Preparing for the Next Financial Crisis 9781138594692, 9781138594708, 9780429488658

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PREPARING FOR THE NEXT FINANCIAL CRISIS

The ramifications of the Global Financial Crisis, which erupted in 2007, continue to surprise not only the general public but also finance professionals, economists, and journalists. Faced with this challenge, Preparing for the Next Financial Crisis goes back to basics. The authors ask: what do theory and empirical observations tell us about the causes and the consequences of financial crisis and instability? In what has become an increasingly complex financial world, what lessons can we learn from economic policies, which have been implemented, and research, which has developed extremely rapidly in recent years, so as not to repeat past mistakes? In this comprehensive review of the literature, which is both complete and balanced, the authors highlight the points of consensus among economists and policymakers. They assess the capacity of economic policies and institutions in limiting the cost of financial instability. In conclusion, they ask if the financial system has become safer, in the light especially of the Covid-19 Global Crisis. Ten years after the GFC crisis, this is a timely review of the reform agenda, the progress made, and the areas where further changes need to be made to address new risks and challenges. Olivier de Bandt, who holds a PhD from the University of Chicago, is an economist and researcher associated with the University of Paris-Nanterre, where he has been teaching banking and financial economics at graduate level. He is an associate editor of the Journal of Financial Stability. Françoise Drumetz and Christian Pfister are also economists. They teach the Financial Stability course in the Sciences Po School of Public Affairs (Paris).

Contemporary Issues in Finance

An Introduction to Cryptocurrencies The Crypto Market Ecosystem Nikos Daskalakis and Panagiotis Georgitseas Preparing for the Next Financial Crisis Olivier de Bandt, Françoise Drumetz and Christian Pfister

For more information about this series, please visit www.routledge.com/ Contemporary-Issues-in-Finance/book-series/CONTEMPFIN ­ ­ ­ ­

PREPARING FOR THE NEXT FINANCIAL CRISIS

Olivier de Bandt, Françoise Drumetz and Christian Pfister

First published 2021 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN and by Routledge 52 Vanderbilt Avenue, New York, NY 10017 Routledge is an imprint of the Taylor & Francis Group, an informa business © 2021 Olivier de Bandt, Françoise Drumetz and Christian Pfister The right of Olivier de Bandt, Françoise Drumetz and Christian Pfister to be identified as authors of this work has been asserted by them in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data A catalog record has been requested for this book ISBN: 9781138594692 (hbk) ISBN: 9781138594708 (pbk) ISBN: 9780429488658 (ebk) Typeset in Bembo by codeMantra

CONTENTS

Preface

1

xiii

Introduction

1

Notions 1.1 Financial stability 4 1.2 Financial fragility, liquidity, and leverage 6 1.2.1 Definitions 6 1.2.2 Theoretical underpinnings 7

4

1.2.1.1 The Diamond and Dybvig model 8 1.2.1.2 Subsequent developments 10

1.3 Safe assets 12 1.4 Bubbles and contagion 14 1.4.1 What is a bubble? 14 1.4.2 Contagion or financial integration? 16 1.5 Moral hazard and too big to fail 17 1.5.1 Moral hazard and time consistency 18 1.5.1.1 Origin of moral hazard 18 1.5.1.2 Consequences of moral hazard for financial stability 19

1.5.2 Concentration of the financial industry and TBTF 19 1.5.2.1 Financial concentration 19 1.5.2.2 TBTF 20

1.6 Systemic risk 21 1.6.1 Definition of systemic risk 21 1.6.2 Sources of systemic risk 22 1.6.2.1 Banking activities 23 1.6.2.2 Financial markets 26 1.6.2.3 Payment systems 27

vi

Contents

2 Financial cycles and crises 2.1 Finance and growth 33 2.1.1 Finance matters for growth 33 2.1.2 Too much finance harms growth 34 2.2 Financial cycles 35 2.2.1 Measuring financial cycles 36 2.2.2 Drivers of financial cycles 37

33

2.2.2.1 Securitization 37 2.2.2.2 Shadow banking 39 2.2.2.3 Run-prone funding patterns 42

2.2.3 Predicting financial cycles 43 2.3 Crises 46 2.3.1 Empirical approaches 46 2.3.2 Theoretical approaches 48 2.3.3 Recent developments 49

3 International dimensions of financial stability 3.1 A global financial cycle? 56 3.1.1 Definition of global financial cycles 56 3.1.2 Do global financial cycles exist? 57 3.2 The Euro area crisis and financial fragmentation 58 3.2.1 A competitiveness crisis, a sovereign debt crisis, a banking crisis 58 3.2.2 Financial fragmentation 61 3.3 International capital flows and financial stability in emerging countries 64 3.3.1 Benefits and challenges of financial globalization 64 3.3.2 Policy options to absorb the impact of international capital flows 65

55

4 Incentives 4.1 Motives and modalities of a public intervention 69 4.1.1 Why intervene? 69

69

4.1.1.1 Normative approach 70 4.1.1.2 Positive approach 71

4.1.2 How to intervene? 72 4.1.2.1 Setting of constraints 73 4.1.2.2 Acting on incentive schemes 74 4.1.2.3 What works best? 74

4.2 Market discipline and transparency 75 4.2.1 Credit rating agencies 75 4.2.2 Accounting standards 77 4.2.2.1 Valuation at historical cost or at fair value 78 4.2.2.2 Perverse incentives? 81

4.2.3 Corporate governance in financial institutions 83

Contents vii

4.2.3.1 Specificity of financial corporate governance 83 4.2.3.2 Importance of governance 84

4.3 Taxation 85 4.3.1 Financial transactions tax 85 4.3.1.1 Motives 85 4.3.1.2 Empirical studies and measures recently adopted 87

4.3.2 Financial activities tax 89 4.3.2.1 Motives 89 4.3.2.2 Implementation 90

4.4 Compensation 91 4.4.1 Level and structure of compensation 92 4.4.1.1 Data 92 4.4.1.2 Interpretation 93

4.4.2 Suggested intervention 94 4.4.3 Measures adopted 95

5 Constraints 5.1 Institutions 103 5.1.1 Deposit insurance 103 5.1.1.1 Benefits and costs of deposit insurance 103 5.1.1.2 Developments in deposit insurance systems since the GFC 105

5.1.2 Limitations of the scope of financial activities 106 5.1.2.1 5.1.2.2 5.1.2.3 5.1.2.4

Benefits and drawbacks of universal banking 106 Segmentation and limitation of banking activities 110 Measures taken or proposed since 2008 111 Issues related to regulation of the shadow banking system 116

5.2 Practices in financial markets 118 5.2.1 Short selling 118 5.2.1.1 Theory 120 5.2.1.2 Empirical evidence 121 5.2.1.3 Regulation 122

5.2.2 High-frequency trading 123 5.2.2.1 Presentation 123 5.2.2.2 Concerns 124

5.2.3 Exchange-traded funds 126 5.2.4 Reuse and rehypothecation of collateral 128

5.3 Financial market infrastructures 130 5.3.1 Role 130 5.3.1.1 Benefits and costs 130 5.3.1.2 Risk management 131

5.3.2 Concerns 132 5.3.2.1 Risk concentration and interconnectedness 132 5.3.2.2 Risk transmission 133

5.3.3 Regulation 134 5.3.3.1 Supervision and definition of standards 134 5.3.3.2 Other measures proposed 134

103

viii

Contents

6 Capital and liquidity standards 6.1 Costs and benefits of capital and liquidity requirements 143 6.1.1 Main issues 143

142

6.1.1.1 Impact on financial intermediation 143 6.1.1.2 Impact on output and credit supply 145 6.1.1.3 Reduction in the cost of crisis 146

6.1.2 Expected impact of regulatory changes 149 6.1.2.1 Differences in approach 150 6.1.2.2 Differences in assessment 151

6.2 Basel I, Basel II, and procyclicality 151 6.2.1 Basel I 152 6.2.2 Basel II 153 6.2.2.1 Main features of Basel II 153 6.2.2.2 Criticisms addressed to Basel II 155

6.3 Basel III 157 6.3.1 Risk-weighted capital ratios 157 6.3.1.1 6.3.1.2 6.3.1.3 6.3.1.4

The strengthening of qualitative requirements for capital 158 The strengthening of quantitative requirements for capital 159 Credit risk 160 Market and counterparty risk 161

6.3.2 Leverage ratio 162 6.3.2.1 Arguments in favour of the return to a simple measure 163 6.3.2.2 Implementation and impact 163

6.3.3 Liquidity ratios 165 6.3.3.1 Liquidity coverage ratio to regulate liquidity at a one-month ­ horizon  165 6.3.3.2 Net stable funding ratio to regulate maturity transformation 166 6.3.3.3 Implementation and further impact 166

6.3.4 Interactions across regulatory requirements 167

6.4 Objectives and constraints of banking supervision 168 6.4.1 Role of banking supervision 168 6.4.2 Forms of intervention of banking supervision authorities 168 6.4.2.1  Off-site ­ supervision  169 6.4.2.2  On-site ­ inspections  171 6.4.2.3 Assessment of Pillar II requirements 172

6.4.3 Financial stability depends on effective prudential supervision 173 6.5 The Solvency II directive for insurance in Europe 174 6.5.1 New quantitative prudential rules 175 6.5.1.1 A new accounting framework to assess the solvency of insurance and reinsurance companies 175 6.5.1.2 New prudential requirements 175

6.5.2 Qualitative requirements have been strengthened 176 6.5.3 Implementation and preliminary assessment of impact 176 6.5.3.1 Implementation of solvency II regulation 176 6.5.3.2 Preliminary assessment of the impact of Solvency II regulation 177

6.5.4 The review of Solvency II 179

Contents ix

7 Crisis management and resolution of financial institutions 7.1 Definition of financial contracts 190 7.1.1 Bailout 191 7.1.2 Voluntary exchange 192 7.1.3 Contingent capital 192

188

7.1.3.1 Threshold 193 7.1.3.2 Conversion rate 194

7.2 Internal bail-in 195 7.2.1 Objectives 195 7.2.2 Implementation 196 7.2.2.1 Scope 196 7.2.2.2 Trigger 197

7.2.3 Impact on financing costs 197 7.2.4 Limitations 198 7.2.4.1 Contagion risk from bail-in and the need to exclude retail deposits 198 7.2.4.2 Higher legal costs 200 7.2.4.3 Spillover risk 200

7.3 Resolution of financial institutions 201 7.3.1 New objectives 201 7.3.1.1 Respond to crisis situations by giving powers to a resolution authority 201 7.3.1.2 Generate financial resources while protecting public finance by involving the private sector 203

7.3.2 Differences between EU and the US 206 7.3.3 Assessment of resolution reforms 206 7.3.3.1 Effectiveness 207 7.3.3.2 Impact 208

7.3.4 Cross-border resolution 209 7.4 Calibration of TLAC 211 7.4.1 Objectives of TLAC 211 7.4.2 Requirements 212 7.4.3 Impact 212 7.4.4 Transposition in EU: MREL 213

8 Macroprudential policy 8.1 Objectives 218 8.1.1 The role of macroprudential policy 219 8.1.1.1 The need for a macroprudential approach 219 8.1.1.2 The complementary role between micro and macroprudential policy 220

8.1.2 The definition of the final objective 222 8.2 Indicators 222 8.2.1 Indicators of the financial cycle 222 8.2.1.1 Types of indicators 223 8.2.1.2 Relevance of indicators 223

8.2.2 Measurement of systemic risk 225

218

x

Contents

8.2.2.1 Measures available 225 8.2.2.2 Assessment 232

8.2.3 Role of stress tests 233 8.2.3.1 Main principles of stress tests 234 8.2.3.2 Strengths and weaknesses of stress tests 236

8.3 Intermediate objectives and instruments 238 8.3.1 A plurality of intermediate objectives and instruments 238 8.3.1.1 Intermediate objectives 238 8.3.1.2 Macroprudential instruments 238

8.3.2 Effectiveness and limits 245 8.3.2.1 Principles of evaluation of instruments 245 8.3.2.2 Applications 245

8.4 Questions related to the implementation of macroprudential policies 248 8.4.1 Communication and responsibility 248 8.4.2 International coordination 249 8.4.3 Statistical information needs 250 9 Economic policies and financial stability 9.1 Monetary policy 259 9.1.1 Levers and constraints in crisis situations 259

259

9.1.1.1 Lender of last resort 259 9.1.1.2 Relationship with fiscal policy 262

9.1.2 Interactions between monetary policy and financial stability 264 9.1.2.1 Has monetary policy been a source of financial instability? 264 9.1.2.2 Interactions between monetary policy and macroprudential policies 267 9.1.2.3 Which consequences for the strategy and the conduct of monetary policy? 268

9.2 Fiscal policy 271 9.2.1 A two-way link between fiscal policy and financial stability 271 9.2.2 How can the loop be loosened? 273 9.3 Structural policies 274 9.3.1 Tax policy 274 9.3.1.1 Tax policy and housing 275 9.3.1.2 Tax policy and debt finance 276

9.3.2 Housing policy 278 9.3.3 Competition policy in the financial sector 279

10 Institutions 10.1 General issues 287 10.1.1 Architecture 288 10.1.1.1 Do we need one or more supervisors? 290 10.1.1.2 What role for the central bank? 291

287

Contents xi

10.1.2 Governance 294 10.1.2.1 Capture and the revolving door 294 10.1.2.2 Independence and accountability 296

10.2 International aspects 299 10.2.1 Institutions 300 10.2.1.1 Groups of countries 300 10.2.1.2 International monetary fund 300 10.2.1.3 Bank for international settlements and associated institutions 305

10.2.2 Extensive reforms or improvements to the existing framework? 306 10.2.2.1 Comprehensive reforms 306 10.2.2.2 Improvements to the existing framework 309

10.3 European aspects 313 10.3.1 Economic aspects 313 10.3.1.1 Risk pooling 313 10.3.1.2 Enactment of rules 318

10.3.2 Financial system aspects 320 10.3.2.1 The European system of financial supervision 321 10.3.2.2 Banking union 322

11 Emerging risks and new challenges 11.1 The global Covid-19 crisis of 2020 333 11.1.1 The second global crisis of the twenty-first century? 334 11.1.1.1 11.1.1.2 11.1.1.3 11.1.1.4

The sanitary crisis 334 The liquidity crisis (March/April 2020) 335 Consequences for financial institutions 336 Potential long-term financial stability consequences of the crisis 337

11.1.2 Policy responses 337 11.1.2.1 11.1.2.2 11.1.2.3 11.1.2.4

Fiscal and monetary policies 337 Prudential regulation 339 Responses by market authorities 340 Responses by international and European institutions 340

11.2 New risks 341 11.2.1 Cyber risk 341 11.2.1.1 Definition 341 11.2.1.2 Costs 342 11.2.1.3 Policies 342

11.2.2 Crypto assets 344 11.2.2.1 Definition 344 11.2.2.2 Risks and responses 346

11.2.3 Climate change related risks 348 11.2.3.1 Definition 348

11.2.3.2 Policy responses 351

11.3 New challenges 352 11.3.1 The feedback loop between inequality, financial stability, and populism 352 11.3.1.1 Inequality and financial stability 353 11.3.1.2 Inequality and macroprudential policies 354

333

xii

Contents

11.3.2 Population ageing, sovereign debt and financial stability 355 11.3.3 Complexity in banking and finance 356 11.3.3.1 Definition 356 11.3.3.2 Implication of complexity for financial stability 357 11.3.3.3 Evolution over time and policy responses 358

Index

365

PREFACE

Financial stability is a topic which is central to the socio- economic well-being of societies. Indeed, as documented in the famous Reinhart-Rogoff book, financial crises are particularly long and deep. Preventing them, or dealing with them if they could not be avoided, is of crucial importance for policymakers. On the other hand, the intrinsic fragility of the banking sector, which originates in their maturity transformation and liquidity creation, makes such prevention hard. For over a century now, policymakers have struggled to combine financial stability (and in particular the absence of bank runs) with the avoidance of bailouts (whose anticipation leads to moral hazard) and the search for a productively efficient banking sector. By the end of 2019, it is fair to say that these three objectives had not been fully secured, especially in Europe (the US picture being more satisfactory): even if the situation is clearly better than in 2007–2008, many banks had less than stellar capitalization and weak profitability, due to persistently low interest rates (and the zero lower bound problem), low GDP growth, overcapacity and emerging competition from fintech and big tech. The book by Olivier de Bandt, Françoise Drumetz and Christian Pfister explains in a very detailed, precise and balanced way how we got there. It is a real ‘tour de force’, since it manages to: • •

•

Rigorously define the various concepts underlying financial stability and financial crises. Discuss the principles behind liquidity and solvency regulation, the key elements of resolution, and the debates around accounting, activity restrictions, or stress tests, to take just some of the topics covered. Compare banking with other financial institutions, like insurance, shadow banking, or market finance more generally.

xiv Preface

•

•

•

•

•

Look at the interaction between financial regulation, including its macroprudential component, and standard macroeconomic policies, to analyse systemic crises and contrast them with microprudential regulation and supervision. Summarize in each case the theoretical as well as empirical economic literature, with its elements of consensus and of disagreements, as well as its associated degrees of relative uncertainty. Add the rich historical dimension, including the evolving institutional architecture of such markets and policy, all this while highlighting differences between jurisdictions. Zoom in on regulatory and supervisory developments across specific time periods, for example the various stages of the Basel framework, an illuminating case study of worldwide governance. Finally, consider the ‘political economy’ dimension of regulation, supervision, and crisis management, detailing policymakers’ incentives to balance safety and soundness considerations with the need to enhance credit to the real economy and economic growth.

While this wide-ranging book seems like a must-read for anybody interested in academic and policy analyses of the topic, it is fair to ask: how much of this historical knowledge is going to be made ‘obsolete’ by the new ‘Covid crisis’, which at this point only started six months ago and whose course is still very much to be written? The answer to this question is undoubtedly: “not much at all, in fact quite the contrary”. Indeed, beyond the well-known maxim that “those who ignore history are condemned to experience it again”, financial stability concerns have become even more relevant with the Covid-19 crisis. This is because all existing challenges have become more acute: interest rates could stay low for longer, the crisis is accelerating the trends towards digitalization which favour fintechs and big tech, and of course the sharp recession, even if it turns out to be V- shaped (which is far from guaranteed), will significantly hurt bank solvency and profitability and the need to shrink the sector. The key questions will then be: will financial stability hold during the crisis? And will the regulatory architecture emerge stronger or weaker from this crisis? In particular, it will be very interesting to see whether regulatory standards will be maintained, up to the drawing down of regulatory buffers, meant to happen in recessions, or instead be relaxed further in order to encourage lending. And whether this will be done transparently or through relaxed accounting standards as far as non-performing loans are concerned. Such a relaxation could be very dangerous, it would be better to ‘bite the bullet’ and accept to use public money if it is needed to clean up the sector. Such a strategy could be useful especially in Europe, whose banking sector is relatively weak. But this would mean temporarily opting out of the strict no-bailout rule of the European Banking Recovery and Resolution Directive in order to put the sector on a sustainable, stronger footing.

Preface  xv

In any case, reading this book is an excellent instrument to access the broad principles and evidence needed to come to an informed opinion about these challenging but all-important issues. Mathias Dewatripont Professor of Economics, Université libre de Bruxelles (Solvay Brussels School and ECARES) Honorary Vice- Governor, National Bank of Belgium

INTRODUCTION

The repetition of crisis events (the Great Financial Crisis in 2007, the euro area sovereign debt crisis, the recent shock caused by the Covid-19 pandemic) and the fragilities in the financial systems (over-indebted sovereigns, high real estate prices, volatile capital flows…) are sources of concern not only for the public but also for finance professionals and economists. Faced with this challenge, “Preparing for the next financial crisis” goes back to the fundamentals: what do theory and empirical observations have to tell us about the causes and the consequences of financial instability? To which extent do economic policies, which have been implemented, and research, which has developed extremely rapidly in recent years, help preserve financial stability in an increasingly complex financial world? The book gives access to a proliferating literature and does not hesitate to review technical subjects essential for a good understanding of the issues at stake. It is unique in blending insights on regulation and its economic rationale, based on the most recent research, as well as emerging issues (cyber- security, digital assets, etc.). The book is aimed first at economics students as well as scholars and researchers in this field. Due to its clarity of exposition, it is also destined to a wider audience (e.g. financial analysts, market economists, etc.) who, in the exercise of their profession, are interested in the challenges of financial stability. It will also interest financial supervisors and regulators who want to confront their own experience to the findings of economic research in their field of expertise. * *** *

2 Introduction

The book is in 11 chapters Chapter 1 (“Basic Concepts”) starts by giving and justifying our definition of financial stability. The basic concepts that will be used in the remainder of the book (financial fragility, liquidity and leverage, moral hazard and TBTF, safe assets, bubbles and contagion, and systemic risk) are then presented. Chapter 2 (“Financial Cycles and Crisis”) recalls that financial activity evolves according to medium-term waves, whose determinants are investigated (financial innovation, regulatory arbitrage…). It then looks more deeply into crisis episodes and attempts to characterize them. Chapter 3 (“International Dimensions of Financial Stability”) analyses the euro area sovereign debt crisis and its impact on financial fragmentation as well as international financial spillovers and the role of international capital flows for financial stability in emerging countries. Chapter 4 (“Incentives”) first asks, from a general point of view, why there is a public intervention to safeguard financial stability in the first course. It then compares, from an empirical point of view, policies and instruments relying on incentives or on constraints, and their respective effectiveness in preserving financial stability. The various instruments, which are analyzed under the heading of “incentives”, are market discipline and transparency, taxation, and remunerations. Chapter 5 (“Constraints”) distinguishes between constraints on financial institutions (deposit insurance, licensing policies, and separation of activities) and constraints on the working of financial markets (constraints on short selling, high-frequency trading, Exchange-Traded-Funds (ETFs), and reuse of collateral, as well as the organization of market infrastructures). Chapter 6 (“Liquidity and Solvency Standards”) explains in detail the economic rationale and design of micro-prudential regulation based on minimum risk management standards to be met by individual institutions. We first assess the cost of liquidity and capital requirements in terms of foregone economic growth versus avoidance of financial crises, and then examine the different instruments adopted in the framework of Basel I, Basel II, and Basel III. We also include a presentation of the supervision of banks and insurance companies. Chapter 7 (“Resolution and Crisis Management”) assesses the new developments associated to bail in and resolution as well as additional requirements (in terms of Total Loss Absorbing Capacity). Chapter 8 (“Macro-Prudential Policies”) considers, in turn, the role, indicators, and instruments of macro-prudential policies and their developments, notably since the GFC, as well as the issues they raise. Chapter 9 (“Economic Policies and Financial Stability”) refers to the role monetary policy, fiscal policy, and structural policies to ensure financial stability. Chapter 10 (“Institutions”) presents, in turn, issues related to the role and design of institutions in charge of financial stability in general, which first arise at the domestic level, then issues at the international level, and finally European aspects, which are specific.

