The global economic crisis – which has been unfolding in various forms since the subprime bubble burst in late 2007 – has come at a high social and economic cost. It has also shattered confidence in US and European banking systems and questioned the capacity of financial markets to channel resources to their best use.
After all, financial industry investments have proven ex post to be excessively risky and the generally accepted view is that their risks were not ex ante sound. The list of examples includes the subprime mortgages in the US and mortgages to markets characterised by real estate bubbles in Europe.
The regulatory reforms that have taken place since the beginning of the crisis have intended, among other objectives, to curtail this excessive appetite for risk. Yet, for regulation to prevent future crises, one must know what caused the excessive risk-taking in the first place.
What is excessive risk-taking?
To explore its causes, the first step is to give a more precise definition of ‘excessive risk-taking’.1 One working definition of excessive risk-taking is a level of risk such that, had it been known and taken into account ex ante by banks’ stakeholders, it would have made the net present value of the bank’s investment project negative.
1 This draws heavily on the Introductory chapter in Dewatripont and Freixas (2012) written by the two editors.
This view of ‘excessive risk-taking’ has the advantage of preserving the option for banks to invest in high-risk ventures provided they result in a corresponding high return and do not jeopardise the continuity of the bank as a going concern. It does not emphasise financial institutions’ possibly overoptimistic expectations but rather the risk-adjusted cost of funds, as well as the lack of transparency that characterises investment in banks:
lending to a financial institution on the basis of a reputation of safe investments in the banking industry supported by a tradition of bailouts by the Treasury where even uninsured debt holders have been protected from the bankruptcy losses.
With this definition in mind, four possible ‘culprits’ stand out:
• Managers’ incentives and corporate governance;
• Understatement of the business cycle risks (capital is excessively cheap and lending excessively permissive in upturns with the opposite holding in downturns);
• Failure of regulatory supervision and market discipline to curb excesses in boom times;
• Moral hazard, whereby banks take too much risk in anticipation of being bailed out in the event of massive losses.
Findings and analysis
First of all, excessive risk-taking is directly related to corporate governance.2 The decisions a bank takes regarding risk levels are ultimately the responsibility of managers and boards of directors. Whether in their strategic decisions managers consider their own bonuses, short-term stock price movements, shareholders’ short-run interests (rather than stakeholders’ long-run ones) or simply the financial institution’s culture of risk, these are all decisions that are substantiated by the board and therefore result from the structure of financial institutions’ corporate governance.
2 For details, see Mehran et al (2012).
The crisis and the future of the banking industry
Mehran et al (2012) argue that corporate governance may be especially weak due to the multiplicity of stakeholders (insured and uninsured depositors, the deposit insurance company, bond holders, subordinate debt holders, and hybrid securities holders), and the complexity of banks’ operations. Moreover the moral hazard created by the too-big-to-fail situation may have led boards to encourage risk-taking as they knew that big losses would be paid largely by taxpayers rather than stakeholders.
Second, the issue of excessive risk-taking may also be related to managers’ and shareholders’ understatement of the business cycle risk of downturn, as the procyclicality of capital may lead to excessive lending, the emergence of bubbles and a financial accelerator effect.3 The fact that banks did not have enough capital once the crisis unravelled is not only a failure of the Basel II regulatory framework and the models it is based on, but also evidence of how critical the issue of procyclicality is for financial stability. The regulatory proposal of Basel III on countercyclical buffers is intended to solve this issue. Still, rigorous analysis of the procyclicality of banks’ capital may indicate that the issue is more complicated than it seems.
Repullo and Saurina (2012) focus on one aspect of this, namely the question of whether and how much additional capital should be required during excessive credit growth phases, and how these excessive credit growth phases are to be identified. They study how the Basel III regulatory framework proposes to tackle the issue and the extent to which the rules accomplish their objectives.
The Basel III countercyclical provisions require higher capital-loan ratios when the credit-to-GDP ratio deviates from its trend. Their analysis, however, shows this works the wrong way for a majority of nations; the deviations are negatively correlated with GDP growth. In short, banks that follow the deviation from trend rule may actually be pursuing a procyclical rather than a countercyclic capital policy. The authors propose a simpler rule – the credit growth rate.
3 For details, see Repullo and Saurina (2012).
Third, it may be argued that the curtailing of excessive risk-taking was the joint responsibility of supervision and market discipline, and that neither did a proper job.4 Theoretically both firms and gatekeepers are supposed to provide accurate information to the market and to supervisory agencies. This information transmission issue has been a key one in the analysis of the crisis, as it has been argued that it was the opacity of some of the structured products, asset-backed securities, collateralised debt obligations, and so on, that was in part responsible for the first stages of the crisis. It has also been stated that the use of fair-value accounting by banks aggravated the crisis. So it is clearly important to assess to what extent these claims are valid.
The market’s main sources of information are firms’ financial reports and credit rating agencies. Freixas and Laux (2012) address a number of reproaches levelled at these sources. On the financial reporting, the use of fair-value analysis has come in for strong criticisms as it caused firms to write down asset falls as the markets collapsed, with this leading to eroded capital and heightened uncertainty. The authors, however, argue that fair value is not much to blame as it only affects banks’ trading portfolios and there is substantial discretion for banks to suspend it if the losses are considered temporary.
They are more critical when it comes to credit rating agencies, concluding that these profit-maximising firms are in an institutional setting that inadequately deals with conflicts of interests. They call for more regulation of credit rating agencies to redress this.
