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The crisis aftermath: new regulatory paradigms

The CEPR e-book explores the origins of excessive risk-taking in the banking industry. It provides the analytical ammunition required to examine regulatory policy at a time when it is undergoing a metamorphosis.

Publication
30 March 2012
Centre for Economic Policy Research 2012
Source: Centre for Economic Policy Research

>  Publication/report produced as part of the project ‘Politics, Economics and Global Governance: The European Dimensions’ funded by the European Commission’s 7th Framework Programme for Research.

Editors:
Mathias Dewatripont, Université Libre de Bruxelles and CEPR
Xavier Freixas, Universitat Pompeu Fabra and CEPR

Authors:
Thorsten Beck, European Banking Center, Tilburg University
Diane Coyle, University of Manchester and CEPR
Mathias Dewatripont, Universite Libre de Bruxelles and CEPR
Xavier Freixas, Universitat Pompeu Fabra and CEPR
Paul Seabright, Toulouse School of Economics and CEPR

Summary:

The current crisis and its high social cost have shattered the confidence of economic agents in the banking system and questioned the capacity of financial markets to channel resources to their best use. While it is essential for the well functioning of economic activity that financial institutions do take risk, the decisions taken by financial intermediaries have proven ex post to be excessively risky. So, what was wrong with financial regulation? How were overoptimistic expectations, short termism and inaccurate risk models implicitly encouraged?

The publication is devoted to exploring the general issue of the origins of excessive risk-taking in the banking industry. In doing so, it will provide the analytical ammunition required to rigorously examine regulatory policy at a time when it is undergoing a complete metamorphosis.

Editors conclusion:

The crisis has challenged regulatory authorities all over the world, forcing them to improvise, think ‘out of the box’ and implement unorthodox microprudential and macroprudential policies. From this a number of lessons have been drawn that lead to our main policy conclusions.

First, it is efficient to define a bank-specific bankruptcy code able to cope with the specificities of such bankruptcies. The lesson learnt from Lehman’s bankruptcy is that a bank bankruptcy code should allow every investor to fully understand the risks they are bearing. This allows a move to a speedy resolution that decreases uncertainty as well as the liquidity freeze associated with bankruptcy and therefore limits contagion. By defining an efficient bankruptcy procedure the social cost of bank bankruptcies is reduced which is the raison d’être of banking regulation.

Once the bankruptcy code is in place, contingency planning is essential. If they are part of banking regulation, contingent convertibles allow for an increase in bank capital in case of bank-specific or systemic trouble. Similarly, living wills (as required by UK regulatory authorities) simplify the liquidation of bank assets and reduce bankruptcy costs.

Of course, the issue is more involved when we refer to global institutions, as bankruptcy extends over different legal constituencies implying possible conflicts of rules. The coordination of these bankruptcy procedures should be planned in advance, knowing that when the bank is in distress, MoUs are not enforceable and only perfectly clear-cut commitments will be acceptable in the face of taxpayer pressure. From that perspective, the European Union has appeared in the light of the crisis as a particularly fragile structure that requires urgent changes. Fortunately the recent decisions of the Council meeting indicate that this is the road that may be followed. Still, we would advocate the centralisation of both resolution and deposit insurance mechanisms, so as to provide more credible discipline for banks and legal certainty for depositors over Europe.

Contingent convertibles and contingent capital will be a definite improvement upon a framework where the basic externality has already been contained. In addition, Basel III new capital rules will obviously go in the right direction. Yet, to conclude, let us stress that because the origin of banking regulation is the social cost of bank bankruptcy, the first point where regulation should act is in decreasing the externalities generated by such bankruptcies by defining a specific, well-designed bankruptcy code.

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