Introduction  3

Chapter 11 (“Emerging Risks and New Challenges”) includes a first section providing a very preliminary assessment of the consequences of Covid-19 for financial stability, and considers also other emerging risks (cyber risk, cryptoassets, climate change) as well as new challenges for financial stability (inequality, population ageing, and financial complexity).

1 NOTIONS

This introductory chapter presents the main notions that will be used in this book and brings together those most tightly linked: – – – – – –

Financial stability (1.1), Financial fragility, liquidity, and leverage (1.2), Safe assets (1.3), Bubbles and contagion (1.4), Moral hazard and “too big to fail” (TBTF) (1.5), Systemic risk (1.6).

1.1 Financial stability In monetary economics, there is a widely accepted definition of price stability: the prices which should be stabilized (those of goods and services) are known; their changes are measured in a precise and transparent manner (using consumer price indices); those changes can be associated with effects on social welfare within a benchmark theoretical framework (the New Keynesian model). In this framework, the central bank uses instruments (a short-term interest rate, asset purchases) to pursue an optimal inflation target corresponding to price stability (Drumetz et al., 2015). In financial economics, there is no such consensus on the definition of financial stability. However, research and literature reviews, including PadoaSchioppa (2003), Allen and Wood (2006), and Borio and Drehmann (2009), provide some common elements of definition for financial stability: –

This definition is of a negative nature, as financial stability is characterized by the absence of instability. Financial stability is thus defined in a fuzzy manner. This is all the more valid as there are indeed measures of financial stability but no generally recognized measure of it (Borio, 2009).

Notions  5

–

–

–

In most cases, the definition of financial stability that is retained is a broad one, as it encompasses the whole financial system (intermediaries, markets, and infrastructure). It is also a demanding definition, as it assigns to the financial system a high level of achievement in fulfilling its main functions (processing of payments; collection and channelling of savings to investment; pricing, transfer, and management of risk; maturity transformation). This broad and demanding definition, combined with a fuzzy definition, can induce a pathological approach (risks are everywhere) and bias policies towards overambitious objectives, supported by overextended instruments. The definition refers to a state (being stable) rather than to a property (reverting to a state of equilibrium or to an equilibrium path after the financial system has been hit by a shock). Conversely, in monetary economics, price stability is not considered just as a state but also, via the roles of expectations and credibility, as a property enabling inflation when the economy is hit by a shock, not to evolve in a persistent manner, but rather to revert towards the central bank’s inflation target. As in the case of price stability, the definition of financial stability aims at casting light on the costs, in terms of social welfare or lost production, of deviations from a stability objective. However, due to the lack both of a clear definition of financial stability and of a benchmark theoretical framework that would ex ante help justify, with a relatively high degree of certainty, using a given instrument with a given vigour, those costs can usually be ascertained only ex post once an episode of financial stress has occurred. This implies that in most cases, policymakers will have to behave as “risk managers” rather than “objective targeters”.

For lack of a better definition, the definition of financial stability which is retained in this book is negative and refers to a state. However, it is neither broad nor demanding. As financial crises which have high costs in terms of social welfare are in most cases banking crises (Reinhart and Rogoff, 2009), the scope of financial stability is defined in a relatively narrow manner and focuses on the banking sector without being restricted to it. Above all, and consistently with the adoption of a negative definition, the objective assigned to financial stability policies is taken to be limiting the costs of financial crises (Chapter 2) rather than preserving at every moment an imprecisely defined state of financial stability. Limiting the scope of financial stability does not prejudge the nature of shocks, which can originate in financial or real estate markets on which banks have direct or indirect exposures. Shocks can also hit other financial intermediaries, such as insurance companies, which play an important role in the financing of banks or other economic agents, such as firms and governments, banks lend to. Also, limiting the scope of financial stability should allow for a better allocation of responsibilities, as regards the respective roles of both incentives and constraints private agents are faced with (Chapters 4 and 5) and those of policies and institutions (part 3). In particular, the overburdening of policies, limiting their efficiency, could be avoided. Indeed, if financial development contributes

6 Notions

positively to economic growth (Chapter 2), principally by improving the allocation of capital, entrusting official agencies with very wide assignments seems to contribute to the deterioration of that allocation.

1.2 Financial fragility, liquidity, and leverage We first define the notions of financial fragility, liquidity, and leverage (1.2.1), and then elaborate on their theoretical underpinnings (1.2.2).

1.2.1 Definitions The notion of “financial fragility” can be used with two meanings: •

•

The first meaning of “financial fragility” focuses on credit demand and relies on the notion of “credit cycle” (Kindleberger, 1978) or on the “financial instability hypothesis” (Minsky, 1986, 1995). In that framework, financial fragility is an intrinsic feature of capitalism. Private agents, who are immersed in a competitive environment, “get carried away” by their “animal spirits” and adopt herd behaviour and extrapolative expectations, which make them both forget past crises and underestimate risk, in particular during periods of rapid innovation. Firms then sharply increase their indebtedness (they get more leveraged), while interest payments absorb a growing part of their cash flows (they get more liquidity- constrained, all the more so as they take on debt mainly at short-term durations). As a result, debt servicing gets more and more vulnerable to an economic slowdown. When this slowdown eventually occurs, the pro- cyclical evolution of risk premia included in interest rates and the behaviour of private agents, who all try to reduce their leverage and sell assets at fire sale prices in order to get liquidity, can lead to a debtdeflation combining falls in output and prices (Fisher, 1933). Defining a fire sale as a forced sale on a dislocated market, Shleifer and Vishny (1992, 2011) apply this notion to markets plagued by adverse selection (1.2.2.2). Following a shock hitting a specific sector in the economy, sellers (e.g. banks trying to sell securitized loans) do not find counterparties among their colleagues who are exposed to the same shock. The assets are bought by non- experts who, due to their lack of expertise, accept to hold those assets only if they can purchase them at a deep discount vis-à-vis their pre- crisis prices. A similar pattern of fire sales in a bust stage of the business cycle can also arise for household credit (Mian and Sufi, 2018). This meaning of “financial fragility” fits well both within partial equilibrium approaches and with the experience and narratives of market participants, in particular during episodes of financial stress. In its second meaning, “financial fragility” stems from market imperfections (“financial frictions”) which are reflected in the formulation of contracts between private agents (Bernanke and Gertler, 1989; Calomiris, 1995;

Notions  7

Carlstrom and Fuerst, 1997). This meaning fits better into general equilibrium approaches (Goodhart et  al., 2006). Along those lines, Calomiris (1995) draws a distinction between “financial shocks”, defined as disruptions of the real economy which originate from financial markets and are more likely to take place in periods of rapid financial innovation, and “financial propagation”, which refers to the way contracts, markets, and financial intermediaries can aggravate shocks which take place elsewhere. He identifies four financial propagators. The first one is the cash flow constraint, which reflects the fact that because of agency and information costs, internal funds are cheaper than external funds. This increases the sensitivity of firms’ investment to changes in their income (“financial accelerator”), making it more volatile than under the neo-classical assumption, in which firms do not take their sources of financing into account when choosing their investments (Modigliani and Miller, 1958). The second propagator results from balance sheet constraints: as in the first meaning of “financial fragility”, firms which increase their leverage in the expansion stage of the business cycle get exposed to the risk of having to reduce their investments more sharply when faced with a fall in demand. The third propagator complements the second one: if, because of privileged relationships with the borrowing firms, notably those which are small or of a medium size (Petersen and Rajan, 1994), banks can reduce their financing costs, a shock which reduces the net values of banks and of their borrowers can be amplified by banks, which will reduce their loan supply, thus propagating a liquidity constraint in the economy. Finally, the fourth propagator derives from the fact that because of a lack of neutrality of finance as a result of the three first propagators, regulations which create distortions can in turn amplify the financial accelerator. The first meaning of financial fragility leads to viewing competition in the financial sector as a factor of financial instability (Chapter 9) and as a consequence to setting regulations which put direct constraints on financial intermediaries and activities (Chapter 5), whereas the second meaning leads to reviewing the incentives of agents (Chapter 4). However, in both meanings of the concept, liquidity and leverage play a central role. This makes these two meanings rather complementary than substitutable, notably in the analysis of financial cycles and crises (Chapter 2).

1.2.2 Theoretical underpinnings The theoretical underpinnings of the notions of liquidity and leverage relate principally to the first one since the notion of leverage is more a matter of business administration. Furthermore, while the notion of leverage refers in principle to the ratio of non-borrowed capital to total assets, it is commonly used in the wider sense of debt. Regarding the notion of liquidity, as it is used in modern literature on financial stability, its theoretical underpinnings are provided in the

8 Notions

early 1980s, when banks’ activity mainly consisted in the distribution of credit to the economy and investment banking was not as developed as it is currently. As a result of the maturity mismatch in banks’ assets and liabilities, the concern of public authorities was then to protect banks against the risk of runs using such mechanisms as deposit insurance (Bryant, 1980; Diamond and Dybvig, 1983) (1.2.1.1). In order to take the development of banks’ activities in financial markets into account, more recent research has extended Diamond and Dybvig’s approach (1.2.1.2).

1.2.1.1 The Diamond and Dybvig model Diamond (2007) provides a simplified presentation of the original model by Diamond and Dybvig (1983) in which they explain why banks choose to create liquidity, i.e. to issue deposits more liquid than the assets (i.e. loans) they hold, thereby exposing themselves to the risk of runs. As a start, the reason why there is a demand for liquidity from the public must be accounted for. In that regard, an asset is considered as illiquid when the proceeds of its sale at some point in time is lower than the discounted value it can on average yield at a future date. As a consequence, the lower the fraction of the current cash flow in the net future discounted value at the date the investor place themselves, the less liquid the asset.1 Consequently, if an investor does not know when they will wish to liquidate their investment in order to consume, they will demand even more liquidity from the asset they accept to hold as they are more risk-averse. Another reason to demand liquid assets derives from the fact that an entrepreneur may have to finance a highly profitable project at a date prior to the one when the illiquid asset that would have financed it would come to maturity, thus at a date when the sale of that illiquid asset has an opportunity cost (Diamond and Rajan, 2001). In such a setting, banks allow investors to share the liquidation risk of an illiquid asset: deposits can be liquid at better conditions than directly held illiquid assets, in which it is the role of banks to invest. However, if depositors expect the bank to default, because the early liquidation of the banks’ assets would be valued less than its deposits, they run since they know the bank will not be able to reimburse all its customers and thus that only the early withdrawals will be satisfied. In other words, if a depositor fears that other depositors may withdraw their deposits, it is optimal, from their point of view, to withdraw their own deposit (Box 1.1). In Diamond and Dybvig (1983), the expectation of default of a bank thus presents a self-fulfilling character, which relates it to “financial instability hypothesis”. However, information asymmetries also play an important role in their model. In the Diamond and Dybvig (1983) model, in case of a run, the bank may have to demand the repayment of the loans it has granted (this is the case Diamond and Dybvig envisage, even though it is legally impossible in most cases). However, this is likely to disrupt economic activity. Diamond and Dybvig (1983) propose contractual solutions (e.g. the suspension of convertibility). However,

Notions  9

considering that such solutions are likely to be unpopular, they also suggest that the government could provide a deposit insurance (Chapter 5) and that the central bank could intervene as a lender of last resort (Chapter 9) to counter the spreading of bank defaults to the economy, two proposals which are not without consequences in terms of moral hazard (1.5). Another possibility is, however, that banks can protect themselves, at least to a certain extent, from liquidity shocks by keeping a part of their assets liquid and by strengthening their own funds, either ex ante (Chapter 6) or when shocks occur (Tirole, 2011, Chapter 7). In the second case, liquidity is increased and leverage is reduced in banks’ balance sheet.

Box 1.1 The risk of a run by depositors in the Diamond and Dybvig (1983) model In order to grasp the main intuition of the Diamond and Dybvig (1983) model, one often refers to the simplified presentation in Diamond (2007). In such an economy, there are three periods (t = 0, 1, and 2) and two types of agents that differ according to their desire to consume either in period 1 (the agent is said to be of “type 1”) or in period 2 (agents are of “type 2”). Agents individually learn their type (whether they are of type 1 or 2) at the beginning of period 1. This is private information as opposed to the proportion t of type 1 agents in the population, which is public information. There is an illiquid asset which, for an investment of 1 at date t = 0, yields a return of R = 2 at date t = 2. If the investment is liquidated in advance at t = 1, the yield is only r = 1.

At date t = 0, consumers are all identical, the expected utility of the representative consumer is given by the utility of their consumption at each date multiplied by the probability of being one of the two types, namely: EU = tU(C1 ) + (1 − t )U (C 2 ) , with C1 their consumption in period 1 and C 2 their consumption in period 2. Diamond and Dybvig show that if consumers are risk-averse, the bank insures depositors against the risk of being type 1 and of being forced to liquidate the illiquid asset. They consider a mutual bank that maximizes depositors’ utility. The bank offers r1 = 1.28 > 1 in period 1 and r2  = 1.813 < 2 in period 2, hence creating an asset, which is more liquid than the initial asset. The bank offers a return which is higher than what depositors would get if they invested directly in the illiquid asset. Indeed, with t = 0.25 (25 depositors out of 100 are of type 1 and prefer consumption in the first period) and with a utility function of the type U = 1 – (1/c), it is easy to check that depositors’ expected utility is such that: 0.25U (1.28) + 0.75U (1.813) = 0.391  > 0.25U (1) + 0.75U ( 2) = 0.375

10 Notions

However, besides such an equilibrium where the bank meets exactly depositors’ liquidity needs (depositors of type 1 truthfully reveal that they are of type 1, hence receive 1.28, and depositors of type 2 announce their type and receive 1.813 in period 2), there exists another equilibrium. In the latter “panic” equilibrium, depositors of type 2 show up at the bank teller and pretend they are of type 1 in order to withdraw their money as soon as in period 1, hence precipitating the failure of the bank. Formally, the proportion of depositors that withdraw in period 1 is noted as f. Depositors anticipate a value for f, noted as fˆ . One equilibrium is based on self-fulfilling expectations, where f = fˆ . If 79 depositors decide to withdraw their money, the bank goes bankrupt since the bank cannot meet deposit outflows in period 1: 0.79 × 1.28 = 101.2 > 100. However, an ­ expectation of fˆ = 0.99 is not self-fulfilling, while fˆ = 1 is self-fulfilling: if a run is expected to occur with certainty, then the run takes place. In con­ trast, if the run is only anticipated with quasi-certainty ( fˆ = 0.99) but leads anyway to the failure of the bank, then the initial expectation was wrong, hence does not constitute an equilibrium. Nevertheless, the withdrawal of deposits by a small fraction of depositors may not be sufficient to trigger a run: a significant proportion of withdrawals is necessary. Diamond (2007) indicates that the threshold level of withdrawal is such that the yield in

()

( )

1− r fˆ R 1  . 1− fˆ

 period 1 is higher than in period 2; so that r1 > r2   fˆ =  

With

the same parameter values as before, the threshold is such that fˆ > 0.5625. Below that level, individuals of type 2 do not prefer the return supplied to type 1 individuals. A run is triggered following a significant revision in expectations such that almost all depositors observe a signal (for instance, news in the press) and believe that the other depositors will respond to it by withdrawing their deposits.

1.2.1.2 Subsequent developments Within an approach, which can be interpreted as implicitly referring to the functioning of an investment bank, Brunnermeier and Pedersen (2009) distinguish two notions of liquidity: the first one is market liquidity and defines how easily an asset can be traded; the second notion is funding liquidity and defines how easily traders can finance their positions. As pointed out by Tirole (2011), market liquidity refers to the asset side of the bank’s balance sheet, whereas funding liquidity refers to the liabilities side. Indeed, from a trader’s point of view, when liquidity is at its peak under both forms, it should be equivalent to sell an asset or to finance its holding by borrowing or to repurchase it (i.e. sell it and promise to buy it back at an agreed price and a given date). In this approach, any reserve of value which can be used, directly or not, as a means of transactions is considered

Notions  11

as liquid. Money thus loses its specificity. Conversely, Keynes (1936), while referring to “liquidity preference”, defines money as being demanded for transaction and precaution motives, whereas other financial assets are held for a speculation motive. In particular, from the contemporary point of view, Treasury bills are liquidity, at least as long as the situation of public finances is considered as sustainable (Chapter 9). The Government should thus increase its supply of securities when the economy is hit by a substantial liquidity shock, as a high level of uncertainty would then prevent the private sector from meeting its liquidity needs by itself (Holmström and Tirole, 1998). Beyond that, shares of mutual funds, invested in safe assets (1.3), could in normal times substitute for insured bank deposits in making payments (Gorton and Pennachi, 1990). From a financial stability point of view, it is worth noting that there can be “breakdowns” in market liquidity, insofar as asset purchasers may not show up in the market, even if prices adjust downward. In that regard, Brunnermeier and Pedersen (2009) show that fluctuations in funding liquidity and market liquidity amplify each other. In particular, the financing of liquidity providers can dry up when market volatility increases and market liquidity vanishes. This is typically the case in financial crises (Chapter 2). Tirole (2011) mentions three triggers for such breakdowns: •

•

Adverse selection. Akerlof (1970) takes the example of the second-hand car market in which information asymmetries are high as sellers have much better information on assets than potential purchasers do. He shows that the sellers of better-quality products are the first ones to exit the market when a concern about the good functioning of the market makes prices fall. Their withdrawal entails another fall in market prices, provoking the exit of sellers of products of lesser quality and so on until transactions stop (Box 1.2). This example can apply to the securitization market in the Great Financial Crisis (GFC) (Chapter 2). In Akerlof (1970), purchasers are equally uninformed. However, market breakdowns can also occur when there are both informed and uninformed market participants. Dow and Han (2018) show that when specialist (informed) market participants are liquidity-constrained, prices become less informative. This creates an adverse selection problem, decreasing the supply of high-quality assets and lowering valuations by non-specialist (uninformed) investors, who become unwilling to supply capital to support the price. Limits to arbitrage. Those limits can result from an insufficient financial capacity of potential purchasers. Allen and Gale (1994) transpose the Diamond and Dybvig model to the case of financial markets in which consumers wishing to consume in a later period do not possess the cash holdings that would enable them to buy the long-term assets sold by consumers wishing to consume early, whose proportion among all consumers varies randomly. They show that the valuation of long-term assets in the secondary market then settles below its fundamental value: this is referred to as “cash in the market pricing”. This type of situations reminds of the “financial instability hypothesis”. However, Holmström and Tirole (2011) show that institutions can also adopt a predatory behaviour, consisting in hoarding liquidity beyond their own needs in order to purchase long-term assets at lower prices in a later period.

12 Notions

•

Regulatory arbitrage. Tirole (2011) provides several examples, notably the relaxing of accounting standards (Chapter 4) in the GFC which allowed financial institutions to return to historical costs instead of market valuations in certain circumstances. An incentive was thus given to sell assets whose market valuation had increased, in comparison with the prices at which they had been purchased, and to keep those whose market valuation had decreased, thus avoiding to record losses.

1.3 Safe assets Safe assets are not riskless assets. According to Gorton (2017), a “safe asset” is an asset that can be used to transact without fear of adverse selection:2 that is, there are no concerns that the counterparty privately knows more about the value of the asset. And, safe assets can also be used to store value through time. More precisely, Gorton (2017) distinguishes three notions of “safe”: •

•

•

The first notion derives from Diamond and Dybvig (1983). Unless there is a run, bank deposits are safe assets which insure against the risk of early consumption needs (1.2). In Holmström and Tirole (1998, 2011), safe assets are “pledgeable”, i.e. assets with cash flows that are readily verifiable, and which can thus be used to transfer wealth across periods. In Gorton and Pennachi (1990), safe debt can be used without fear of being taken advantage of by privately informed agents: in the words of Holmström (2015), there are “no questions asked” about its face value. Such debt is produced by banks and, according to Dang et al. (2017), banks’ balance sheets must be opaque (Chapter 4) to avoid questions being asked: information about the bank’s assets must be kept secret. This can be achieved if banks make loans to consumers and small businesses, about which acquiring information is costly, whereas large firms borrow in capital markets.

Safe assets can come in different forms: •

•

There are short- and long-term safe assets. Short-term safe assets are best fitted for transaction purposes. They are money (currency and deposits) or money-like (bills). Long-term safe assets can be used as stores of value. Safe assets must be backed in order to be “safe”. This can be done by the government, thanks to its taxation power, in the case of government bonds or publicly insured bank deposits. It can also be done by private agents using collateral such as mortgages, which are themselves backed by property the average value of which does not usually fall very much. Governmentproduced safe debt is safer than privately produced safe debt, to the extent that public finances are seen as sustainable (Chapter 9).