Fourth, excessive risk-taking may be the result of another form of market discipline if all banks in distress are to be bailed out.5 This would, of course, be taken into account by a bank’s managers and board of directors and completely distort the bank’s decision since, in this case, bankruptcy threats are no longer credible. Consequently, how regulatory agencies and Treasuries organise banks’ resolutions will determine future moral hazard. It is therefore worth considering how a bank in distress can be
4 Freixas and Laux (2012).
5 Freixas and Dewatripont (2012).
The crisis and the future of the banking industry
restructured in an orderly way, whether it is to be closed or bailed out in such a way as to preserve banks’ incentives and be credible while limiting contagion to other banks.
Freixas and Dewatripont (2012) argue that the first objective of regulation is therefore to reduce the cost of bankruptcies; this is the main focus of the last chapter. Banking resolution should be thought of as a bargaining game between shareholders and regulators. Shareholders want to maximise the value of their shares while regulatory authorities’ main objective is to preserve financial stability at the lowest possible cost.
Given this, time plays against the regulatory authority. The authors thus argue for bankruptcy rules that are specially crafted for the banking sector (and different from those applying to non-financial corporations).
In this game, time is of the essence – even with the perfectly efficient bankruptcy procedure. Banks in distress should be quickly closed or quickly bailed out. The chapter’s examination of banking crises in different countries shows great variety in the procedures followed and concludes that theory has no clear-cut recommendations to offer.
Plainly the design of the bank resolution mechanisms is critical. One proposal is to add a layer of capital to prevent future crises, but the authors defend the possibilities opened by contingent capital and by bail-ins. They argue that these types of mechanisms would preserve the best characteristics of debt and therefore limit moral hazard. The authors conclude by considering cross-country resolution and the challenges it implies and discuss the recent changes in the European banking resolution framework.
References
Dewatripont, M and X Freixas, eds (2012), The Crisis Aftermath: New Regulatory Paradigms, London: Centre for Economic Policy Research.
Mehran, H, A Morrison and J Shapiro (2012). “Corporate Governance and Banks: What Have We Learned from the Financial Crisis?”, in Dewatripont, M and X Freixas (eds), The Crisis Aftermath: New Regulatory Paradigms, London: CEPR.
Repullo, R and J Saurina (2010), “The Countercyclical Capital Buffer of Basel III: A Critical Assessment”, in Dewatripont, M and X Freixas (eds), The Crisis Aftermath:
New Regulatory Paradigms, London: CEPR.
Freixas, X and C Laux (2012), Disclosure, Transparency and Market Discipline”, in Dewatripont, M and X Freixas (eds), The Crisis Aftermath: New Regulatory Paradigms, London: CEPR.
Dewatripont, M and X Freixas (2012), “Bank Resolution: Lessons from the Crisis” in Dewatripont, M and X Freixas (eds), The Crisis Aftermath: New Regulatory Paradigms, London: CEPR.
The crisis and the future of the banking industry
About the author
Xavier Freixas (Ph D. Toulouse 1978) is Professor at the Universitat Pompeu Fabra in Barcelona (Spain) and Research Fellow at CEPR. He is also Chairman of the Risk Based Regulation Program of the Global Association of Risk Professionals (GARP).
He is past president of the European Finance Association and has previously been Deutsche Bank Professor of European Financial Integration at Oxford University, Houblon Norman Senior Fellow of the Bank of England and Joint Executive Director Fundación de Estudios de Economía Aplicada FEDEA), 1989-1991, Professor at Montpellier and Toulouse Universities.
He has published a number of papers in the main economic and finance journals (Journal of Financial Economics, Review of Financial Studies, Econometrica, Journal of Political Economy,…).
He has been a consultant for the European Investment Bank, the New York Fed, the ECB, the World Bank, the Interamerican Development Bank, MEFF and the European Investment Bank.
He is Associate Editor of Journal of Financial Intermediation, Review of Finance, Journal of Banking and Finance and Journal of Financial Services Research.
His research contributions deal with the issues of payment systems risk, contagion and the lender of last resort and the He is well known for his research work in the banking area, that has been published in the main journals in the field, as well as for his book Microeconomics of banking (MIT Press, 1997), co-authored with Jean-Charles Rochet.
1 Introduction
When the dust settles and the final numbers are tallied up, it should be of no surprise if the massive support provided in the (ongoing) crisis to banks and other financial institutions – directly in the form of assistance from governments and central banks, and indirectly through support from international organisations, including to sovereigns under stress – has meant that taxpayers, especially in Europe, have engaged in the largest cross-border transfer of wealth since the Marshall Plan. The crisis has also shown that the ad hoc solutions typically used to deal with failed globally systemically important financial institutions (G-SIFIs)1 lead to much turmoil in international financial markets and worsen the real economic and social consequences of crises.
Importantly, events have made abundantly clear (again) that, for all the efforts invested in the harmonisation of rules and agreements to share more information, supervisors had little incentive to genuinely cooperate before the crisis and did too little to help prevent the weaknesses and failures of many G-SIFIs. These facts, together with the ongoing turmoil in Europe and elsewhere, remind us of the high costs from not having a system that can effectively and efficiently deal with G-SIFIs under stress.
A better approach to dealing with G-SIFIs is therefore sorely needed. Many policy efforts are underway (by individual countries, the Basle Committee on Banking
1 While it is hard to define exactly what a G-SIFI is, and there can obviously not be a final list, the FSB (2011) lists 29
“G-SIFIs” for which certain resolution-related requirements will need to be met by end-2012.
Stijn Claessens
IMF, University of Amsterdam, and CEPR