of an upside gain, thus they should not be possibility of an upside gain, thus they should not be exposed to downside risk. If they were exposed to such risk exposed to downside risk. If they were exposed to such risk then they would require higher interest rates. then they would require higher interest rates.

If the banks were forced to pay higher interest rates, they If the banks were forced to pay higher interest rates, they would then pass this cost on to their consumers. As a would then pass this cost on to their consumers. As a result, households would pay more for their mortgages and result, households would pay more for their mortgages and other loans. other loans.

In addition, it is claimed, senior bondholders are not In addition, it is claimed, senior bondholders are not typically hedge funds, but insurance companies and typically hedge funds, but insurance companies and pensions funds. If senior bonds become more risky, so do pensions funds. If senior bonds become more risky, so do these funds.these funds.

CounterargumentsCounterarguments If senior bonders were expected to take significant haircuts If senior bonders were expected to take significant haircuts

in the event of insolvency, hey would have an incentive to in the event of insolvency, hey would have an incentive to become more selective about which bonds they purchase. become more selective about which bonds they purchase.

Both they and society, because it cares about the health of Both they and society, because it cares about the health of pension and insurance funds, would become more careful pension and insurance funds, would become more careful about monitoring the behaviour of the issuers of the bonds.about monitoring the behaviour of the issuers of the bonds.

Issuers of senior bonds would have an incentive to become Issuers of senior bonds would have an incentive to become more transparent and to engage in less risky behaviour. more transparent and to engage in less risky behaviour.

In the event of the failure of a sufficiently large bank, In the event of the failure of a sufficiently large bank, protecting all senior bond holders may simply not be protecting all senior bond holders may simply not be feasible. feasible.

Society is partially to blameSociety is partially to blame

The current banking crisis is to a large extent the The current banking crisis is to a large extent the result of supervisory and regulatory failures, as result of supervisory and regulatory failures, as well as governments’ policy blunders.well as governments’ policy blunders.

In a democratic society, the ultimate In a democratic society, the ultimate responsibility for much of the crisis then lies with responsibility for much of the crisis then lies with the electorate. the electorate.

In addition to fairness issues, if the failure of an In addition to fairness issues, if the failure of an institution causes significant systemic risk and institution causes significant systemic risk and other financial firms must contribute to making other financial firms must contribute to making up the loss, then it forces financial firms to lose up the loss, then it forces financial firms to lose liquidity just when they need it.liquidity just when they need it.

Fairness vs. FlexibilityFairness vs. Flexibility

The different spins on the handling of WaMu The different spins on the handling of WaMu result from the conflict between efficiency and result from the conflict between efficiency and property rights that is inherent in the design of property rights that is inherent in the design of bank resolution regimes. bank resolution regimes.

Such regimes could in principle rely on statute, Such regimes could in principle rely on statute, and thus spell out the rules of the game in and thus spell out the rules of the game in advance, promoting fairness and protecting the advance, promoting fairness and protecting the rights of property owners. rights of property owners.

Or, they can rely on the discretion of regulators, Or, they can rely on the discretion of regulators, and thus allow the necessary flexibility to deal and thus allow the necessary flexibility to deal with previously unforeseen events. with previously unforeseen events.

Banks should be taken over before they failBanks should be taken over before they fail

To insure that a bank’s business continues To insure that a bank’s business continues without interruption, it is best to take it over without interruption, it is best to take it over beforebefore it becomes insolvent. it becomes insolvent.

But, if the firm has not yet failed, then there may But, if the firm has not yet failed, then there may be a chance that it might not fail and in this case, be a chance that it might not fail and in this case, seizing it amounts to confiscation.seizing it amounts to confiscation.

The problem is further complicated by the The problem is further complicated by the problem that it can be difficult to assess whether problem that it can be difficult to assess whether or not a financial firm is solvent or likely to or not a financial firm is solvent or likely to become so. become so.

Where is Europe going from here?Where is Europe going from here? Euro Area and other EU policymakers hope to attain a Banking Union consisting Euro Area and other EU policymakers hope to attain a Banking Union consisting

of three components. The first is a Single Supervisory Mechanism (SSM). Under of three components. The first is a Single Supervisory Mechanism (SSM). Under the SSM the important banks of the Euro Area and those of any other member the SSM the important banks of the Euro Area and those of any other member states of the EU that choose to participate would be supervised by the ECB. states of the EU that choose to participate would be supervised by the ECB. Less important banks would be supervised by the national authorities with the Less important banks would be supervised by the national authorities with the ECB having ultimate responsibility.ECB having ultimate responsibility.

The details of the SSM were agreed on 19 Mar 2013, approved by the European The details of the SSM were agreed on 19 Mar 2013, approved by the European Parliament on 12 Sept 2013 and it is set to become operational in late 2014. Parliament on 12 Sept 2013 and it is set to become operational in late 2014. The ECB will have the enormous power of being able to license and authorize The ECB will have the enormous power of being able to license and authorize credit institutions. credit institutions.

The not-yet-agreed-upon second component is a single deposit scheme.The not-yet-agreed-upon second component is a single deposit scheme.

The third, the most ambitious and perhaps the most important component is a The third, the most ambitious and perhaps the most important component is a Single Resolution Authority (SRA). On 10 Jul 2013 the Commission proposed the Single Resolution Authority (SRA). On 10 Jul 2013 the Commission proposed the details of a possible SRA.details of a possible SRA.

Single Resolution MechanismSingle Resolution Mechanism

On 18 Dec 2013 the Council agreed On 18 Dec 2013 the Council agreed on a draft Single Resolution on a draft Single Resolution Mechamism.Mechamism.

It is hopsed it will become It is hopsed it will become operational on 1 Jan 2015.operational on 1 Jan 2015.