Notions  13

Box 1.2 Adverse selection and the risk of market breakdown In order to illustrate the mechanism of adverse selection uncovered by Akerlof (1970), it is possible to adapt an example introduced by Kreps (1990) to the sector of loan securitization. In this example, banks decide to securitize their portfolio of residential mortgages and to sell them to investors. Loans are gathered into different “pools” (e.g. a portfolio of 100 different individual mortgages). For a given bank, the loans were already granted to individual borrowers, so that one can assume that the quality cannot be improved by the originator: it is exogenous to the bank that securitizes its assets. To simplify, it is also assumed that the characteristics of all pools are identical (initial amount, maturity, etc.). However, pools exhibit different levels of performance as measured by the final return, which depends on the capacity of initial borrowers to meet the contractual obligations in terms of debt services. Only the bank which granted the initial loan possesses such information. As a consequence, there are two types of loan pools. A “good” pool has a value of €300,000 for the final investor and €250,000 for the bank (the difference may reflect a situation where the bank has more investment alternatives, hence has a lower reservation price). A “bad” pool has a value of €200,000 for the investor and €100,000 for the bank. There are twice as many “bad” pools as “good” pools. If final investors could check the characteristics of the pool in detail (if sufficient documentation was available), no problem would occur. “Good” pools would be sold at €300,000 and bad pools at €200,000. If the issuing bank had no private information on the quality of the loan, given that a pool is “bad” with a two-third probability, the expected value of a pool would be €150,000 for the issuer and € 233,000 for an investor. With fixed supply and perfectly elastic demand, the price would settle at €233,000. But this is not the way markets actually work. Akerlof illustrates this mechanism with the market for second-hand cars, which are either of good quality (“peach”) or of bad quality (“lemon”). The bank that securitizes its loan portfolio is in a similar position as the owner of a second-hand car: he knows the value of the portfolio. It is possible to show that the market breaks down if the investor does not receive any information. Indeed, in the case where the market clears at a price above €100,000, all the bad pools are supplied to the market. In contrast, good pools are supplied to the market only if the price clears above €250,000. If the price is posted between €100,000 and €250,000, investors conclude it is necessarily of bad quality and bid for a value of €200,000. If the price is posted above €250,000, investors value the pool at €233,000. As a consequence, the price will clear at €200,000 and only bad pools will be sold: good pools will be excluded from the market since banks find it is not worth assembling pools at such a low price.

14 Notions

As a consequence of their specialness, the returns on safe assets are lower than they would otherwise be: this is called the “convenience yield”. Using the spread between Aaa-rated US corporate bonds and Treasury securities as a measure, Krishnamurthy and Vissing-Jørgensen (2012) estimate this convenience yield was on average 73 points on US Treasury securities over the period 1926–2008. It increases when Treasuries are relatively scarce. According to Bernanke (2005), the main reason behind the deterioration of the US current account over the period 1996–2003 was a “savings glut”, i.e. a general shortage of assets. Caballero et al. (2017) focus on the global shortage of safe assets. This safe asset shortage is driven by the high rate of growth of emerging economies such as China, which do not produce domestic safe assets. In the 2000s, the shortage distorted the incentives of the financial system towards the issuance of privately produced safe assets, such as AAA-rated securitized instruments which played an important role at the start of the GFC (Chapter 2). But the GFC itself, and the euro area sovereign debt crisis that followed (Chapter 10), led to both a rise in demand for safe assets, due to a “flight to safety”, and to a fall in their supply, as mortgage-backed securities and then Greek or Italian public debt were not perceived as safe anymore. Consequently, the real safe rate increased, creating a “safety trap” (i.e. a liquidity trap in which the emergence of an endogenous risk premium alters the connection between macroeconomic policy and economic activity). This resulted from the fact that monetary policy could not push interest rates below the effective lower bound, i.e. a slightly negative nominal interest rate reflecting the cost of holding and storing cash (Caballero and Farhi, 2018).

1.4 Bubbles and contagion Financial crises are often preceded by bubbles, whatever the stage of economic development (Kindleberger, 1978; Reinhart and Rogoff, 2009). These episodes have common characteristics: • •

An increase in the prices of financial and/or real assets well above the change in their risk-adjusted fundamental value, leading to a crash (1.4.1). A propagation to financial markets, domestic or foreign, which can be explained by two competing assumptions (1.4.2): contagion or financial integration.

1.4.1 What is a bubble? Kindleberger (1978) provides a five- stage narrative. In the first stage, the emergence of a new technology or a financial innovation increases profit and/or growth expectations. This leads to a boom stage, characterized by low volatility, credit expansion, and increases in investment. The rise in asset prices is accelerating, beyond what fundamental economic determinants would suggest. In a third stage, known as euphoria, the rise in asset prices becomes explosive. Some

Notions  15

investors are aware that there is a bubble. However, they succeed in selling to a much larger number of less sophisticated buyers, resulting in a sharp increase in the volume of transactions and price volatility. In the fourth stage, when sophisticated investors sell their assets on a massive scale to reduce their position and to take their profits, prices start to fall. In a fifth stage, known as the panic stage, unsophisticated investors try to sell the assets they hold, causing sharp declines in prices, amplified by margin calls and the deterioration of balance sheets. If the bubble is fuelled by credit, its bursting may give rise to a systemic financial crisis (Brunnermeier et al., 2017 and 1.5). These stylized facts reflect in particular the period preceding the GFC during which low interest rates, strong credit, and asset price dynamics prevailed. The literature on financial bubbles (Brunnermeier and Oehmke, 2013) has attempted to formalize this narrative and to identify which frictions may allow bubbles to develop. A rational bubble appears when investors expect the value of an asset to rise, and as long as the bubble does not burst, the price of the asset will rise explosively (Blanchard and Watson, 1982; Shiller, 2000). If buyers expect an increase in prices, it makes sense to buy when prices rise. As prices lose their rebalancing property, the likelihood of the bubble bursting increases. This mechanism may also explain a self- sustaining situation of falling prices or a lasting misalignment of asset prices below their equilibrium level. The presence of informational frictions of delegated investment or of inefficient credit booms can help to sustain bubbles. Informational frictions allow the development of a bubble, in particular if there is a synchronization problem between rational investors (Abreu and Brunnermeier, 2003). Each investor becomes aware at some point that a bubble is forming, but does not know if others are or when they will become aware. The starting point of the bubble and its amplitude are therefore not common knowledge. Moreover, no single investor can, on their own, burst the bubble. In such an environment, each investor is uncertain of the behaviour of others. Therefore, they have an interest in taking advantage of the rise in the price of the asset as long as the bubble persists, thus delaying its bursting. In the context of a synchronization problem, nonfundamental news may trigger sharp price declines, as even relatively insignificant news events may lead investors to synchronize their asset sales (Fair, 2002). Delegated portfolio management can introduce additional frictions such as short-termism or incentives to buy overvalued assets. Fund managers may be more sensitive to short-term asset price movements than to long-term arbitrage opportunities because temporary losses lead to fund outflows (Shleifer and Vishny, 1997). Moreover, fund managers have limited liability, which may induce risk-shifting behaviour. For example, they may have incentives to buy overvalued assets because not trading would reveal to their clients that they have low skill (Allen and Gorton, 1993). Allen and Gale (2000) highlight the role of inefficient credit booms. In their model, investors borrow funds to acquire risky and non-risky assets with the

16 Notions

objective of maximizing the value of their portfolio through leverage. Banks, on the other hand, cannot invest directly in non-risky assets and do not control the allocation that investors will make between the two asset classes. In this model, the equilibrium price of risky assets is higher than would be observed in an economy where funds are invested directly. Consequently, investment in risky assets fuelled by credit may lead to a bubble. Bubbles, which appear as an “anomaly” or a misalignment in relation to the long-term equilibrium, can be compared to another important concept, “contagion”, which evokes even more clearly a “pathological” situation affecting the dynamics of the financial system.

1.4.2 Contagion or financial integration? By reference to the medical field, where it means the transmission of a disease by simple contact, contagion in the financial field corresponds to the particularly rapid and widespread propagation of a shock in the financial system to other parts of the system in proportions or at a faster rate than usually observed. The word “contagion” may be used to depict, for example, the bankruptcy of a bank triggering the bankruptcy of other banks or the collapse of a financial market leading to the paralysis of another market. Therefore, contagion is an important component of systemic risk (1.5). It is the “domino” effect, at the source of negative externalities or of non-linearities, often referred to as “regime change”. An example of a very quick propagation is provided by the subprime crisis in 2007 whose impact on other components of the financial system was seemingly out of proportion with the importance of the subprime market (4% of the overall US mortgage market, according to Brunnermeier and Oehmke, 2013). However, empirically, contagion is difficult to identify. The challenge consists in disentangling it from interdependence (de Bandt and Hartmann, 2000; Dungey and Renault, 2018). Contagion arises if and only if there is a significant increase in cross-market linkages after a shock to an individual country or to a group of countries (Sentana, 2018). It is not simply revealed by the increasing correlation of performance indicators during a crisis period. As stressed by Forbes and Rigobon (2002), in times of crisis rising correlation coefficients are associated with rising volatility. Simple indicators of correlation between asset returns may be biased upward (i.e. in the sense of accepting the contagion hypothesis) and need to be adjusted to correct this bias in order to catch only the part which is not due to rising volatility. Testing with adjusted correlation coefficients for stock market contagion during currency crises in emerging economies and during the 1987 US stock market crash, Forbes and Rigobon (2002) find virtually no contagion, only interdependence. Brière et al. (2012) study 16 crises, which occurred between 1978 and 2010 in developed economies. They conclude that contagion in financial markets is an artefact of globalization, a conclusion consistent with the work of Forbes and Rigobon (2002). However, Dungey and Renault (2018) argue that when contemplating the potential of contagion from a “source” to a “target” market, Forbes

Notions  17

and Rigobon do not take into account the fact that the volatility of the “target” market may change both for reasons associated with the “source” and for idiosyncratic reasons. They propose a new method to identify contagion and conclude that contagion phenomena – during the Asian financial crisis of 1997–1998, between industries in the US stock market in 2007–2008 or in the European sovereign CDS market in 2008–2013 – may be hidden by the Forbes-Rigobon adjustment.

1.5 Moral hazard and too big to fail Just as adverse selection (1.2), moral hazard results from information asymmetries in the principal-agent relationship, i.e. a relationship in which the action of an agent, called the “principal”, depends on the action of another agent, the “agent”, about whom she/he is imperfectly informed. However, in adverse selection, the information imperfection relates to the type of agent (the type of car seller in the example provided in Akerlof (1970), Box 1.2). In moral hazard, the information imperfection relates to the level of effort delivered by the agent. The notion of moral hazard was used first in the economics of insurance, as it appeared that insured motorists drove faster than non-insured motorists or that insured buildings went on fire more frequently than non-insured buildings. However, moral hazard does not necessarily refer to a deliberate fraud on the part of the agent. In the literature on financial stability, just as in its more common use in the media, the phrase rather refers to the notion of an “invitation” to take on more risk. By protecting the agent from the detrimental consequences of their actions, the principal lowers their incentives to monitor her/his risk-taking, thus cancelling, at least partly, the intended benefit from her/his intervention. In the case of financial stability, the principal is in most cases the government and it intervenes in order to protect the economy against financial fragility by creating safety nets (1.2). However, safety nets can in turn create moral hazard in the form of excessive risk-taking. This results from time inconsistency (1.5.1), a notion that originates from game theory and is frequently used in the literature on monetary policy (Drumetz et al., 2015). In the case of time inconsistency, the promise of an agent to give up an action in advance (e.g. the promise of the government not to bailout a bank on the brink of default) is not credible, since it can be anticipated that the temptation to intervene will at some time be too compelling. In the example given above, the default of the bank, especially if it is a large bank, could severely disrupt the economy, as no other agent could rapidly replace the defaulting bank. Indeed, whereas in the framework of the Diamond and Dybvig (1983) model, the mere threat of a suspension of deposit convertibility would be enough to prevent a run (in the absence of aggregate uncertainty, i.e. provided no generalized crisis is occurring). Ennis and Keister (2009) show that this threat is not credible since it is always better ex post not to carry it out. As a result of the growing concentration of the financial sector, the notion of moral hazard is related to the one of “too big to fail” (TBTF), according to which some financial agents are too large for the government to allow them default (1.5.2).

18 Notions

1.5.1 Moral hazard and time consistency A distinction is drawn between the origin of moral hazard (1.5.1.1) and its consequences for financial stability (1.5.1.2).

1.5.1.1 Origin of moral hazard Alessandri and Haldane (2009) indicate that the introduction of a safety net for banks is at the origin of an asymmetric payoff (i.e. a situation in which they stand more to gain than to lose). The safety net is made of three elements: • • •

The liquidity insurance, provided by the intervention of the central bank as the lender of last resort, which is the oldest element (Chapter 9); Deposit insurance, introduced first in the US in 1934 and then generalized (Chapter 5); Capital insurance, as the Government intervenes to bail out banks which have realized losses that do not allow them to fulfil capital requirements anymore (Chapter 6).

The incentives for depositors, counterparties in the interbank market and shareholders to monitor banks are consequently strongly lowered (Calomiris and Kahn, 1991). In particular, shareholders and top managers, the fixed remuneration of whom is small in comparison with their variable remuneration (Chapter 4), stand to make limited losses against potentially unlimited gains. This puts bankers in a situation similar to the one in which they would hold a put option, allowing them to sell an asset at a given price, and that its holder thus exercises only in case of gain (i.e. if the market price is higher than the exercise price). In the framework of a repeated game, banks thus enter strategies in which, according to Alessandri and Haldane (2009), the gains from more risk-taking are privatized, whereas the potential losses are socialized. The authors provide examples of such strategies (higher leverage and trading portfolios, diversification of business lines, sales of high default risk assets such as subprime securities, issuance of out-of-the-money options). Within a more formalized approach, Farhi and Tirole (2012) show that when all banks engage in more severe maturity mismatch, authorities have little choice but to intervene in case of distress. In turn, banks have interest in adopting risky balance sheet structures and to correlate their risk exposures, a situation they refer to as “collective moral hazard”. This creates both current and future social costs, as the public intervention sows the seeds of the next crisis, which requires macro-prudential supervision (Chapter 8). Much in the same spirit, and taking size asymmetries into account, Dávila and Walther (2017) show that the presence of large banks increases aggregate leverage and the magnitude of bailouts. As large banks internalize that their decisions directly affect the government’s optimal bailout policy and small banks also choose higher borrowing when large banks are present, since banks’ leverage choices are strategic complements.

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1.5.1.2 Consequences of moral hazard for financial stability Moral hazard can be viewed as a factor increasing the costs of banking crises, or even as a factor of banking crises. The first approach can be found in Honohan and Klingebiel (2003). They study 40 cases of banking crises in 34 countries (including 25 emerging or developing economies) over the period 2000–2004. They estimate the direct fiscal cost of an accommodating approach of those crises, possibly involving blanket guarantees of deposits, an unlimited liquidity support and repeated recapitalizations as well as debtors’ bailouts and regulatory forbearance (i.e. the practice consisting in suspending, implicitly or explicitly, the implementation of regulations, which would lead to the closure of banks). Those measures all involve moral hazard, only have transitory effects in most cases and tend to increase significantly the costs of banking crises in the medium term in comparison with a strict approach. The estimated average costs are 6.7% of GDP for regulatory forbearance resulting in not winding down insolvent banks (24% of banking crisis cases3), 4.1% of GDP for suspending or not applying rigorously standards for loans classification or loan loss provisioning (84% of cases), 6.3% of GDP for repeated recapitalizations (24% of cases), 6.3% of GDP for unlimited liquidity support (58% of cases), 3.1% for debtors’ bailouts (21% of cases), and 2.9% of GDP for the provision of blanket guarantees (55% of cases). The second approach can be found in Calomiris (2009). He studies banking crises over the long period, focusing especially on the cases of the UK and US. Retaining the same threshold of 1% of GDP for losses on defaulting banks as Caprio and Klingebiel (1996) to characterize severe banking crises, he notes that there were very few such crises before World War I (Argentina in 1890, Australia and Italy in 1893, Norway in 1900, and perhaps also Brazil). Conversely, 140 episodes of severe banking crises occurred in the 30 years preceding his study. His interpretation is that before 1914, market discipline provided banks with incentives to behave prudently, whereas since the Great Depression, a well-intended but counterproductive public intervention de facto has provided banks with incentives to take on risk they would not have otherwise taken. He particularly refers to two sorts of measures: the extension of the safety net and the constraints put on the banking sector, such as restrictions on competition and direct interventions in the distribution of credit.

1.5.2 Concentration of the financial industry and TBTF 1.5.2.1 Financial concentration There is a high degree of concentration in the financial industry, be it in financial markets or in banking markets. The largest financial market in the world is the foreign exchange market, with a turnover of more than 5 trillion dollar/day in 2016 (BIS, 2016). On this

20 Notions TABLE 1.1 Five-bank ­ asset concentration

Australia Brazil Canada China France Germany India Italy Japan Spain United Kingdom United States

2000

2008

2016

83.5 49.3 67.8 45.3 68.3 86.1 44.4 88.8 42.6 82.0 46.5 28.1

85.9 62.5 92.9 71.2 73.3 85.6 41.4 62.6 58.6 77.8 79.1 44.9

93.4 85.0 83.4 52.9 74.4 77.2 44.3 71.6 60.4 80.9 70.3 46.6

Source: World Bank DataBank.

market, according to Euromoney (2018), the five largest participants accounted for a cumulated market share of 40.1% in 2018. The corresponding market share was already 38.4% in 2000. Banking markets also appear as very concentrated, as shown in Table 1.1 for a selection of developed and emerging economies. In all these economies, the share of the five largest banks in terms of total assets has been higher than 40% since 2008 and their domestic banking markets thus appear as oligopolies. Developments have been particularly dramatic in the US, both because the five-bank asset concentration jumped by 18.5 percentage points between 2000 and 2016 and also because the US domestic market is the largest in the world.

1.5.2.2 TBTF The phrase “too big to fail” (TBTF) was coined by the Comptroller of the Currency, in charge of licensing, regulating, and supervising nationwide chartered banks, as he testified before the US Congress in September 1984 about the bailing out of Continental Illinois, then ranked as the eighth bank in the country. On that occasion, the Comptroller indicated that a blanket guarantee would be provided to the 11 largest banks as they were too big for their default to be envisaged. Since then, the notion has been broadened to encompass financial institutions which are tightly linked to the rest of the financial system or play a role which is considered as strategic in the financing of some economic activities or the liquidity of some segments of financial markets. The term used to designate the set of financial institutions to which a privileged status is, in this way, granted is “systemic”, or “systemically important” (Chapter 8), or “too interconnected to fail”. Such a broadening of the notion implies an extension of moral hazard.

Notions  21

A whole strand of the literature has developed on assessing TBTF and pricing it. The main results of this literature can be summarized as follows: • •

•

•

•

•

• •

Systemic risk (1.6) grows with bank size (Laeven et al., 2016). A bank’s size, relative to the size of the entire banking system, has a large positive and non-linear effect on the probability of public sector intervention for a bank (Rose and Wieladek, 2012, on the case of UK banks). There is an element of subsidy, in the form of lower financing costs, in being recognized as TBTF. This subsidy is sizeable: it was estimated at 80 basis points in 2009 (Ueda and Weder di Mauro, 2013). However, it has declined in the post-crisis era (a conservative estimate of 35 basis points for systemically important banks is provided by Gudmundsson, 2016). The subsidy benefits the shareholders and managers of big banks and penalizes smaller banks that have to pay a higher cost for capital (Acharya et al., 2012; Gandhi and Lustig, 2015; Moenninghoff et al., 2015) as well as taxpayers whose money is used to bail out banks (Veronesi and Zingales, 2010). As a result, equity is cheap for large financial institutions (Gandhi et al., 2016), and the banks’ ratio of the market value to book value of their equity varies over time in line with the value of government guarantees (Atkeson et al., 2018). The subsidy to the financial sector’s shareholders is particularly large in times of crisis. Kelly et al. (2016) value the collective insurance saving due to the government’s implicit guarantee during the 2007–2009 financial crisis at $282 billion, or 16.4 per cent of the total equity value of the US financial sector. This creates a bias towards size (Kane, 2000; Molyneux et al., 2014), distorting incentives (Chapter 4) and weakening competition (Chapter 9). At least in the case of the US Dodd-Franck Act of 2010, financial markets were doubtful that the TBTF status had been ended by the recent financial reforms, in particular for the largest banks (Gao et al., 2018).

1.6 Systemic risk Several times during the GFC, systemic risk was alluded to by the authorities in charge of financial stability in order to justify public interventions or new regulations. This was notably during depositors’ panic in September 2007 when the UK bank Northern Rock had to acknowledge that short-term funding in the interbank market was no longer an option, and at the time of the failure of Lehman Brothers in September 2008 that triggered a severe liquidity crisis and the freezing of the interbank market. The notion of systemic risk is defined (1.6.1), and its main causes and determinants are discussed (1.6.2) (the measurement of systemic risk is addressed in Chapter 8).

1.6.1 Definition of systemic risk Economists do not agree on a single definition of systemic risk and many definitions were and are still offered. However, it is possible to provide a few directions

22 Notions

(de Bandt and Hartmann, 2019). In financial economics, “systemic risk” is the risk of a “systemic event”, i.e. of adverse events affecting a large share of the financial system, alienating partially or totally, but to a significant extent, its ability to exert its main functions, namely the provision of financial services, the channelling of savings to investment and the allocation of risk in the economy, with macroeconomic and welfare consequences. This definition is consistent with the one given above for financial stability (1.1), in the sense that it corresponds to the most severe and extreme cases of financial instability. The economic literature highlights several forms of systemic events: • •

•

Contagion effects (1.4.2). Common exposures of some sectors of the financial system to some types of assets, or to some shocks affecting particular markets or to macroeconomic shocks. In that case, there is a lack of diversification of risks and as a consequence, the effect of shocks may be amplified. Financial imbalances, as the existence of “bubbles” or situations where excessive credit growth leads to overindebtedness, which can abruptly unravel, with negative consequences on markets and financial intermediaries.

Systemic risk corresponds to a situation characterized by a significant probability of occurrence of these three types of events, also factoring in their impact. In most cases, it is a low probability event (“rare event”) with high impact. The consequences are more serious, when more institutions fail or more markets collapse or become inoperative. It also depends on the severity of the impacts on the real economy. If the real economy is affected (e.g. if GDP significantly slows down or even drops after a recession caused by a financial crisis), one often refers to the “vertical” dimension of systemic risk, while the “horizontal” dimension corresponds to contagion limited to the financial sector (de Bandt and Hartmann, 2019). The majority of authors give more prominence to the first dimension (see, e.g., European Central Bank, 2009), but it is useful to distinguish these two channels of transmission of shocks.

1.6.2 Sources of systemic risk Externality is at the core of systemic risk: profit or utility maximization at the individual level does not necessarily take into account interactions among agents, possibly leading to a suboptimal equilibrium from an aggregate welfare point of view. It is also important to distinguish between systemic and systematic risk. The latter is a financial market risk, a “usual” type of random shock in the economy but with an aggregate or macroeconomic dimension, hence neither diversifiable nor insurable. For example, an exogenous shock (like an exchange rate depreciation or a stock market crash) may have macroeconomic effects (wealth effects), and even trigger the default of financial institutions.

Notions  23

But since the effects are almost contemporaneous, and there is neither contagion, nor propagation among institutions, nor even endogenous spillovers to the financial system, it does not qualify for systemic risk in the “narrow” sense. At most, one could think of systemic risk in the broad sense. It is therefore crucial to assess precisely which are the factors underlying such an externality. Three sectors may be distinguished: banking activities (1.6.2.1), financial markets (1.6.2.2), and payment systems (1.6.2.3).

1.6.2.1 Banking activities Several factors may explain the existence of systemic risk in the banking sector: • • • •

Asymmetric information, associated with amplification effects linked to excessive debt levels or liquidity shocks; Common exposures in the upward phase of the leverage cycle or during euphoric periods; Banking interconnections or links to other parts of the financial system; The propagation of macroeconomic shocks.

1.6.2.1.1 Asymmetric information and amplification effects Beyond the theoretical concepts discussed above (1.2), several authors generalized the Diamond and Dybvig (1983) seminal model in order to characterize depositors’ behaviour and the risk of a systemic crisis. In Jacklin and Bhattacharya (1988), the bank-run equilibrium is triggered by bad news received by depositors who fear losses on their deposits or a failure of the bank. For Chari and Jagannathan (1988), a depositor infers the overall state of the banking system, hence the opportunity to withdraw deposits, from the length of the line of depositors queuing to withdraw their money from her/his own bank. The conclusions of these models were confronted with data in many empirical papers covering the US at the end of the nineteenth century and before 1914, and then during the Great Depression (see the literature review in de Bandt and Hartmann, 2019). Indeed, the introduction of deposit insurance systems in the post-World War II era and before the deregulation period of the 1990s coincided with the disappearance of banking failures, if one excludes the S&L crisis in the 1980s in US (Chapter 4) as well as bank runs as main vector of banking panics. Later, the “subprime crisis” witnessed a few examples of bank runs. However, they were often the consequence rather than the source of the crisis, as in the case of Northern Rock, which was up to 75% funded in the interbank market that went under stress and came to a halt in the early months of the GFC. In addition, deposit insurance is only partial (below a certain amount), so that run on deposits may still occur, but from informed investors, or other participants in the interbank market or hedge funds. French (2010) analyses their contribution to the failure of Bear Stearns and Lehman Brothers.

24 Notions

1.6.2.1.2 Common exposures Several models of contagion are based on common exposures to the same class of assets, or to the same individual assets. It may result from rational herding ( Banerjee, 1992) under uncertainty or be motivated by reputational objectives (an individual bank manager is less likely to be fired, if the poor performance of his portfolio is correlated with that of other managers). In addition, banks may have an incentive to follow correlated investment strategies (by contributing to a real estate bubble and keeping granting loans while prices are over valuated) in order to maximize the joint probability of defaults, since banks increase the likelihood of a bail out by public authorities (Fahri and Tirole, 2012). This may also be the consequence of diversification, inducing institutions’ holdings to become more similar to each other. A negative externality may arise when intermediaries’ actions to diversify are optimal from individual intermediaries’ point of view, but prove to be suboptimal for the financial system (Ibragimov et al., 2011). Similarly, indirect contagion, associated with deleveraging and fire sales that affect negatively the market price of commonly held assets in stress scenarios, leads to price-mediated contagion across institutions. Such a situation prevailed at the start of the GFC, with the collapse of many hedge funds, known as the “Quant Meltdown” of August 2007, which triggered a market-wide deleveraging and a sudden withdrawal of market-making risk capital (Khandani and Lo, 2011). It was also clear during the European Sovereign Crisis (Greenwood et al., 2015). Large overlapping portfolios can become important amplifiers of stress across financial markets during times of crisis (Cont and Schaanning, 2017, 2018). 1.6.2.1.3 Interconnections The network of banks’ bilateral exposures increases the transmission of shocks among banks and the likelihood of systemic events. Allen and Gale’s (2000) seminal paper has initiated a vast research agenda on the properties of networks. Research has been very active (Upper and Worms, 2004, for the German interbank market; van Lelyveld and Liedorp, 2006, for the Netherlands; Gouriéroux, Héam and Monfort, 2012, for France), leading to quantitative measurement and monitoring of systemic risk (Chapter 8). The earlier conclusion was that denser networks, with increasing interconnection, where all participants are connected to the others – as opposed to only to a few major institutions– allowed a better risk diversification, hence more financial stability and less systemic risk. Battiston et al. (2012a, b) as well as Haldane and May (2011) challenge that view. The argument raised by these authors is derived from a parallelism with life sciences and in particular food cycles. Complexity of species may imply more fragility, so that the negative relationship between interconnection and systemic risk may actually appear to be non-monotonic and rather hump-shaped, depending on various factors (the initial situation of the banking system, the size of the shock, the nature of the links between banks). Weaker banks that are more interconnected may create more contagion.

Notions  25

1.6.2.1.4 Macroeconomic shocks Finally, several models include propagation mechanisms of financial shocks to the real economy in order to take the “vertical” dimension of systemic risk into account (Bernanke and Gertler, 1989; Kiyotaki and Moore, 1997; Bernanke, Gertler and Gilchrist, 1999). Beyond the model of Goodhart, Sunirand, and Tsomocos (2006) with a disaggregated banking sector, several macroeconomic models developed since the GFC now integrate a fully fledged financial sector and are able to generate multiple equilibria that are at the root of systemic risk. One important step in the characterization of financial instability in these models is the introduction of occasionally binding credit constraints of agents that give rise to a non-linearity and amplification of economic fluctuations after a bad shock ( Lorenzoni, 2008; Korinek, 2011). Brunnermeier and Sannikov (2014) developed a macroeconomic model with a financial sector, where a “volatility paradox” is uncovered: lower exogenous risks lead to greater leverage and may lead to higher endogenous risk. However, financial instability in the (static) general equilibrium model of Boissay (2011) does not rely on occasionally binding constraints but on the scope for freezes of (runs on) banks’ wholesale funding markets. Banks differ in their ability to assess the investment projects they fund, but their financiers cannot observe their proficiency. Therefore, there may be multiple equilibria: a crisis equilibrium in which wholesale funding markets freeze – because financiers loose trust in banks’ investment choices – and economic activity collapses, and another equilibrium in which high bank leverage is financed without a crisis and economic activity is high. The shift from one equilibrium to the other implies a major non-linearity and is not predictable. Boissay et al. (2016) introduce the possibility of wholesale bank funding market freezes in a dynamic stochastic general equilibrium model, showing how long credit booms can be followed by such liquidity crises (and without multiple equilibria). Illustrating the form of systemic risk characterized by the build-up and unravelling of widespread financial imbalances, they show that crises can happen entirely endogenously, without any exogenous shocks, and that agents form expectations about them (anticipating the likelihood of such crises). Gertler and Kiyotaki (2013) incorporate self-fulfilling retail depositor runs in a dynamic stochastic general equilibrium model. The shift from the no-run to the run equilibrium also creates a major non-linearity, but in tranquil times the possibility of a bank run is unanticipated. Aoki and Nikolov (2012) capture two types of non-linearities: one through the leverage constraint of banks hit by a negative shock and another through switches between multiple equilibria. The multiple equilibria originate from the incentives to not only lend to firms but also to invest in assets whose values may deviate from fundamentals in a self-fulfilling manner. When trust in the valuation of these assets erodes, the equilibrium materializes in which banks make losses and then deleverage, and the economy collapses.

26 Notions

1.6.2.2 Financial markets Financial markets, where funding is made through a multiplicity of shareholders and shares are quoted in continuous time, are not subject to issues related to the indivisible nature of investments financed by bank loans. Some authors like Schwartz (1986) even considered that crisis in financial markets was only “pseudo crisis” if they did not trigger depositors’ runs to base money. In addition, asset managers are pure intermediaries and do not hold investments on their balance sheets, so that losses are directly supported by the final investors. Nevertheless, as indicated below, the GFC provided evidence that financial markets were not immune to systemic risk, with runs in the repo market and the market for Money Market Mutual Funds (MMMF) that are described below. First, rational bubbles are possible (1.3). Second, more generally, there are two main channels of systemic risk: investors’ exposures and asymmetric information (ECB, 2009). 1.6.2.2.1 Exposures Kyle and Xiong (2001) show that if investors experience losses in a market following a stock market crash, they will rebalance their portfolio which may lead to the liquidation of exposures to another market, precipitating the crisis in the latter market. In addition, there are multiple exposures of intermediaries to other financial firms, through the money market, derivative markets and large value payment systems. The GFC provided evidence of the systemic nature of these markets in which big banks participate. Beyond the multiplicity of exposures, the complexity of the exposures may generate systemic risk. The main motive of the rescue of the AIG monoliner insurer by US authorities in September 2008 was its exposures to several large financial institutions in the US and Europe that would have experienced major losses otherwise with knock- on effects. There is also the issue of the exposures to some intermediaries that are large enough to affect equilibrium prices. They can trigger sharp price movements, as in the case of the LTCM hedge fund during the Asian crisis at the end of the 1990s. In addition, margin calls in derivative markets, following a large shock, may lead to fire sales, with a more severe impact on prices when the sell-off is observed for several intermediaries at the same time. Price effects propagate systemic risk by amplifying the effects of the initial shock (Greenwood et al., 2015). 1.6.2.2.2 Asymmetric information King and Wadhwani (1990) highlight how global traders need to solve a signal extraction problem when facing a deviation in the price of foreign stocks. They need to distinguish between systematic information that also affects their own country’s stock prices, and purely idiosyncratic information embedded in foreign prices.

Notions  27

During the GFC, some markets shut down following a major shock because of adverse selection, with repercussions to other markets. The market for repurchase agreements (repo)4 was adversely impacted by the lack of confidence of operators, as described by Gorton and Metrick (2012), who noticed that “during this time period, several classes of assets stopped entirely from being used as collateral, an unprecedented event that is equivalent to a haircut of 100 percent”. More generally, a market shutdown creates a funding shortage for banking and non-banking participants. For example, some investment funds may become illiquid, possibly triggering a run ( fund run). In 2007–2008, money market investment funds labelled as “dynamic” heavily invested in risky assets (in order to increase their yield), notably in securitized assets, experienced from their investors massive redemptions that might have caused their insolvency. Furthermore, US MMMF had a fixed unit value at 1 USD (constant net asset value or CNAV), hence were close to bank deposits without either official government guarantee or deposit insurance from the FDIC. Following the failure of Lehman Brothers, MMMF experienced massive outflows and the most sophisticated clients reallocated their investments across funds (Schmidt et al., 2016). The absence of standardization of credit derivatives negotiated over-thecounter (OTC) led to a phenomenon of loss of confidence of market participants towards their counterparties, as in the case in the quasi-bankruptcy of Bear Stearns, the collapse of Lehman Brothers and the troubles experienced by AIG, as these institutions were major participants in the OTC market (Rochet, 2010). Several models highlight the role of the opacity of OTC markets or derivative instruments or practices in securitization in the emergence of systemic risk, notably during the subprime crisis (Tirole, 2011).

1.6.2.3 Payment systems Payment and settlement systems ensure the effectiveness of transactions associated with exposures of financial institutions in the interbank market. Their organization determines how shocks may propagate across institutions. There are two broad families of payment and settlement systems. In net payment systems, all incoming and outgoing payments are netted before a single payment is made to settle the batch of transactions, typically once a day. Balances may accumulate over the day and may need to be unwound in case of failure of one institution. Systemic risk is therefore more acute, given the provisional nature of the transactions that may be challenged before the end- of-the- day settlement. In contrast, in real-time gross settlement (RTGS) systems, like Fedwire in the US or Target2 in the euro area, payments are finalized almost immediately through the accounts maintained by the banks with the central bank, as long as the sending bank has enough reserves (possibly by posting collateral with the central bank). However, the system may be slowed down, as participants may wait for incoming payments, in order to save on collateral. Network

28 Notions

externalities may amplify such individual behaviour at the system level, hence generating systemic risk. The central bank may then have to intervene as lender of last resort (Chapter 9).

Notes 1 Diamond and Dybvig (1983) consider an asset at three dates –t = 0, 1, and 2. A unit invested at t = 0 returns r at date 1, and R at date 2. The lower the ratio r /R, the more illiquid the asset. 2 On adverse selection, see 1.5. 3 There may be different reasons for some cases. 4 “Repos” are short-term collateralized borrowing contracts where transactions are frequently collateralized with securitized bonds. The “haircut” is defined by the difference between the cash received and the value of the collateral.

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Cont R., Schaanning E. (2018), “Monitoring Indirect Contagion”, Mimeo, Imperial College London and Norges Bank, SSRN, June 6, 2018. Dang T.V., Gorton G., Holström B., Ordoñez G. (2017), “Banks as Secret Keepers”, American Economic Review, 107(4), 1005–1029. Dávila E., Walther A. (2017), “Does Size Matter? Bailouts with Large and Small Banks”, NBER Working Paper, 24132. Diamond D.W. (2007), “Banks and Liquidity Creation: A Simple Exposition of the Diamond-Dybvig Model”, Federal Reserve Bank of Richmond, Economic Quarterly, 93(2), 189–200. Diamond D.W., Dybvig P.H. (1983), “Bank Runs, Deposit Insurance, and Liquidity”, Journal of Political Economy, 91(3), 401–419. Diamond D.W., Rajan R.G. (2001), “Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking”, Journal of Political Economy, 109(2), 287–327. Dow J., Han J. (2018), “The Paradox of Financial Fire Sales: The Role of Arbitrage Capital in Determining Liquidity”, Journal of Finance, 73(1), 229–274. Drumetz F., Pfister C., Sahuc J.-G. (2015), Politique monétaire, Brussels: De Boeck. Dungey M., Renault E. (2018), “Identifying Contagion”, Journal of Applied Econometrics, 33, 227–250. Ennis H.M., Keister T. (2009), “Bank Runs and Institutions: The Perils of Intervention”, American Economic Review, 99(4), 1588–1607. Euromoney (2018), Euromoney FX Survey 2018: Overall Results, https://www.euromoney. ­ ­ com/article/b18bzd2g51lqkn/fx-survey-2018-overall-results. European Central Bank (2009), “Special Issues: The Concept of Systemic Risk”, Financial Stability Review, December, 134–142. Fair R.C. (2002), “Events that Shook the Market”, Journal of Business, 75(4), 713–731. Farhi E., Tirole J. (2012), “Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts”, American Economic Review, 102(1), 60–93. Fisher I. (1933), “The Debt Deflation Theory of Great Depressions”, Econometrica, 1, 337–357. Forbes K., Rigobon R. (2002), “No Contagion, Only Interdependence: Measuring Stock Market Comovements. Journal of Finance”, 57(5), 2223–2261. French K.R., Baily M.N., Campbell J.Y., Cochrane J.H., Diamond D.W., Duffie D., Kashyap A.H., Mishkin F.S., Rajan R.G., Scharfstein D.S., Shiller R.J., Shin H.S., Slaughter M.J., Stein J.C., Stulz R.M. (2010), The Squam Lake Report – Fixing the Financial System, Princeton, NJ and Oxford: Princeton University Press. Gandhi P., Lustig H. (2015), “Size Anomalies in U.S. Bank Stock Returns”, Journal of Finance, 70(2), 733–768. Gandhi P., Lustig H., Plazzi A. (2016), “Equity Is Cheap for Large Financial Institutions: The International Evidence”, NBER Working Paper, 22355. Gao Y., Liao S., Wang X. (2018), “Capital Markets’ Assessment of the Economic Impact of the Dodd-Franck Act on Systemically Important Financial Firms”, Journal of Banking and Finance, 86, 204–223. Gertler M., Kiyotaki N. (2013), “Banking, Liquidity and Bank Runs in an InfiniteHorizon Economy”, NBER Working Paper, 19129. Goodhart C.A.E., Sunirand P., Tsomocos D.P. (2006), “A Model to Analyse Financial Fragility”, Economic Theory, 27, 107–142. Gorton G.B. (2017), “The History and Economics of Safe Assets”, Annual Review of Economics, 9, 547–586. Gorton G.B., Metrick A. (2012), “Securitized Banking and the Run on Repo”, Journal of Financial Economics, 104(2012), 425–451.

Notions  31

Gorton G.B., Pennachi G. (1990), “Financial Intermediaries and Liquidity Creation”, Journal of Finance, 45(1), 49–71. Gouriéroux C., Héam J.C., Monfort A. (2012), “Bilateral Exposures and Systemic Solvency Risk”, Canadian Journal of Economics, 45(4), 1273–1309. Greenwood R., Landier A., Thesmar D. (2015), “Vulnerable banks”, Journal of Financial Economics, 115(3), 471–485. Gudmundsson T. (2016), “Whose Credit Line Is It Anyway: An Update on Banks’ Implicit Subsidies”, IMF Working Paper, WP/16/224. Haldane A.G., May R.M. (2011), “Systemic Risk in Banking Ecosystems”, Nature, 469, 351–355. Holmström B. (2015), “Understanding the Role of Debt in the Financial System”, BIS Working Paper, 479. Holmström B., Tirole J. (1998), “Private and Public Supply of Liquidity”, Journal of Political Economy, 106(1), 1–40. Holmström B., Tirole J. (2011), Inside and Outside Liquidity, Cambridge and London: MIT Press. Honohan P., Klingebiel D. (2003), “The Fiscal Cost Implications of an Accommodating Approach to Banking Crises”, Journal of Banking and Finance, 27, 1539–1560. Ibragimov R., Jaffee D., Walden J. (2011), “Diversification Disasters”, Journal of Financial Economics, 99(2), 333–348. Jacklin C., Bhattacharya S. (1988), “Distinguishing Panics and Information-based Bank Runs: Welfare and Policy Implications”, Journal of Political Economy, 96, 568–592. Kane E.J. (2000), “Incentives for Banking Megamergers: What Motives Might Regulators Infer from Event- Study Evidence?”, Journal of Money, Credit and Banking, 32(3), 671–705. Kelly B., Lustig H., Van Nieuwerburgh S. (2016), “Too- Systemic-to-Fail: What Option Markets Imply about Sector-Wide Government Gurantees?”, American Economic Review, 108(6), 1278–1319. Keynes J.M. (1936), The General Theory of Employment, Interest and Money, London: Macmillan. Khandani A.E., Lo A.W. (2011), “What Happened to the Quants in August 2007? Evidence from Factors and Transactions Data”, Journal of Financial Markets, 14(1), February 2011, 1–46. Kindleberger C.P. (1978), Manias, Panics, and Crashes, A History of Financial Crises, New York: John Wiley and Sons. King M., Wadhwani S. (1990), “Transmission of Volatility between Stock Markets”, Review of Financial Studies, 3(1), 5–35. Kiyotaki N,. Moore J. (1997), “Credit Cycles”, Journal of Political Economy, 105(2), 211–248. Korinek A. (2011), “Systemic Risk-Taking: Amplification Effects, Externalities, and Regulatory Responses”, ECB Working Paper, 1345. Kreps D. (1990), A Couse in Microeconomic Theory, Princeton, NJ: Princeton University Press. Krishnamurthy A., Vissing-Jørgensen A. (2012), “The Aggregate Demand for Treasury Debt”, Journal of Political Economy, 120(2), 233–267. Kyle S., Xiong W. (2001), “Contagion as a Wealth Effect”, Journal of Finance, 56(4), 1401–1440. Laeven L., Ratnovski L., Tong H. (2016), “Bank Size, Capital, and Systemic Risk: Some International Evidence”, Journal of Banking and Finance, 69, S25–S34. Lorenzoni G. (2008), “Inefficient Credit Booms”, Review of Economic Studies, 75, 809–833. Mian A., Sufi A. (2018), “Finance and Business Cycle: The Credit-Driven Household Demand Channel”, Journal of Economic Perspectives, 32(3), 31–58.

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Minsky H.P. (1986), Stabilizing an Unstable Economy, New Haven, CT: Yale University Press. Minsky H.P. (1995), “Financial Factors in the Economics of Capitalism”, Journal of Financial Services Research, 9, 197–208. Modigliani F., Miller M. (1958), “The Cost of Capital, Corporation Finance and the Theory of Investment”, American Economic Review, 48(2), 261–275. Moenninghoff S.C., Ongena S., Wieandt A. (2015), “The Perennial Challenge to Counter Too-Big-to-Fail in Banking: Empirical Evidence from the New International Regulation Dealing with Global Systemically Important Banks”, Journal of Banking and Finance, 61, 221–236. Molyneux P., Schaeck K., Zhou T.M. (2014), “‘Too Systemically Important to Fail’, in Banking  –  Evidence from Bank Mergers and Acquisitions”, Journal of International Money and Finance, 49, 258–282. Padoa- Schioppa T. (2003), “Central Banks and Financial Stability: Exploring a Land in Between”, in V. Gaspar, P. Hartmann and O. Sleijpen (eds.), The Transformation of the European Financial System, Second ECB Central Banking Conference, Francfort- onMain, 269–310. Petersen M.A., Rajan R.G. (1994), “The Benefits of Lending Relationships: Evidence from Small Business Data”, Journal of Finance, 49(1), 3–37. Reinhart C.M., Rogoff K.S. (2009), This Time Is Different. Eight Centuries of Financial Folly, Princeton, NJ: Princeton University Press. Rochet, J.C. (2010), “An Industrial Organisation Approach to the Too-Big-To-Fail Problem”, Financial Stability Review, Banque de France, 14, 93–100. Rose A.K., Wieladek T. (2012), “Too Big to Fail: Some Empirical Evidence on the Causes and Consequences of Public Banking Interventions in the UK”, Journal of International Money and Finance, 31, 2038–2051. Schmidt L., Timmermann A., Wermer R. (2016), “Runs on Money- Market Mutual Funds”, American Economic Review, 106(9), 2625–2657. Schwartz A.S. (1986), “Real and Pseudo-Financial Crises”, in F. Capie and G.E. Wood (eds.), Financial Crises and The World Banking System, London: MacMillan Press, 11–31. Sentana E. (2018), “Volatility, Diversification and Contagion”, CEPR Discussion Paper, 12824. Shiller R. (2000), Irrational Exuberance, Princeton, NJ: Princeton University Press. Shleifer A., Vishny R.W. (1992), “Liquidation Values and Debt Capacity: A Market Equilibrium Approach”, Journal of Finance, 52(1), 33–55. Shleifer A., Vishny R.W. (1997), “A Survey of Corporate Governance”, Journal of Finance, 52, 737–783. Shleifer A., Vishny R.W. (2011), “Fire Sales in Finance and Macroeconomics”, Journal of Economic Perspectives, 25(1), 29–48. Tirole J. (2011), “Illiquidity and All Its Friends”, Journal of Economic Literature, 49(2), 287–325. Ueda K., Weder di Mauro B. (2013), “Quantifying Structural Subsidy Values for Systemically Important Financial Institutions”, Journal of Banking and Finance, 37(10), 3830–3842. Upper C., Worms A. (2004), “Estimating Bilateral Exposures in the German Interbank Market”, European Economic Review, 48(4), 827–49. van Lelyveld I., Liedorp F. (2006), “Interbank Contagion in the Dutch Banking Sector”, International Journal of Central Banking, 2, 99–133. Veronesi P., Zingales L. (2010), “Paulson’s Gift”, Journal of Financial Economics, 97, 339–368.

2 FINANCIAL CYCLES AND CRISES

Finance matters for growth (2.1). However, asset prices and credit are characterized by recurrent ebbs and flows – the financial cycle – whose drivers are investigated (2.2). The chapter then looks more deeply into crisis episodes and attempts to characterize them (2.3).

2.1 Finance and growth In his presidential address to the American Finance Association, Zingales (2015) remarks that for most academic economists, the answer to the question “Does finance benefit society?” seems obvious. However, he also notes that this positive feeling is not shared by society at large because of the GFC. In a long-term perspective, throughout history, finance has been perceived as a rent-seeking activity. But for Zingales, even the most severe critics of the financial sector agree that a good financial system is essential for a well-functioning economy. Zingales goes further by noting that “evidence on the negative effects of financial development has been collected since the crisis, even that based on pre-crisis data. The same evidence could have been gathered before the crisis and was not”. Do economists have an inflated view of the benefits of finance? Actually, finance matters for growth (2.1.1). However, too much finance can be detrimental to growth (2.1.2).

2.1.1 Finance matters for growth Theoretically, finance is positive for growth. Indeed financial development – i.e. the emergence of banks and financial markets – can promote economic growth through a variety of channels. Following ECB (2018), financial development: − −

facilitates the exchange of goods and services, mobilizes and pools savings,

34  Financial cycles and crises

− − − − −

facilitates the trading, diversification, and management of risk, produces information ex ante regarding possible investments, allocates capital, monitors investment ex post and exerts corporate governance after the financing.

In a nutshell, financial development helps to overcome frictions notably by increasing the efficiency of savings mobility and resource allocation to productive sectors (Greenwood et  al., 2010). Moreover, a more efficient financial system reduces agency costs (Aghion et al., 2005) and promotes risk- sharing in the economy (Bencivenga and Smith, 1991). A large body of evidence documents that, on average, a bigger financial system is correlated with higher growth both cross- sectionally and over time (Levine, 2005). In order to address the limitations of purely cross- country studies: −

−

−

Rajan and Zingales (1998) propose a cross- country and cross-industry approach. More efficient financial intermediaries help reduce the wedge between external and internal finance. Indeed, Rajan and Zingales show that industries that rely more heavily than others on external finance for technological reasons benefit more from financial development than other industries. Finance causes growth. Exploiting the consequences of the French banking deregulation of 1985, Bertrand et al. (2007) show that deregulation led to higher productivity at the firm level, higher entry rates for firms in bank-dependent industries and higher exit rates for the worst-performing firms. Love (2003) uses firm-level data to provide evidence that the sensitivity of investment to internal funds is greater in countries with more poorly developed financial markets.

Does financial structure affect economic growth? Empirical evidence usually concludes that bank- and market-based financial systems support economic growth in general (Levine, 2002). However, their contribution seems to vary according to the level of economic and financial development. Banks play a major role in the industrial take- off: Gerschenkron (1962) documents the role of large banks in the financing of heavy industries in Germany in the late nineteenth century. As income rises, the link between increasing economic output and increasing bank development becomes weaker (Demirgüç-Kunt et al., 2013). One of the reasons could be that market finance is better at promoting innovation, productivity, and financing new sources of growth (Hsu et al., 2014).

2.1.2 Too much finance harms growth However, more recent studies have found evidence of the non-linearity in the growth-finance nexus (Cecchetti and Kharroubi, 2012; Low and Singh, 2014;

Financial cycles and crises  35

Arcand et al., 2015; Cournède and Denk, 2015). More credit is not always good for growth. Arcand et al. (2015) and Cecchetti and Kharroubi (2012) evidence a tipping point – around 80%–100% of GDP – beyond which further expansion of credit to the private sector has a negative effect on output growth. According to Schularick and Taylor (2012), lagged credit growth is a predictor of financial crises and financial stability risks increase with the size of the financial sector. There are five main explanations for the non-linearities in the finance-growth nexus (Coeuré, 2014; ECB, 2018). At high levels of financial development: −

− −

− −

a further deepening of financial markets may be associated with a type of financial services, such as mortgage finance, with lower growth potential than, for example, a credit to a young innovative firm (Chakraborty et al., 2018); financial systems tend to develop non-interest income financial activities which are riskier (Hahm et al., 2013); a drain on human capital from the real economy to the financial system occurs due to excessively high wages paid, reflecting the extraction of excessively high informational rents; in turn, this drain reduces the rates of innovation and growth in the real economy (Philippon and Reshef, 2012); an expansion of the financial sector can reflect increased risk-taking; the complexity and interconnectedness of financial institutions increases with the size of the overall financial system.

Therefore, an oversized financial industry can be detrimental to real economic activity. It may also induce excessive risk-taking by banks which become “too large to save” by domestic taxpayers. This macroeconomic problem is not necessarily identical to the microeconomic problem of individual institutions being too big to fail (Coeuré, 2014): even if the financial sector is small relative to the real economy, it may be comprised of banks whose incentives are misaligned due to TBTF considerations. However, Laeven et al. (2014) note that larger financial systems tend to have larger banks. For example, according to the European Systemic Risk Board (2014), the expansion of the EU banking sector since the mid-1990s can be entirely attributed to the growth of the 20 largest banks. To address the risk of “oversized finance” or of “overbanking”, policies tend to combine micro- and macro-prudential tools to reduce vulnerabilities associated with the size of the financial sector (Laeven et al., 2014).

2.2 Financial cycles The GFC has revived the empirical literature on the interactions between business cycles and financial cycles. Cyclical fluctuations in the real economy are not always driven by the financial system. However, the most severe fluctuations are typically associated with financial booms and busts. This section presents issues pertaining to the measurement (2.2.1), the drivers (2.2.2), and the predictability (2.2.3) of financial cycles.

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2.2.1 Measuring financial cycles Previous research on financial cycles has been based mostly on historical narratives (e.g. Kindleberger, 1978). Current research is more analytical and systematic. However, financial cycles are not directly observable and must be inferred (Schüler et al., 2015). Consequently, there is no consensus on the precise definition of financial cycles (Borio, 2014). In a broad sense, they are generally characterized by common fluctuations in a set of variables – credit and asset prices – that pertain to the financial sector and are important for financial stability. According to this literature, there is a strong relationship between financial and business cycles. However, financial cycles are longer, deeper, and sharper than business cycles. These results seem to hold whatever the econometric technique used, be it turning point analysis, frequency-based filters, model-based filters, or looking at financial and economic variables in the frequency domain. For example: −

−

Claessens et al. (2012), who employ a classical turning point analysis for 44 countries over the period 1960–2010, find that recessions associated with financial disruption episodes, notably house and equity price busts, tend to be longer and deeper. Recoveries combined with rapid growth in credit and house prices tend to be stronger. Overall, fluctuations in house prices are most closely associated with the depth of the recessions and strength of recoveries. Schüler et al. (2017) aggregate credit and asset prices into a composite financial cycle index for G-7 countries over 1970–2013, focusing on the most important common cycle frequencies. They find that financial cycles tend to be long, lasting on average 15 years in contrast to 9 years for an average business cycle, with pronounced booms and busts and amplitude of more than twice that of business cycles. Moreover, while business cycles are homogeneously related across G-7 countries, cross- country synchronization of financial cycles is strong for most but not all countries, Germany and Japan seeming to be weakly related among G-7 countries.

The finding that credit- and asset price-driven cyclical fluctuations yield higher peaks and lower troughs than normal business cycles, with more prolonged periods of boom and bust, is in line with recent theoretical and empirical approaches to financial crises (2.3.3). In that literature, the financial system can both act as amplifier of shocks and be the source of shocks that trigger business cycle fluctuations. The balance sheet of households, firms, and banks can give rise to procyclical mechanisms through changes in the value of collateral, such as residential property in the case of households (ECB, 2017), owing to the ability, in some countries, to collateralize via mortgage borrowing this asset type. Therefore, credit-driven expansions can give rise to capital misallocation in favour of relatively low-productivity activities, such as housing and property development (2.1.2).

Financial cycles and crises  37

2.2.2 Drivers of financial cycles Why do financial booms often turn to bust and cause serious financial and macroeconomic strains? According to Borio (2014), financial cycles refer to the self-reinforcing interactions between perceptions of value and risk, risk-taking and financing constraints, often in combination with financial innovation. Indeed, if risk management, prudential regulation, and oversight fail to keep up, financial innovation – such as securitization (2.2.2.1) and shadow banking (2.2.2.2) – may help to feed the boom and subsequent bust (see Box 2.1: the unfolding of the GFC). Structural weaknesses such as high leverage (Chapter 1) and unstable and run-prone funding patterns (2.2.2.3) may also amplify a boom and precipitate a bust.

2.2.2.1 Securitization Traditionally, financial intermediaries originated loans that they held on their balance sheets until maturity. Securitization got its start in the 1970s when home mortgages were pooled by US government-backed agencies ( Jobst, 2008). Starting in the 1980s, pools of other income-producing assets began to be securitized, leading to the development of an “originate-to- distribute” model. We review the definition (2.2.2.1.1), the rationale for (2.2.2.1.2) and the vulnerabilities (2.2.2.1.3) of securitization.

2.2.2.1.1 Definition Securitization refers to the process of taking an illiquid asset or group of assets and, through financial engineering, transforming them into a security that can be traded in a financial market. Assets that can be transformed in this manner include mortgages, consumer finance receivables (credit card receivables, car loans, student loans), etc. The loans are assigned or sold to a third party, a Special Purpose Vehicle (SPV) or a trust, moving the loans off-balance sheet. To finance the purchase of the portfolio of loans, the SPV, in turn, issues tradable, interestbearing securities – Mortgage-Backed Securities (MBS) in the case of mortgage assets, asset-backed securities (ABS) in the case of non-mortgage assets. The interest and principal payments of the securities are dependent on the cash flows generated by the reference portfolio. The reference portfolio is divided in several slices, called tranches, each of which has a different level of risk associated with it and is sold separately. Investment return and losses are allocated among the various tranches – junior, mezzanine, and senior  –  according to their seniority: expected portfolio losses are first allocated to the junior tranche, which receives the highest return, and progressively to the more senior tranches until all expected losses are absorbed.

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Other types of securitization than ABS and MBS include (Gorton and Metrick, 2013): − −

−

Loan sales: a single commercial and industrial loan is sold by a bank by writing a new claim that is linked to the loan. Asset-backed commercial paper (ABCP) conduits and structured investment vehicles (SIVs): they undertake arbitrage activities by purchasing mostly highly rated medium- and long-term ABS and fund themselves with cheaper, mostly short-term, highly rated commercial paper and mediumterm notes. During the GFC, many ABCP conduits and SIVs had to unwind or to be rescued by their sponsors because investors refused to roll their short-term liabilities (Box 2.1). Collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs): these vehicles buy portfolios of ABS in the case of CDOs and portfolios of commercial and industrial loans in the case of CLOs. To finance the purchase of the portfolio, they issue different tranches of risk in the financial markets.

2.2.2.1.2 Rationale Gorton and Metrick (2013) document two hypotheses, which may help to explain the development of the supply and demand for securitized bonds: −

−

On the supply side, the response of US banks to increased deregulation and competition since the early 1980s (such as the deregulation of activities, in particular the removal of deposit-rate ceilings on deposit accounts, the relaxation of entry restrictions, the emergence of substitutes for bank loans such as junk bonds underwritten by non-bank entities and commercial paper issued directly by firms into the capital market). These factors caused the traditional banking model to lose market shares and become less profitable. If banks found that off-balance sheet financing was becoming cheaper than on-balance sheet financing because the cost of bank capital rose in the wake of the removal of deposit rate ceilings, then they had an incentive to securitize. On the demand side, the growth in demand for securitized bonds from institutional investors: increasing demand for collateral may have outstripped the available collateral in the form of agency and Treasury bonds. Demand of collateral was increasing because of the development of three areas where collateral needs to be posted: derivatives, which require posting collateral when the position becomes a liability for one side of the transaction; clearing and settlement systems; the use of sale and repurchase agreements (repos, 2.2.2.3). In this context, securitization may have been attractive as a way to create collateral, which has to preserve value: since ABS cash-flows are passive, emanating from many contractual arrangements, the assets of the SPV, and thus the securities they issue, are expected to retain their value.

Financial cycles and crises  39

2.2.2.1.3 Vulnerabilities A widespread opinion before the GFC was that securitization increases the resilience of the financial system to default by borrowers by dispersing credit risk (Shin, 2009b). However, the GFC has shown that if inadequately managed and supervised, securitization also has the capacity to increase leverage, to exacerbate misaligned incentives in the financial intermediation chain and thus to amplify systemic risk (Box 2.1). The main vulnerability (Adrian and Ashcraft, 2012; Gorton and Metrick, 2013; Segoviano et  al., 2015) consists in issues with asymmetric information, agency, and moral hazard problems at all stages of the securitization process. In a nutshell, the originator of a loan relies on soft information on borrowers, which is not transmissible to the financial market. Furthermore, the originator may have had few incentives pre- GFC to screen borrowers at the “originate” phase or to continue to monitor the original borrower once she/he off-loaded credit risk at the “distribute” phase, all the more so because the originator often had little economic interest in the loans she/he underwrote (“no skin in the game”). The emergence of complex and non-transparent products where risks are difficult to assess (Box 2.1) may also have signalled misaligned incentives for originators or other securitization intermediaries. However, the review of literature in Gorton and Metrick (2013) is not conclusive, with limited evidence of faulty practices in some US (subprime) mortgage markets, which cannot be generalized to other markets and other countries. For example, according to Albertazzi et al. (2017), despite the presence of asymmetric information in securitization deals for Italian small and medium- sized firms when relationships between the borrower and the lender are weak, credit-risk transfer did not globally lead to lax credit screening. A strong relationship between the borrower and the bank is a credible enough commitment to continue to monitor after securitization. Moreover, regulatory reforms have been adopted post- GFC to rehabilitate securitization markets (Segoviano et al., 2015).

2.2.2.2 Shadow banking Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sector guarantees. The assets and liabilities that collateralize and fund the shadow banking system are largely the product of a range of securitization and securitized lending techniques (2.2.2.1). These activities are conducted by specialized financial intermediaries called shadow banks (Pozsar et al., 2013). However, the regulated banking system plays a role as well: when banks control off-balance sheet SPVs, which invest in securitized loan portfolios, they are interconnected with the shadow banking system. We review the definition (2.2.2.2.1), the rationale for (2.2.2.2.2) and the vulnerabilities (2.2.2.2.3) of the shadow banking system.

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2.2.2.2.1 Definition With its 2018 Report, the Financial Stability Board (FSB) has moved away from the term “shadow banking” and adopted the term “non-bank financial intermediation” (NBFI), with a view to suppressing the negative connotation of shadow banking activities which contributed to the GFC. NBFI refers to a credit intermediation system “involving entities and activities (fully or partly) outside the regular banking system”. NBFI comprises insurance corporations, pension funds, other financial institutions (OFIs) – i.e. investment funds, money market funds, hedge funds, structured finance vehicles, broker-dealers … – and financial auxiliaries – i.e. financial corporations that are principally engaged in activities associated with transactions in financial assets and liabilities but in circumstances that do not involve the auxiliary taking ownership of the financial assets and liabilities being transacted. The FSB (2020) further notes that NBFI “is a valuable alternative to bank financing […], fostering competition and supporting economic activity” but “may also become a source of systemic risk, both directly and through its interconnectedness with the banking system, if it involves activities that are typically performed by banks such as maturity/liquidity transformation and the creation of leverage”. The assets of OFIs stood at $114 trillion globally at end-2018, representing 30% of the total global financial assets (compared to a pre- crisis peak at 27% in 2007). The largest OFI sectors are in the euro area, in the US and in China. FSB’s (2020) “narrow measure” of shadow banking, which refers to non-bank financial entity types that may pose bank-like financial stability risks, stood at $52 trillion at the global level, representing 14% of total global financial assets. The narrow measure groups five types of OFIs: −

− −

− −

Collective investment vehicles with features that make them susceptible to runs (open-ended fixed income funds, credit hedge funds and money market funds investing mostly in credit assets and involved in credit transformation). Non-bank financial entities engaging in loan provision that is dependent on short-term funding (e.g. leasing companies, consumer credit companies…). Market intermediaries that depend on short-term funding or secured funding of client assets (broker- dealers employing significant leverage and having recourse to funding on the repo market). Entities involved in the facilitation of credit creation (financial guarantors, credit insurers). Securitization-based credit intermediation.

2.2.2.2.2 Rationale Adrian et al. (2018) explore two main motives to shadow credit intermediation: •

Specialization: shadow credit intermediation is performed through chains of NBFIs. The shadow bank system decomposes the credit intermediation into

Financial cycles and crises  41

a chain of wholesale-funded, securitization-based lending, from loan origination to pooling and structuring of loans into term ABS, funded through repos, and to ABS intermediation performed by credit hedge funds, SIVs, etc. This “vertical slicing” of the traditional banks’ credit intermediation process can receive two explanations: (i) economies of scale and, consequently, a significant reduction in the cost of intermediation; (ii) “bankruptcy remoteness” obtained by selling loans to a SPV that is independent of the credit risk profile of the sponsor through securitization. −

Regulatory arbitrage: for example, the rapid expansion of ABCP resulted in part from changes in regulatory capital rules.

2.2.2.2.3 Vulnerabilities Even if the shadow banking system helped to expand credit and lower borrowing costs before the GFC, it also played a crucial role in making the financial system more fragile (Ferrante, 2018). While in the US investment banks such as Lehman Brothers, Bear Stearns, and Merrill Lynch experienced failures during the GFC, partly because of shadow banking, European banks have also been hit hard. One reason is that the shadow banking and the traditional banking systems are closely interconnected. Abad et al. (2017) provide a mapping of the interconnections between EU banks and shadow banking. They show that in 2015, many of the EU banks’ exposures to shadow banking were towards non-EU entities, particularly US-domiciled shadow banking entities. By providing it with the assets it manages and refinancing them, the traditional banking system implicitly or explicitly supports the shadow banking system in its function of transforming liquidity and maturity. In addition, the banking system invests, alongside households and businesses, in the financial assets issued by the shadow banking system. These close links are likely to amplify the procyclical nature of leverage (Chapter 1). Indeed, shadow banks are more amenable to giving rise to systemic risk than other forms of financing (Adrian et al., 2018) for five main reasons: − −

−

Transformation of risk: leverage, complexity and opaqueness tend to be more prominent than in the case of bank- or market-based finance. Implicit private sponsor support: shadow banking activity often benefits from the presumption of private sponsor support, such as an implied credit guarantee or a credit line to an off-balance sheet entity provided by a bank concerned with incurring reputational damage if investors’ return expectations are not met. Therefore, stresses experienced by shadow banking entities may affect sponsors who may not have the capital or the liquidity to absorb these contingent liabilities. Agency problems: the splitting up of intermediation activity across multiple NBFIs has the potential to aggravate agency problems.

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− −

Funding base: funding is principally short-term runnable instruments (2.2.2.3), including but not limited to wholesale markets. Efforts to strengthen the regulation and oversight of NBFIs need to be pursued.

Acharya et  al. (2013), for example, consider that with ABCP conduits, banks have concentrated rather than dispersed risks within the banking sector; their empirical results indicate that most of the losses have been borne by banks sponsoring securitization vehicles rather than by external investors. Moreover, as Gennaioli et al. (2013) show from a theoretical perspective, when extreme risks are neglected and therefore underpriced, as was the case in the period preceding the subprime crisis, securitization increases systemic risk.

2.2.2.3 Run-prone funding patterns The large- scale combination of liquidity and/or maturity transformation and high leverage leads to a risk of fire sale in case of a run on short-term funding instruments, i.e. a bank run in the modern sense. During the GFC, there was a run, not on traditional bank deposits, but on the repo market (Gorton and Metrick, 2012 and Box 2.1). The repo market was, at the time, one of the larger money markets, together with the ABCP market (2.2.2.1). A repurchase agreement is the sale of securities together with an agreement that the seller will buy back the securities later. In a repo transaction, one party deposits or lends money overnight and receives the repo rate. In addition, bonds are provided as collateral to the depositor/lender. This collateral is valued at market rates and is returned to the borrower when the repo matures, if it is not rolled over (Gorton and Metrick, 2013). Repos are over-collateralized, and the difference between the value of the collateral and the sale price is called the repo haircut. This collateral was often ABS. When investors lost confidence in ABS, repo haircuts increased and investors refused to renew commercial paper for ABCP conduits. There was a run on repo. The sponsors of the conduits were forced to sell assets, depreciating their prices, leading to further sales, etc. Indeed, a panic may arise in a situation in which longer-term illiquid assets are financed by short-term liquid liabilities and in which providers of shortterm funding lose confidence in the borrower or become worried that other short-term lenders may lose confidence. Even if some lenders know that market rumours about an intermediary’s solvency are unfounded, it may however be in their interest to participate in the run, as few intermediaries would remain solvent if they had to sell their assets urgently at a discount (fire sale, Chapter 1). As a result, fears of panic can become self-realizing and blur the line between illiquidity and insolvency. In addition, panic is likely to encourage financial intermediaries to reallocate their portfolios in favour of liquid safe assets, such as government bonds. Since the supply of safe assets is relatively inelastic in the short term, this reallocation does not increase the liquidity of the financial system as a whole. Moreover, it increases

Financial cycles and crises  43

the price of liquid assets and decreases the market value of less liquid assets such as loans, thereby contracting the supply of credit to financial or non-financial agents. The central bank can mitigate these effects by agreeing to lend, in these exceptional circumstances, against less liquid but high-quality collateral (Chapter 9).

2.2.3 Predicting financial cycles Financial cycles are hard to predict because, paradoxically, a financial system can be most vulnerable when it looks more robust. According to Minsky’s (1992) instability hypothesis, when they observe low financial risk, economic agents are induced to increase risk-taking. Therefore, low risk may endogenously increase the probability of market turmoil and crisis. In a nutshell, stability may be destabilizing. This low volatility channel has been explored in a theoretical framework by: − −

−

Danielsson et al. (2012), whereby low risk induces economic agents to take more risk, Brunnermeier and Sannikov (2014), who identify a “volatility paradox” where low exogenous risk can lead to more extreme volatility spikes in the crisis regime because low fundamental risk leads to higher equilibrium leverage, thus increasing the probability of a systemic event, Bhattacharya et al. (2015), whereby agents update their expectations during good times and increase their leverage.

A considerable time may pass between an observation of low volatility and a crisis. Consequently, early warning indicators – which take into account measured risk, for example, ex-post outcomes in price volatility – are likely to be of limited use since they signal high risk once a crisis is already underway. However, Danielsson et al. (2018a, b), by decomposing volatility into trend (i.e. usual/expected volatility) and deviation from trend (which affects risk-taking behaviour), find strong evidence for low volatility causing crises. According to the authors, an observation of low risk would be a significant crisis predictor.

Box 2.1 The unfolding of the GFC viewed through the lens of the literature Bernanke (2010, 2012) distinguishes between the triggers (i.e. the proximate causes) and the vulnerabilities (i.e. the structural weaknesses) within the financial system that served to spread and amplify the initial shock. This distinction is useful in that it explains why the factors that touched off the crisis seem disproportionate to the magnitude of the economic and financial reaction. (Continued)

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The main trigger of the GFC was the boom and the bust in the US housing market. According to Reinhart and Rogoff (2009), the beginning of the crisis in the US does not deviate from the regularities observed during 18 banking crises that have affected developed countries since World War II, notably in Spain (1977), Norway (1987), Finland and Sweden (1991), and Japan (1992): a housing boom in the four years preceding the crisis, although sharper in the US than in the five previous examples, followed by a sudden and very rapid decline. Fuelled by a widespread optimism about future increases in house prices, household leverage had increased markedly, in line with the rapid increase in mortgage debt. Thus, the housing boom had made households and banks financially vulnerable (Gertler and Gilchrist, 2018). Declining house prices affected household spending and, in turn, economic activity. The bust was followed by the collapse of the subprime mortgage market. Judged in relation to the size of global financial markets, aggregate exposures to subprime mortgages were quite modest. Losses on subprime mortgages, or even in the US housing market, can account for the crisis only insofar as they interacted with fundamental vulnerabilities outside the traditional banking sector that served to amplify their effects (Bernanke, 2012). Many of these vulnerabilities were associated with the increased importance of the shadow banking system. As a matter of fact, the rise in US house prices occurred in a context of: − −

increasing securitization (Brunnermeier, 2009), a shift of credit provision away from the traditional commercial activities of loan origination and deposit issuing towards a “securitized banking” business model.

The emergence of complex and opaque products was a contributing factor to the GFC (Segoviano et al., 2015). For example, mezzanine tranches of mortgage securitizations, which themselves have embedded leverage, were often purchased by CDOs which, in turn, issued senior and subordinated tranches, creating additional leverage on top of that embedded in subordinated tranches (CGFS, 2009). Another key vulnerability of the financial system was the heavy reliance of the shadow banking sector as well as some of the largest global banks on various forms of short-term wholesale funding, including commercial paper, repos, securities lending transactions and interbank loans (Bernanke, 2010, 2.2.2.3). The GFC revealed how such linkages can have negative externalities for the banking system and act as an additional channel for the transmission of risk. Moreover, the flexibility and low perceived cost of short-term funding also supported a trend towards higher leverage and greater maturity mismatch in the financial system as a whole. Since shadow banks do not benefit from a government-provided safety net, alternative mechanisms were employed such as the collateralization of

Financial cycles and crises  45

liabilities or ratings by credit agencies. With the housing market bust, declining house prices and rising rates of foreclosures raised serious concerns about the values of mortgage-related assets and uncertainty about where the losses would fall. Investors realized that these mechanisms might not be adequate to protect them against losses. A powerful, self-reinforcing panic began. Widespread flight from the shadow banking system occurred. Losses were felt at key nodes of the financial system (Bernanke, 2010), notably highly leveraged banks, broker-dealers, and securitization vehicles, as a result of poor risk management by financial intermediaries and investors. In particular, investors in ABCP became concerned about the credit quality and the liquidation value of collateral and stopped refinancing ABCPs. However, banks had insured outside investors in ABCPs by providing guarantees to conduits, which required paying off maturing ABCPs at par. Therefore, ABCP conduits, often set up by banks for regulatory arbitrage motives (i.e. to reduce their effective capital requirements), provided little risk transfer during the run, as losses from conduits remained with banks instead of outside investors. Actually, ABCP conduits were a form of securitization without risk transfer (Acharya et al., 2013). The most acute phase of the GFC occurred in September 2008 with the collapse of Lehman Brothers, an investment bank and, in that sense, a shadow bank, with a very significant increase in risk pricing, a freeze in the money market and an overall increase in risk premiums on equities, bonds, loans, and securitized instruments. The securitization market came to a halt, making it more difficult for traditional financial intermediaries to finance loans to households and businesses (Campbell et al., 2011). To sum up, the GFC combined two forms of interaction between banking distress and the real economy (Gertler and Kiyotaki, 2015): − −

depletion of capital for losses on subprime loans and related assets forced many financial institutions to contract lending and raise the cost of credit, weakening financial positions led to classic runs on a variety of financial institutions, mainly the shadow banking system. The asset fire sales induced by the runs amplified the overall distress in financial markets, raising credit costs which, in turn, helped trigger the sharp contraction in economic activity.

Moreover, the statutory framework of financial regulation in place before the GFC contained serious gaps (Bernanke, 2012): shadow banks were not, for the most part, subject to consistent and effective regulatory oversight and to meaningful prudential regulation. These gaps in statutory authority had the additional effect of limiting the information available to regulators and, consequently, may have made it more difficult to recognize the underlying vulnerabilities and complex interlinkages in the overall financial system.

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2.3 Crises Crises (and booms) are the most intense forms of financial cycles because large movements in financial variables are often associated with highly volatile fluctuations in economic activity (Terrones et al., 2011). However, there is no unanimously accepted definition of financial crises. They can be considered from two perspectives, empirical (2.3.1) and theoretical (2.3.2), with the two approaches informing each other (Gorton, 2012). Since the GFC, recent research has investigated balance sheet and leverage constraints facing all types of borrowers and the non-linear character of financial crises (2.3.3).

2.3.1 Empirical approaches Economic history reveals eight patterns, identified by the empirical literature (Gorton, 2012; Claessens and Kose, 2013): −

−

− − −

− − −

Financial crises occur from time to time in market economies (Kindleberger, 1978; Reinhart and Rogoff, 2009). According to Laeven and Valencia (2008), 147 banking crises occurred in developed and emerging countries over 1970–2011. However, market economies experience long periods of financial stability, as in developed countries from the 1940s to the early 1970s, for reasons that are not fully understood yet but which could be explained by the existence of capital controls and very strict domestic financial regulations (Taylor, 2012). That being said, too strict regulation hinders innovation and limits competition, has therefore a cost and does not guarantee financial stability, as financial entities have no incentive to monitor their risk-taking. Generally, financial crises are sudden and begin with a liquidity crisis (Chapter 1) affecting the banks and markets (Laeven and Valencia, 2008). A sovereign debt crisis frequently follows the banking crisis (Reinhart and Rogoff, 2009). Financial crises are preceded by a credit boom (Reinhart and Rogoff, 2009; Gourinchas and Obstfeld, 2012; Mendoza and Terrones, 2012; Schularick and Taylor, 2012), often in connection with an increase in asset prices, particularly in real estate, and an appreciation of the real exchange rate. An increase in leverage and a deterioration in competitiveness thus seem to foreshadow the outbreak of a crisis. Crises occur near the peak of the business cycle after the credit boom, at a time when growth is beginning to slow (Gorton, 1988). Recovery from a crisis is generally slow (Cerra and Saxena, 2008; Reinhart and Rogoff, 2009). Indeed, financial crises are costly in terms of growth, particularly banking crises (Dell’Ariccia et  al., 2008), because the weakening of banks hinders the recovery of credit distribution, even if relatively large firms can partially

Financial cycles and crises  47

compensate for the contraction in banks’ credit supply through increased market financing (Adrian et al., 2012). However, the precise measurement of the costs of a crisis is complex (Laeven and Valencia, 2010). These stylized facts highlight the fundamental characteristic but also the difficulties involved in explaining financial crises (Gorton, 2012): −

−

−

−

−

The fundamental characteristic of financial crises is the manifestation of systemic risk (Chapter 1). However, the concept of financial crisis is broader than that of a systemic event, which refers to the entire financial system (through an “abnormal” contagion mechanism or following a macroeconomic shock that affects a large part of the banking sector). The failure of an individual bank, without contagion to other banks, is a financial crisis, even if it is not necessarily “systemic”. Indeed, there is a crisis in two situations: first, when holders of bank debt run on the bank (bank run, Chapter 1) or even on many or all banks to request repayment of their deposits; the failing bank and in the event of a systemic crisis, the entire banking system must then be rescued by the central bank or even by the government; second, when even in the absence of a run, the banking system is so weakened, for example, as a result of a macroeconomic shock that institutions must be rescued or, ultimately, nationalized. Therefore, there is a continuum of events with a growing adverse impact on financial stability and on the real economy, ranging from (i) the failure of a small bank – which will not be called a financial crisis – to (ii) the failure of a large bank – which will lead to a financial crisis, since many depositors are involved – and to (iii) a systemic crisis, involving the failure of more than one bank (de Bandt et al., 2010). Financial crises raise several difficulties of interpretation, attributable in particular to the evolving nature of the financial system, as observed during the GFC: what is the scope of the banking system? The GFC first affected the shadow banking system rather than the regulated banking system. What is the scope of bank debts that may be subject to a run? During the last crisis, there was, with few exceptions (e.g. Northern Rock in the UK, cited by Shin, 2009a), no run on deposits but a run on repos, a particular form of short-term bank debt. The explanation of financial crises is subject to ambiguities due to the reliance on public intervention to identify a crisis when there was no run (or the run was not noticed by observers outside the financial system, as happened during the GFC). A contrario, this points out that expectations of public intervention may have prevented or delayed a run. Correlatively, empirical studies most often use observable events – bank defaults, public intervention – to date crises. These events sometimes occur well after the onset of the crisis, and the dating of crises, and thus the analysis of their causes, is fraught with uncertainty (Boyd et al., 2009).

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2.3.2 Theoretical approaches The theory of financial crises should ideally explain why market economies experience protracted phases of financial stability, which are abruptly interrupted following a regime change characterized by a run on short-term bank debt and followed by a slow recovery in activity. Such a goal is far from being achieved (Gorton, 2012). Financial crises have long been analysed according to two polar approaches (Mishkin, 1991 and Chapter 1): −

−

The monetarist approach, which closely links financial crises and banking panics (Friedman and Schwartz, 1963). Banking panics may be at the origin of a contraction in the money supply that could lead to a recession. According to this approach, periods characterized by a sharp fall in asset prices and an increase in business bankruptcies would only be “pseudo- crises”, as they do not imply a reduction in the money supply and a corresponding intervention by the central bank as lender of last resort. The broader approach of Minsky (1972) and Kindleberger (1978), according to which a significant decline in asset prices, the failure of financial or nonfinancial firms, deflation or disinflation constitute a financial crisis.

The advantage of the first approach is that it is based on a rigorous definition of the financial crisis, particularly in relation to the notion of systemic risk (Chapter 1), and is less vulnerable than the second approach to the risk, identified by monetarists, of justifying excessive public interventions that could undermine economic efficiency. However, the monetarist approach does not explain either the deterioration in macroeconomic conditions generally observed before the crisis broke out or the outbreak of the panic phenomenon. On the other hand, in a conception derived from the theory on informational asymmetries, Mishkin (1991) defines a financial crisis as the inability of financial markets to effectively direct financing to entities with the most profitable investment opportunities, due to the worsening of adverse selection and moral hazard problems that lead to a tightening of credit supply, a widening of the spread between bad and good debtors and a contraction in activity. Goldstein and Razin (2013) recall that over the past 30 years, three streams of literature have developed in parallel to explain each a type of crisis: − − −

Banking crises and panics Credit frictions and market freezes Currency crises.

Indeed, there is a gap in the literature between, on the one hand, analyses of the banking system in closed economies (e.g. Diamond and Dybvig, 1983; Chapter 1) and, on the other hand, their extension to macroeconomic analyses in open economies, which make the link between banking, exchange rate and balance of

Financial cycles and crises  49

payments crises. It was only in the wake of the Asian crises of the late 1990s that these currents tried to join forces, as several types of crises could occur simultaneously, amplifying their effects (Kaminsky and Reinhart, 1999): −

−

−

Banking crises and panics: they stem from a lack of coordination between creditors, whether traditionally depositors (Northern Rock) or on the repo market. Investors refuse to renew their financing because they anticipate that other participants will not renew their credit lines, thus precipitating the bankruptcy of borrowers. Credit frictions and market paralysis, which amplify shocks in the presence of moral hazard and adverse selection (Chapter 1). If, due to agency problems, the debtor can invest in projects that are riskier than initially planned (risk-shifting), in particular because they are not sufficiently involved in the success of the initial investment (not enough skin in the game), or because of the existence of informational asymmetries between creditors and debtors, lenders will tighten their credit offer. This can lead to total freeze under extreme conditions (Holmström and Tirole, 1998; Tirole, 2012). These financial frictions have persistent effects, likely to amplify shocks (Brunnermeier et al., 2012). In addition, if the quality of loans deteriorates due to moral hazard and adverse selection problems, the banks’ financing difficulties, and therefore the risks of banking panics, are likely to worsen. Exchange rate crises: here, too, there is a coordination problem, with speculators attacking a currency because they anticipate that other speculators will join them, which may lead the central bank to abandon the fixed exchange rate. The exchange rate crisis is thus self-realizing. The Asian crises of the late 1990s led to the development of models combining exchange rate and banking crises and financial friction. The analysis of banking crises linked to currency crises has thus become an autonomous field of the literature, focusing on phenomena of external imbalances and contagion from the still underdeveloped financial systems of emerging countries, with industrialized countries appearing more stable. But the subprime crisis has radically reversed the perspective since the GFC broke out at the heart of the financial systems of developed countries.

Moreover, as Gorton (2012) has pointed out, models that display shock amplifications or persistent shocks do not allow for real crises, which are not conventional recessions but breaks or regime changes, to occur. In addition, the theory does not really account for the role of the weakening of households and bank balance sheets in the GFC.

2.3.3 Recent developments In their survey of new research on financial crises, Gertler and Gilchrist (2018) note that the GFC necessitated to shift more attention to balance sheet constraints

50  Financial cycles and crises

and leverage facing households and banks, and to capture the nonlinear dimension of financial crises. Indeed, pre- crisis research focused on constraints facing non-financial firms (i.e. traditional financial accelerator models “à la Kiyotaki and Moore”, 1997). However, financial crises are associated with a deterioration of the balance sheets of borrowers of all types (non-financial firms, but also households and banks). The contraction of balance sheets leads to a disruption of credit flows, inducing borrowers to curtail spending sharply. The exposure of the borrower depends on the degree to which she/he relies on debt: the higher the fraction of financing that is debt as opposed to equity, the more sensitive the balance sheet becomes to fluctuations in asset prices. This is a justification for capital requirements (Chapter 6). Gertler and Gilchrist (2018) point out that pre- GFC, households and banks were highly vulnerable to the decline in house prices because their leverage had increased sharply. Household leverage was in the form of mortgage debt in the context of a dramatic boom in housing prices. Banks financed the increase in their mortgage holdings by short-term debt. Recent research has incorporated balance sheet constraints on households (e.g. Guerrieri and Lorenzoni, 2017) and on banks (e.g. Gertler and Kiyotaki, 2015 – see Box 2.1; Brunnermeier and Sannikov, 2014). Mian and Sufi (2018) focus on the “credit- driven household demand channel” which rests on three pillars: − − −

An expansion in credit supply generates expansion and contraction in economic activity. The expansionary phase of the credit cycle boosts household demand as opposed to boosting productive capacity of firms in the economy. The contraction in the aftermath of a large increase in household debt is driven by a decline in aggregate demand which is amplified by nominal rigidities, constraints on monetary policy and banking sector disruptions.

Moreover, financial crises are non-linear events with asymmetric movements during the boom and the bust phases. Recent research has tried to generate nonlinearity through balance sheet constraints that bind only during recessions, not booms (e.g. He and Krishnamurthy, 2014), precautionary behaviour leading borrowers to reduce spending by more in response to a contraction in the balance sheet than they increase it in the case of a strengthening of similar magnitude (Brunnermeier and Sannikov, 2014) or through bank runs which generate a non-linear rise in credit spreads and a contraction in asset prices and output (Gertler et al., 2017).

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3 INTERNATIONAL DIMENSIONS OF FINANCIAL STABILITY

The world economy has experienced growing financial liberalization and integration in the last 30 years. However, abrupt and large capital outflows observed in the wake of the GFC have altered views on the costs and benefits of openness to international capital flows. Sudden stops or capital flow reversals have occurred in emerging countries (Asia, Argentina, Brazil, Turkey, etc.), but advanced economies too have not been immune to sudden stops. According to Agosin et  al. (2019), who used data for 59 countries, 22 of which are developed economies, over the period 1976–2010, advanced economies and emerging ones have had the same number of sudden stops for capital inflows. During the sovereign debt crisis in the euro area (2011–2012), several peripheral countries with current account deficits experienced a sudden stop of private financial inflows. They had to cope with sharply rising borrowing costs and significant difficulties to access financial and money markets. Moreover, Eichengreen and Gupta (2016) note that global financial factors, i.e. global risk aversion, demand for liquidity and US monetary policy, had played a larger role in sudden stops in the 2000s compared to the previous decade. Accordingly, recent research has focused on the extent to which factors specific to global capital markets – i.e. exogenous to conditions in the borrowing countries – may explain capital inflows and outflows. This chapter begins by examining if, because of international capital markets integration, a global financial cycle exists (3.1). Then, the euro area crisis and the resulting fragmentation of the area’s money and capital markets are considered (3.2). Finally, the consequences of international financial flows on financial stability in emerging countries are analysed (3.3).

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3.1 A global financial cycle? Financial markets have become more integrated internationally over the past decades, leading to a synchronization of capital flows and asset prices. Analysing extreme movements in capital flows using data on both inflows and outflows in a sample of 58 countries over the period from 1980 through 2009, Forbes and Warnock (2012) find that global factors, and especially global risk, are key to understanding periods of extreme capital flows by domestic and foreign investors. Global risk is measured by the VIX, the Chicago Board Options Exchange volatility index which reflects the implied near-term volatility of S&P 500 index options. The VIX is considered as a measure of uncertainty and risk aversion in financial markets. Indeed, the co-movement of capital flows and risky asset prices has increased in the run-up to the GFC, peaking during the crisis, then has returned to a level slightly lower than in the 2000s but higher than in the 1990s (Habib and Venditti, 2018). In such an integrated environment, are shocks transmitted faster and more uniformly across the global economy and is it still possible to insulate domestic financial stability from external factors? Lane and Milesi-Ferretti (2017) document that advanced economies were especially exposed to the GFC which initially took the form of a freeze in credit markets because, during the run-up to the GFC, they had attracted large- scale debt inflows, intermediated through banks, which were partly recycled to fund foreign equity assets (FDI and portfolio equity) and partly used to fund current account deficits in the US and some euro area economies (Box 3.1). According to recent research, notably the work of Rey (2013, 2015), there is a global financial cycle (i.e. global fluctuations in financial activity), strongly influenced by changes in US monetary policy and in risk aversion globally, which explains co-movements and variations in cross-border capital flows for the period 1990–2012. Small and emerging economies are particularly affected. Even fixed assets such as housing that are non-tradable, can be affected because global investors search for yield (IMF, 2018). This section considers two issues: the definition of global financial cycles (3.1.1) and the existence of global financial cycles (3.1.2).

3.1.1 Definition of global financial cycles According to Rey (2013, 2015), increasing financial integration has led to the emergence of global financial cycles, strongly influenced by US monetary policy. Global financial cycles are associated with surges and retrenchments in capital flows, booms and busts in asset prices and crises. They are defined by large common movements in risky asset prices, credit growth, and leverage around the world. Indeed, risky asset prices such as stocks, corporate bonds, etc. have an important common component (Passari and Rey, 2015; Miranda-Agrippino and Rey, 2019). Capital flows are also highly correlated with one another and

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negatively correlated with the VIX. Leverage level and growth are also negatively correlated with the VIX. According to Rey (2015), these co-movements in asset prices worldwide do not just reflect market integration. They are, to some extent, caused by monetary conditions in the centre country (the US) which, owing to the central role played by the US dollar in global financial markets, have an impact on changes in aggregate risk aversion and volatility, capital flows, and the leverage of the financial sector in many parts of the international financial system. As capital flows respond to US monetary policy, they may not be appropriate for the cyclical conditions of other economies, leading to excessive growth in boom times and excessive retrenchment in bad times. Therefore, financial imbalances may arise and, as a consequence, domestic output may be affected. In such a world, letting the exchange rate float may not fully insulate the domestic economy, even if it is a large country, from global factors. Monetary policy used to be faced with a classical trilemma: if the capital account is open, it is impossible to run an independent monetary policy by setting the policy rate autonomously from that of the main centre country and, at the same time, have an exchange rate target or a fixed exchange rate. If global financial cycles exist, a global risk shock could be transmitted to capital flows and risky asset prices, irrespective of the prevailing exchange rate regime. Monetary policy would now be faced with a dilemma: once the capital account is open, domestic financial conditions are largely influenced by external factors, irrespective of the policy rate set by the domestic central bank and of the exchange rate. Therefore, monetary policy has only two choices – free capital mobility or monetary independence which are independent of the exchange rate regime.

3.1.2 Do global financial cycles exist? Global factors are today more important drivers of domestic financial conditions than they were 30 years ago, but evidence of their influence is mixed. They seem to matter more during stress periods and for equity flows than for debt flows. Moreover, evidence of a trilemma is elusive: −

According to the 150-year perspective provided by Jordà et al. (2019), a global financial cycle does exist among advanced economies. Its importance has increased over time, the co-movement in credit, house prices, and equity prices having reached historical highs over the past few decades. In particular, the post-1980 increase in equity co-movements exceeds the increase in the comovement in other real or financial variables and seems to be largely driven by common market responses (labelled “risk appetite” by the authors, i.e. time variation in investor sentiment, financial frictions…) to US monetary policy.

−

However, a number of papers adopting a medium-term perspective find limited quantitative evidence in support of a global financial cycle or underline

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its time-varying influence. Measuring the global financial cycle between 1990 and 2015, both directly via conventional centre-country variables such as the VIX and indirectly (proxied by common dynamic factors extracted from actual capital flows), Cerutti et al. (2019) find that the global financial cycle rarely explains systematically more than a quarter of the variation in “most types of capital flows, in most countries, for most of the time”. According to Amiti et al. (2019), who narrow the focus to cross-border banking flows for the period 2000–2017 for advanced and emerging economies, these results could be explained by the fact that the global financial cycle is not necessarily persistent: the common factor which is the dominant driver in explaining overall bank capital flows during the run-up to the GFC virtually disappears in the post-crisis period, overshadowed by idiosyncratic (country- and bank- specific) factors. Therefore, for Amiti et al. (2019), the global financial cycle is not very useful for understanding how economies emerge from crises. −

Most papers find no strong evidence of a dilemma. For Habib and Venditti (2018), if global risk aversion does emerge as a significant driver of capital flows and stock returns between 1990 and 2017, its impact is amplified by capital account openness, but not necessarily by the exchange rate regime. Moreover, the existence of a causal nexus between US monetary policy and capital flows cannot be excluded, but according to their analysis, the quantitative relevance of changes in US interest rates for international capital flows appears limited. Last, if financial market tensions have been typically synchronized between the US and the euro area, financial conditions in the euro area have often decoupled from those in the US. Bekaert and Mehl (2019) also provide results that are not consistent with the dilemma hypothesis: for countries with flexible exchange rates, the sensitivity of local interest rate changes to international base rate changes is rather limited and is not affected by the extent of de facto financial market integration. Therefore, according to Obstfeld (2015), the trilemma still applies but a more nuanced approach is required: financial globalization complicates monetary policy, but exchange rate flexibility continues to be crucial as a shock absorber.

3.2 The Euro area crisis and financial fragmentation The euro area crisis was a competitiveness crisis, a sovereign debt crisis and a banking crisis (3.2.1). Measures taken to prevent financial fragmentation avoided a larger collapse (3.2.2).

3.2.1 A competitiveness crisis, a sovereign debt crisis, a banking crisis The crisis in the euro area originated from a competitiveness and debt crisis that was fuelled by massive capital inflows within the area and the weakness of

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Box 3.1 Capital flows and the GFC – the “savings glut” and the “global banking” views Did current account imbalances fuel a credit boom and risk-taking in major advanced economies? From a historical point of view, there is a correlation between large current account imbalances in major advanced economies and the frequency of financial crises (Reinhart and Rogoff, 2009; Taylor, 2013).

1. The “savings glut” view The parallel increase in the US current account deficit – which peaked at 6% of GDP in 2006 – and the surpluses in emerging countries, first and foremost China, led to a “savings glut view” (Bernanke, 2005). According to this view, emerging countries’ central banks accumulated foreign exchange reserves in order to resist appreciation pressures on their currencies resulting from an export-based and financially underdeveloped growth model, which creates an imbalance between ex ante savings and investment. Reserves were used to acquire US dollar safe assets. The resulting surge in net capital inflows into the US eased financial conditions, lowered global long-term interest rates and risk premia, resulting in a credit boom and an overall deterioration in credit quality in advanced economies. Borio and Disyatat (2011) argue that the “savings glut view” gives a distorted interpretation of the role of current account imbalances in triggering the GFC and therefore has no explanatory power on the financial vulnerabilities that caused the GFC. Current accounts capture the net financial flows that arise from trade in goods and services. They exclude the underlying changes in gross flows and their contribution to existing stocks, including all the transactions involving only trade in financial assets, which make up the bulk of cross-border financial activity. In a nutshell, the current account has no informative content on the domestic financial system’s role in cross-border lending and borrowing flows or in the patterns of cross-border financial intermediation. Moreover, it is not indicative of the extent to which investments are financed from abroad or of the influence of cross-border capital flows on domestic financial conditions. In this respect, Borio and Disyatat (2011) note that the geographical breakdown of capital inflows in the US is not consistent with the “savings glut view”: Europe accounted for around one-half of total gross inflows to the US in 2007, with more than half coming from the UK, a current account deficit country, and one-third from the euro area, a region roughly in balance. This amount alone exceeded that from China and from Japan, two large surplus economies. Lane and McQuaid (2014), who investigate the dynamics of credit and international capital flows for 54 advanced and emerging economies over (Continued)

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the period 2003–2008, reach a similar conclusion: credit developments are strongly related to cross-border debt inflows, including both the portfolio and the bank flows, the response to capital inflows being larger in advanced than in emerging economies. Capital inflows may fuel credit booms.

2. The “global banking” view Moreover, Borio and Disyatat (2011) note that foreign holdings of US securities by European residents made up almost half of all foreign holdings before the GFC. China and Japan also had large holdings, reflecting the accumulation of foreign exchange reserves. But, while total holdings of US debt securities in 2007 were particularly high in China and Japan, holdings of privately issued mortgage-backed securities (MBS) were concentrated in advanced economies and offshore centres. This evidence gave rise to an alternative “global banking glut view” (Shin, 2012). Banks from both surplus and deficit countries, mainly in Europe, set up conduits that held risky US MBS funded by short-term commercial paper (Acharya and Schnabl, 2010), thus fuelling unsustainable leveraging by US households. According to McCauley (2018), the predictions of the “global banking view” match key features of the GFC closer than the “savings glut view”. Following the “savings glut view”, foreign exchange reserve managers being risk-adverse, their inflows should have been invested in safe assets (US Treasuries and fixed- rate Agency securities), lowering Treasury yields and fixed- rate mortgage yields and increasing mortgage spreads, thus biasing mortgage lending towards those carrying fixed rates. Two predicted effects of the “savings glut view” did hold: inflows in US Treasuries and lower Treasury yields. However, predictions regarding mortgage flows and yields were not realized. Spreads on fixed- rate Agency and risky private jumbo MBS actually narrowed in the 2000s. Moreover, floating rate mortgages predominated in private label MBS. The underlying reason was that some European banks preferred to match their mostly short-term dollar funding with floating- rate MBS. To sum up, according to McCauley (2018), European banks’ vulnerability arose from their role as producers of ultimately toxic assets (with a market share of a third in the production of highly leveraged MBS) as well as from their role as investors which were ultimate holders of such paper; their affiliates’ US balance sheets required massive write- downs in 2008. However, as stressed by Bertaut et al. (2012), the “savings glut” and the “global banking” views are not exclusive from one another. Both inflows into safe assets as well as European acquisition of securitized products played a role in contributing to downward pressures on US interest rates, inducing a search for yield.

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European institutions, and amplified by the “doom loop” between sovereign and banks’ balance sheets (Tirole, 2012; Fahri and Tirole, 2018, Chapter 9). Peripheral countries (Ireland, Italy, Spain, Portugal, and Greece) experienced large capital inflows from other member countries during the run-up to, and creation of, the euro area. In a context of falling inflation, low interest rates, disappearing currency risk and low stock of capital per worker, core-country investors expanded their cross-border supply of credit in these countries, including shortterm financing, intermediated by banks, with negligible compensation for default risk, let alone a possible exit from the euro area (Cecchetti and Schoenholtz, 2018). The literature (e.g. Benigno et al., 2015) tends to draw a connection between the relatively poor performance of peripheral countries and these large capital inflows. Indeed, capital markets in peripheral countries lacked the depth to channel these flows (Brunnermeier and Reis, 2019). Resources were shifted out of the tradable productive sector into government finance (Greece, Portugal) and into the non-tradable sector (e.g. real estate in Ireland and Spain), and productivity growth slowed down. However, wages increased faster than productivity and competitiveness deteriorated. Property boom-bust cycles and current account deficits made investors suddenly aware of the deterioration in competitiveness and led to concerns about the sustainability of rising sovereign debt levels. Growing concerns about sovereign risk (2011–2012) led to a weakening of banks’ balance sheets due to losses on their sovereign bond portfolio, increasing their funding costs, with a negative impact on credit supply. In a “deadly embrace” (Fahri and Tirole, 2018), concerns about euro area banks and the perspective of having to bail some of them out undermined, in turn, the sovereign debt market. Channels of contagion to other countries of the euro area were also liable to come into play when, for example, a foreign bank was exposed to the country suffering the shock because it had extended loans to corporations or households in that country or because of sovereign bond holdings, etc.

3.2.2 Financial fragmentation Prior to the GFC, differences in the yields of sovereign bonds had almost disappeared. They reappeared during the GFC, which had a significant impact in peripheral countries, and peaked during the sovereign debt crisis. At that time, the solvency of some member countries, and even their continued presence in the euro area, was questioned, leading investors to demand growing risk premia. The spread between Greek and German ten-year bonds, which was in the order of 50 basis points before the crisis (in retrospect, an acute underestimation of risks present in the Greek economy), reached 300 basis points in Spring 2009 and exceeded 1,000 basis points in 2010. Peripheral countries which accumulated excessive sovereign debt were free riding in a currency union without clear and binding fiscal rules (Tirole, 2012). Admittedly, sovereign default risk premia did increase during the sovereign crisis. If investors had had full confidence in the ex post possibility of bailouts,

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spreads between euro area sovereign bonds would not have increased. Instead, interest rates would have risen across the board. However, the “domino” effect mentioned by Tirole (2012) came into play since no single member country could bail out all the others: with the deterioration in the fiscal situation in a sufficiently large number of countries, credit spreads had to increase in the absence of institutional risk-pooling in the euro area. Evidence of financial fragmentation also appeared in the interbank market in 2011–2012 with increasing interest rate differentials across countries and vanishing cross-border funding. Increased counterparty risk of borrowers in non-core euro area countries resulted in less lending by banks in core countries. Indeed, concerns about market access in the future can lead banks either to increase their short-term lending rate or to withdraw entirely from interbank lending (Eisenschmidt et al., 2018). Fragmentation in the interbank market is a sign of impairment in the initial transmission of monetary policy, which can undermine its effectiveness in steering broad credit conditions for households and firms. To address impairments in the interbank market, the ECB introduced measures such as fixed rate tender procedures with full allotment and very long-term refinancing operations, leading to a build-up in Trans-European Automated Real-Time Gross Settlement Express Transfer System (TARGET) balances (Box 3.2).

Box 3.2 TARGET balances TARGET2 is the real-time gross settlement system owned and operated by the Eurosystem which settles euro- denominated payments continuously on an individual transaction-by-transaction basis without netting. TARGET balances are intra- Eurosystem assets and liabilities on the balance sheets of national central banks (NCBs) of the euro area vis-à-vis the European Central Bank (ECB) resulting from net cross-border payments in the form of central bank reserves via the TARGET2 payment system (Eisenschmidt et al., 2017). Two episodes of sharp increases in TARGET balances have led to debates over what their accumulation means and what should be done about it: a demand- driven episode during the first years of the euro area crisis till the sovereign debt crisis in 2011–2012; a supply- driven episode during the Eurosystem’s Asset Purchase Programme (APP) which began in 2014. This box first recalls how the TARGET2 mechanism works and then analyzes the different drivers of the increase in TARGET balances during these two episodes.

1. How does the TARGET2 mechanism work? Intra-system balances are an inherent feature of a decentralized monetary union and, therefore, of a decentralized monetary policy implementation, where banks have their central bank accounts spread across several NCBs

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which constitute, together with the ECB, the Eurosystem (Eisenschmidt et al., 2017). TARGET2 ensures that bank reserves held with the Eurosystem are fully fungible across euro area member countries. Full fungibility implies that the rate paid by any bank to borrow reserves in the unsecured overnight market should be a function of the level of aggregate liquidity in the euro area rather than of domestic liquidity. Reserves are held by Eurosystem counterparties (i.e. banks) in their accounts with their respective NCBs. TARGET2 settles on these accounts eurodenominated payments related to monetary policy operations, interbank payments by banks on behalf of clients or on their own initiative and transactions related to the settlement of financial market infrastructures (payment systems, securities settlement, etc.). The NCBs transfer or deduct funds from their respective banking systems. The emergence of TARGET balances is the result of differences in cross-border receipts and payments between euro area countries through TARGET2: a net inflow (outflow) of funds into (out of) the country generates an increase (decrease) in the claim position or a decrease (increase) in the liability position (Alves et al., 2018).

2. Drivers of the increase in TARGET balances during the sovereign debt crisis (2011–2012) then during the APP (beginning in 2014) Prior to the GFC, TARGET balances existed but were relatively small: excess liquidity (reserves in excess of the liquidity needs of the banking system) was practically zero. With the GFC and then the sovereign crisis in the euro area, TARGET balances increased very sharply. In August 2012, the liabilities (i.e. inflows persistently below outflows) accumulated by Italy, Ireland, Portugal, and Spain peaked at 875 billion euros, while German, Dutch, and Finnish claims reached 940 billion euros. Because of a high level of both perceived risk and risk aversion, banks in lower-rated countries experienced funding difficulties: foreign investors refrained from rolling over their investments and domestic investors partly “fled to quality” to core countries. Moreover, banks in general were hoarding liquidity and building up liquidity buffers, limiting the circulation of liquidity among banks and in particular across borders. In this context of loss of market-based funding – and even of loss of access to wholesale funding markets of entire national banking systems – the ECB decided to accommodate all demand for reserves (subject to collateral availability) by introducing new measures, inter alia fixed rate tenders with full allotment and very long-term refinancing operations. Banks in lower-rated peripheral countries (e.g. Spain and Italy) participated very significantly in the Eurosystem refinancing operations, substituting central bank credit to market funding. (Continued)

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This very high take-up served mainly to fill emergency funding gaps, and, in the context of an interbank market freeze, the liquidity provided accumulated in countries that were least affected by the crisis via cross-border flows. However, large TARGET balances may also arise for other reasons than financial market frictions, financial fragmentation or unsustainable balance of payments developments. The supply- driven surge in TARGET balances beginning in 2015 is a case in point. In 2014, the ECB started to conduct APP aimed at fending off deflationary pressures, in particular the Public Sector Purchase Programme (PSPP), which began in March 2015. Given the decentralized implementation of monetary policy in the euro area, under the APP, each Eurosystem central bank creates reserves on its own balance sheet in order to fund purchases from non-residents located in other euro area countries or in the rest of the world. Then, these reserves frequently flow across borders depending on the location of counterparties and of their settlement accounts, which are often concentrated in a small number of countries (Germany, the Netherlands, Luxembourg, or Finland, whose claims reached 1,294 billion euros in October 2018), when the counterparties are non-residents of the euro area. Moreover, the portfolio rebalancing process APP operations support may also come into play depending on the choice of the initial seller to hold the liquidity obtained from the sale or to purchase another asset (Alves et al., 2018).

3.3 International capital flows and financial stability in emerging countries Financial globalization entails benefits and challenges for emerging countries (3.3.1). What are the policy options available to absorb the impact of capital flows (3.3.2)?

3.3.1 Benefits and challenges of financial globalization Reducing or removing frictions on cross-border capital flows tends, inter alia, to equalize the cost of capital across countries and can enhance the ability of domestic and foreign households to share risks. Moreover, freer capital mobility may discipline macroeconomic policies because the capacity of a government to make bad choices is more constrained. However, emerging countries may not benefit fully from financial globalization. The review of literature provided in Wei (2018) explores four main structural reasons: −

The opening of the capital account in the context of a distorted domestic financial system  –  which channels domestic savings towards less efficient firms – could exacerbate the misallocation of resources, fuelling asset price bubbles and increasing the risk of a domestic financial crisis.

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−

−

−

Distortions in the international capital market, such as sudden stops of international capital flows, may induce falling asset prices and shrinking ability to obtain financing. Distortions in the labour market may deter firm entry. Consequently, once the capital account is opened, a part of domestic savings leave the country for a better return abroad. Weaknesses in domestic public governance may exacerbate all these distortions, which makes governance reforms all the more relevant.

Moreover, financial integration fastens the transmission of monetary policy and financial shocks from advanced to emerging countries (3.1). According to Scheubel et al. (2019), approximately half of sudden stops and currency crises in emerging countries are driven by global factors, with an adverse impact on growth which depends on the exchange rate regime. In this context, a relatively lax monetary environment of centre economies tends to increase global liquidity and change the global financial intermediaries’ appetite for risk, driving large-scale, cross-border capital flows from low-yielding centre economies to high-yielding emerging economies, causing currency appreciations, credit booms and high asset prices and, consequently, increasing the risk of a subsequent financial crisis in the recipient country. The combination of high bank leverage and rapid currency appreciation tends to expose the emerging economies to the risk of capital reversal.

3.3.2 Policy options to absorb the impact of international capital flows A number of tools can help emerging countries to manage capital flows. −

−

Exchange rate flexibility: according to the IMF’s institutional view (Adrian, 2018), countries with floating exchange rates are the least susceptible to crises. Greater exchange rate flexibility may help financial sector resilience in the long run by discouraging, inter alia, unhedged foreign exchange borrowing by households and firms (provided the relevant instruments exist), dollarization of bank liabilities and excessive dependence on foreign currency wholesale funding. However, excessive foreign exchange volatility in the short run can be detrimental to financial intermediation and could call for other temporary measures. Capital flow measures: for the IMF (Adrian, 2018), capital flow measures should be used only in a limited number of circumstances when other macroeconomic policy responses are not sufficient or available. However, the abrupt and large capital outflows from peripheral Europe and many emerging economies in the wake of the GFC have altered the views in academia on the (ir)relevance of capital inflow controls. A number of economists have suggested that, in the presence of financial frictions, capital controls or macro-prudential policy would be, in addition to monetary policy, helpful

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−

−

to manage external shocks affecting emerging economies. Indeed, many emerging economies, which opened up their financial markets and moved away from rigidly pegged exchange rates, have been subject to extremely volatile capital flows and crises associated with sudden stops in capital inflows (Devereux et al., 2019). Therefore, according to, for example, Fahri and Wering (2014), capital controls – working in the opposite way to risk premium shocks, i.e. taxes on capital inflows during capital inflow surges and subsidies to capital outflows when the capital flows revert – are needed to maximize welfare even with a flexible exchange rate regime. Ben Zeev (2017) shows empirically that strict capital inflow controls moderate the effects of global lending supply shocks, thus reducing macroeconomic volatility. However, he stresses that capital controls are no free lunches because they induce a trade-off between output volatility and output growth: over the period 1995–2014, the average growth rate of emerging countries that opted for light capital controls is more than double the growth rate of countries that enforced strict controls. Macro-prudential measures (Chapter 8): in emerging economies, macroprudential tools may help contain systemic risk from volatile capital flows even when the measures do not target capital flows per se (Adrian, 2018). These tools may be used to reduce the risk of financial stress from capital outflows (by building capital buffers to protect against credit risk from foreign exchange borrowing or by reducing volatile wholesale funding through foreign exchange) and to dampen the procyclicality of capital inflows (by constraining bank leverage and by curbing excessive credit to local borrowers, including through foreign exchange). However, in an open economy, macro-prudential restrictions might be more easily circumvented (Cerutti et al., 2017): capital flow management measures may then have to be used as a complement to macro-prudential measures. Recourse to the Global Financial Safety Net (GFSN): the GFSN comprises two major components, lending support by the IMF and foreign exchange reserve accumulation (Chapter 10). According to the existing literature cited by Scheubel et al. (2019), (i) IMF lending reduces growth, but this could be explained by the conditionality of IMF lending which tends to be tougher when the crisis is particularly pronounced and thereby more difficult for the country to implement; in turn, compliance with conditionality and loan size reduce the probability of a future banking crisis; (ii) foreign exchange reserve accumulation is associated with higher post-crisis economic performance. However, the effect of foreign exchange reserve accumulation on the reversal of capital flows seems to depend on whether residents or foreign investors are considered: international reserves seem to particularly facilitate foreign financial disinvestment. Scheubel et al. (2019) find that the mere availability of GFSN access is not sufficient to cushion capital flow episodes in globally driven crises. They also stress that a more targeted use of safety net resources is necessary because their effectiveness depends on which type of crisis they are used for: IMF

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lending use is more effective after currency crises (balance of payments crises or to prevent disorderly exchange rate movements) than after sudden stops and the benefits come with a delay; when considering IMF and reserve use jointly, mainly IMF support influences the growth outcome, and mainly for currency crises is of limited effectiveness and only during sudden stops.

Bibliography Acharya V.V., Schnabl P. (2010), “Do Global Banks Spread Global Imbalances? AssetBacked Commercial Paper during the Financial Crisis of 2007–2009”, IMF Economic Review, 58(1), 37–73. Adrian T. (2018), “Challenges for Monetary Policy from Global Financial Cycles”, Speech at the Swiss National Bank, May 8, https://www.imf.org/en/News/Articles/2018/05/07/ sp050818-challenges-for-monetary-policy-from-global-financial-cycles. ­ ­ ­ ­ ­ ­ ­ Agosin M.R., Diaz J.D., Karnani M. (2019), “Sudden Stops of Capital Flows: Do Foreign Assets Behave Differently from Foreign Liabilities?”, Journal of International Money and Finance, 96, 28–36. Alves P., Millaruelo A., del Rio A. (2018), “The Increase in TARGET Balances in the Euro Area since 2015”, Banco de España, Economic Bulletin, 4. Amiti M., McGuire P., Weinstein D.E. (2019), “International Bank Flows and the Global Financial Cycle”, IMF Economic Review, 67, 61–108. Bekaert G., Mehl A. (2019), “On the Global Financial Market Integration “Swoosh’ and the Trilemma”, Journal of International Money and Finance, 94, 227–245. Ben Zeev N. (2017), “Capital Controls as Shock Absorbers”, Journal of International Economics, 109, 43–67. Benigno G., Converse N., Fornaro L. (2015), “Large Capital Inflows, Sectoral Allocation, and Economic Performance”, Journal of International Money and Finance, 55, 60–87. Bernanke B.S. (2005), “The Global Saving Glut and the Current Account”, Sandridge Lecture, Virginia Association of Economists, Richmond, Virginia, https://www. federalreserve.gov/boarddocs/speeches/2005/200503102/. Bertaut C., Pounder DeMarco L., Kamin S., Tryon R. (2012), “ABS Inflows to the United States and the Global Financial Crisis”, Journal of International Economics, 88, 219–234. Borio C., Disyatat P. (2011): “Global Imbalances and the Financial Crisis: Link or No Link?”, BIS Working Papers, 346. Brunnermeier M.K, Reis R. (2019), “A Crash Course on the Euro Area Crisis”, NBER Working Paper Series, 26229. Cecchetti S., Schoenholtz K. (2018), “Sudden Stops: A Primer on Balance- of-Payments Crises”, VOX, CEPR Policy Portal, 09 July 2018, https://voxeu.org/content/ sudden-stops-primer-balance-payments-crises. ­ ­ ­ ­ ­ Cerutti E., Claessens S., Laeven L. (2017), “The Use and Effectiveness of Macroprudential Policies: New Evidence, Journal of Financial Stability, 28, 203–224. Cerutti E., Claessens S., Rose A.K. (2019), “How Important Is the Global Financial Cycle?”, IMF Economic Review, 67, 24–60. Devereux M.B., Young E.R., Yu C. (2019), “Capital Controls and Monetary Policy in Sudden-Stop ­ economies”, Journal of Monetary Economics, 103, 52–74. Eichengreen B., Gupta P. (2016), “Managing Sudden Stops”, World Bank Group, Policy Research Working Paper, 7639.

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Eisenschmidt J., Kedan D., Schmitz M., Adalid R., Papsdorf P. (2017), “The Eurosystem’s Asset Purchase Programme and TARGET Balances”, ECB Occasional Paper Series, n°196. Eisenschmidt J., Kedan D., Tietz R. (2018), “Measuring Fragmentation in the Euro Area Unsecured Overnight Interbank Money Market, a Monetary Policy Transmission Approach”, ECB Economic Bulletin, 5, 72–85. Fahri E., Tirole J. (2018), “Deadly Embrace: Sovereign and Financial Balance Sheets Doom Loops”, Review of Economic Studies, 85, 1781–1823. Fahri E., Werning I. (2014), “Dilemma not Trilemma? Capital Controls and Exchange Rates with Volatile Capital Flows”, IMF Economic Review, 62(4), 569–605. Forbes K.J., Warnock F.E. (2012), “Capital Flow Waves: Surges, Stops, Flight, and a Retrenchment”, Journal of International Economics, 88, 235–251. Habib M.M., Venditti F. (2018), “The Global Financial Cycle: Implications for the Global Economy and the Euro Area”, ECB Economic Bulletin, 6, 52–72. IMF (2018), “House Prices Synchronization: What Role for Financial Frictions?”, Global Financial Stability Report, Chapter 3, April. Jordà O., Schularick M., Taylor A.M., Ward F. (2019), Global Financial Cycles and Risk Premiums“, IMF Economic Review, 67, 109–150. Lane P.R., McQuaid P. (2014), “Domestic Credit Growth and International Capital Flows”, Scandinavian Journal of Economics, 116(1), 218–252. Lane P.R., Milesi-Ferretti F.M. (2017), “International Financial Integration in the Aftermath of the Global Financial Crisis”, IMF Working Papers, 17/115. McCauley R. (2018), “The 2008 Crisis: Transpacific or Transatlantic?”, BIS Quarterly Review, December, 39–58. Miranda-Agrippino S., Rey H. (2019), “US Monetary Policy and the Global Financial Cycle”, NBER Working Paper Series, 21722. Obstfeld M. (2015), “Trilemma and Tradeoffs: Living with Financial Globalization”, BIS Working Papers, 480. Passari E., Rey H. (2015), “Financial Flows and the International Monetary System”, Economic Journal, 125, 675–698. Reinhart C.M., Rogoff K.S. (2009), This Time Is Different: Eight Centuries of Financial Folly, Princeton, NJ: Princeton University Press. Rey H. (2013), “Dilemma Not Trilemma: The Global Financial Cycle and Monetary Independence”, Proceedings of the 2013 Federal Reserve Bank of Kansas City Economic Symposium at Jackson Hole, 285–333. Rey H. (2015), “International Channels of Transmission of Monetary Policy and the Mundellian Trilemma”, Mundell Fleming Lecture, December 22. Scheubel B., Stracca L., Tille C. (2019), “Taming the Global Financial Cycle: What Role for the Global Financial Safety Net?”, Journal of International Money and Finance, 94, 160–182. Shin H.S. (2012), “Global Banking Glut and Loan Risk Premium”, IMF Economic Review, 60(2), 155–192. Taylor A.M. (2013), “External Imbalances and Financial Crises”, IMF Working Papers, 13/260. Tirole J. (2012), “The Euro Crisis: Some Reflexions on Institutional Reform”, Banque de France, Financial Stability Review, 16, 225–242. Wei S.J. (2018), “Managing Financial Globalization: Insights from the Recent Literature”, NBER Working Paper Series, 24330.

4 INCENTIVES

This chapter looks first into the motives and modalities of a public intervention to safeguard financial stability (4.1). In that regard, the modalities of a public intervention can take two main forms, depending on whether they rely on incentives (dealt with in this chapter) or constraints (dealt with in Chapter 5). In a market economy, incentives are provided by market discipline, supported by transparency (4.2). However, public authorities may also wish to influence market incentives through recourse to taxation in order to promote financial stability (4.3). Finally, compensation is a powerful incentive scheme for employees in the financial sector, and interacts with financial stability (4.4).

4.1 Motives and modalities of a public intervention A move towards deregulation of the financial sector was at play in most developed economies in the 30 years or so which preceded the GFC. However, this move was only partial and the financial sector has for long been subjected to regulation. Furthermore, just as the financial sector had been more heavily regulated in the aftermath of the Great Depression and World War II, new measures to regulate it have been implemented or put forward since the GFC. Hence, two questions can be asked: why intervene (4.1.1)? In case there is intervention, how can it be effective (4.1.2)?

4.1.1 Why intervene? This question is usually asked from a normative point of view (4.1.1.1), but some elements of a more positive approach have also been offered (4.1.1.2).

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4.1.1.1 Normative approach From a normative point of view, the question is: “In which cases is a public intervention justified?” The answer in the economic literature is that two conditions have to be fulfilled: there has to be a market failure and the benefits of a public intervention have to outweigh the costs (Pigou, 1932; Coase, 1960). Three cases of market failures can be distinguished: − −

−

There is monopoly power. There are externalities. In the case of financial stability, externalities can arise as a result of leveraging (Chapter 1) or a search for liquidity which can be particularly acute in times of crisis. There are negative externalities when a bank defaults and the social costs of bank crises can potentially be much higher than those supported by their shareholders. Those costs are of five sorts (Goodhart, 2010): direct legal and accounting costs of closing the firm; possible dislocation of financial markets and payment systems; loss of information, notably on customers, as well as losses of specific competences of the employees of the defaulting institution, as some of them can admittedly be reemployed, but most often after a delay; immediate uncertainty and possible definitive loss of creditors, whose assets are in any case frozen during the unfolding of the default process; and loss of access to a financing by the debtors, who have an explicit or implicit agreement from the intermediary to borrow more. Information asymmetries which inter alia make banks subject to runs (Chapter 1).

Addressing the first source of market failure falls into the realm of competition policy (Chapter 9). Addressing the other two sources of market failure has led to the deployment of “safety nets” in order to preserve financial stability. Financial agents were concerned from a very early stage to limit their risk exposure, notably by centralizing their payments within clearing houses (Kroszner, 1999). However, those schemes showed limits in the presence of systemic risk which necessitated the intervention of the central bank as a lender of last resort (Chapter 9), unless they were organized as “clubs” which de facto put barriers to entry (Bordo, 1999). For safety nets to be justified, they should however also produce benefits which outweigh their costs (Calomiris, 1999). Such costs are of three sorts: − − −

Public intervention generates moral hazard (Chapter 1). Any public intervention has a direct implementation and monitoring cost. This cost is borne both by the regulated entities and by the regulator. Distorting the incentives of the private sector can hurt medium- and longterm economic growth. In that regard, public interventions aiming at preserving financial stability should be evaluated with regard to the impediment they create to the development of financial efficacy and deepening. Indeed, the latter one contributes, through a better allocation of capital, to higher economic growth (Beck, 2010; Levine, 2011).

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4.1.1.2 Positive approach The positive approach, also called political economy approach, is less frequently adopted than the normative approach in the economic literature. It aims at answering the question: “Why do public authorities intervene?” The answer developed by Stigler (1971) and Calomiris and Haber (2014) is that there exists a demand for and a supply of regulation: demand exploits the unique capacity of supply to constrain the population as a whole, in order to make the interests of a group or of an industry prevail over those of society. Demand for public intervention can take four different forms (Stigler, 1971): −

−

−

−

Subsidies, the demand for which is rarely expressed as entrants on the market can then benefit from them, which diminishes the relative advantage of the incumbents. Controls to entry, which are conversely more often put forward, since they benefit those demanding them and allow them to capture monopoly rents. For instance, in all countries, access to some financial activities, such as banking, is restricted. Penalties to substitutes and incentives to complements. In the financial industry, each category of intermediaries endeavours to get a specific regulatory statute and a privileged tax treatment for the products it supplies. Direct price setting (Stigler, 1971, mentions the prohibition of the remuneration of sight deposits).

The positive approach leaves little room to the maximization of social welfare, in contrast with the normative approach. Is there then a role for economists in that approach (Calomiris, 1999; Zingales, 2015)? In fact, within such an approach, economists can perform different roles: −

They can provide ex post analysis. For instance, in the recent literature, Dam and Koetter (2012) show that within the German banking industry during 1995–2006, a change of bailout expectations by two standard deviations increases the probability of official distress by 6.6%–9.4%. Chavaz and Rose (2016) find that recipients of the 2008 public capital injection programme (Troubled Asset Relief Program  –  TARP) increased mortgage and small business lending by 23%–60% more in areas inside their home representative’s district than elsewhere. Mishra and Reshef (2019) use curriculum vitae of all central bank governors around the world in 1970–2011 and find that a central bank governor with financial sector experience deregulates three times more than a governor without financial sector experience. Carlson and Wheelock (2018) show that after the founding of the Federal Reserve, the interbank system became more resilient to solvency shocks but less resilient to liquidity shocks as banks sharply reduced their liquid assets, thus increasing the likelihood that the lender of last resort would be needed (Chapter 9).

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−

−

−

According to Becker and Ivashina (2018), increased bond holdings by the domestic banking sectors of euro area countries generated a crowding out of corporate lending during the sovereign debt crisis period (2010–2011). Economists can also analyse how different groups of interest and thought interact in the shaping of regulation to help formulate “politically-robust”, simple solutions. In that vein, Kroszner and Strahan (2000) show how taking into account rivalry of interests within the banking industry (large versus small banks) and between industries (banks versus insurance) as well as measures of legislator ideology and partisanship was helpful in bringing about the 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA), which reformed the US deposit insurance system after the savings and loans banks crisis of the mid-1980s. Economists can also explain why institutions do not fulfil their missions, and in the process help define and apply such notions as the “revolving door” or the “captive regulator” (Chapter 10). Among recent instances, Brezis (2017) proposes a framework in which the interaction of elites and the existence of the revolving door lead to lower economic growth. Using a sample of FDIC auctions between 2007 and 2014, Igan et al. (2017) find that bidding banks that lobby regulators have a higher probability of winning an auction and that the FDIC incurs higher costs in such auctions, amounting to 16.4% of the total resolution losses. Eichler et al. (2018) find that a deterioration in bank health in a district increases the probability that this district’s representative in the FOMC votes to ease interest rates. Finally, academics in economics can be transparent on the negative aspects of the financial industry (Zingales, 2015)!

4.1.2 How to intervene? The question is usually answered by referring to Weitzman’s (1974) seminal article. If an activity has to be regulated, is it better to intervene by setting ­quantities – e.g. through the imposition of quotas – and letting producers adjust prices, or by setting prices and letting producers adjust quantities? Weitzman’s answer is that it is indifferent if there is no uncertainty on the private costs of intervention and its social benefits. However, as soon as there is uncertainty, as is frequent, one should use quantities as instruments when the loss of a marginal social benefit would be large in comparison with the cost imposed on private agents. Conversely, prices should be set by regulation when the social benefit curve is flatter than the private cost curve. In reality, in the financial sector, public authorities seldom intervene by setting prices or quantities directly. In the following, a distinction is rather drawn between two approaches. On the one hand, the setting of constraints (4.1.2.1) tightly frames the activities of financial agents and forces the other private agents to adapt, possibly by dislocating the management of their financial assets and liabilities abroad. On the other hand, acting on incentive schemes (4.1.2.2) has a more diffuse impact and leaves more leeway for an interaction between financial and other private agents. The effectiveness of both approaches in promoting financial stability is compared (4.1.2.3).

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4.1.2.1 Setting of constraints The constraints that aim at preserving financial stability often pursue the objective of increasing the charter value of financial intermediaries, in the hope that their shareholders and managers will behave prudently in order to keep their rents. However, by creating moral hazard (Chapter 1), such actions can have an effect opposite to the one intended. Production processes (4.1.2.1.1) and/or activities (4.1.2.1.2) can be constrained. 4.1.2.1.1 Constraints on production processes Stiglitz (2001) dismisses public intervention in the form of setting capital requirements (Chapter 6) insofar as the cost of banking capital would be high. Increasing capital requirements would thus lower the franchise value of banks, giving them incentives to take more risk. Conversely, he prefers measures which raise the charter value of banks, such as the setting of ceilings on deposit rates or restrictions to entry. Above all, he supports direct intervention on production processes, such as the regulation of exchange rate positions, putting restrictions on “speculative” credit, setting collateral requirements for borrowers and diversification requirements for lenders or putting limits to the growth of assets. Many of those measures are part of macro-prudential policies (Chapter 8) and some come under the heading of “financial repression” (Reinhart, 2012). Finally, in case a crisis occurs, Stiglitz (2001) is of the opinion that banks should not be allowed to default or be recapitalized, but rather that capital requirements should be suspended and impaired bank assets bought by the government at prices above discounted values. 4.1.2.1.2 Constraints on activities Proposals to constrain activities usually aim first at separating them, with category of activities being entrusted to a specific class of intermediaries. Tobin (1987) suggests that commercial banks collect only banknotes which they would invest in Government securities as well as insured deposits invested in shortterm loans to firms and households. Boyd et al. (1998) present a model in which commercial banks take advantage of the moral hazard created by deposit insurance (Chapter 5) to extend their activities to the purchase of shares, which can be interpreted as an argument supporting the limitation of banking activities, at least in instances where insurance deposit schemes are “generous”. Haldane (2010) supports the view that, as an application of Weitzman (1974), prohibitions should limit “banking pollution”. He gives as examples the McFadden Act (1927), which limited bank branching in the States of the US till 1994, and the Glass-Steagall Act (1933), which barred commercial banks from conducting most securities transactions, till it was repealed in 1999. He observes that the period during which those regulations prevailed were marked by a high level of bank stability and a low level of bank concentration.

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4.1.2.2 Acting on incentive schemes Proposals to act on incentive schemes are more common than those promoting constraints. They essentially aim at limiting moral hazard by aligning the interests of the various stakeholders (shareholders, debtholders, employees (in particular white collars), and taxpayers whose interests are normally also taken into account by the regulators and supervisors). Allowing defaults is part of this approach, as a way to incentivize those stakeholders to monitor the risk-taking of financial intermediaries. The objective is not to avoid financial crises at any cost, but rather to minimize their costs (Freixas, 2010), which fits well with the viewpoint taken in this book (Chapter 1). The elements of that approach most commonly mentioned include: −

−

−

An emphasis on market discipline and transparency (4.2), implying the divulgation of information on guarantees granted by the intermediaries, notably in the conduct of securitization operations (Goodhart, 2010; Greenspan, 2010), the limitation of guarantees granted by public authorities to banks’ creditors (Levine, 2011), enhanced information provision by rating agencies (Calomiris, 2009) as well as on the clearing of over-the-counter (OTC) derivative markets transactions (Calomiris, 2009; Goodhart, 2010), on the remuneration of top executives (Freixas, 2010, 4.4) and on policies that encourage access to property, thus supporting leveraging (Calomiris, 2009; Greenspan, 2010, Chapter 9). Measures to limit moral hazard such as the definition of resolution mechanisms that are specific to banks, the imposition of increased capital requirements on financial institutions considered as systemic (Calomiris, 2009; Beck, 2010; Freixas, 2010; Goodhart, 2010, Chapters 7 and 8) or the requirement that some unguaranteed debt instruments should be issued (Calomiris, 1999, 2009; Freixas, 2010; Greenspan, 2010). Avoiding regulatory arbitrage (Calomiris, 2009; Freixas, 2010; Goodhart, 2010; Greenspan, 2010; Kroszner and Strahan, 2011), rather in the geographic dimension (institutions in different countries should be treated in a comparable manner) than in the institutional dimension (similar activities conducted by different categories of institutions should be treated homogenously).

4.1.2.3 What works best? Not much literature has endeavoured to decide between the two approaches on empirical ground. However, using data collected on 107 countries in the late 1990s, Barth et al. (2004) find that financial stability is negatively related to restrictions on activities, barriers to entry by foreign banks and the generosity of deposit insurance schemes. Hryckiewicz (2014) studies a panel of 23 financial crises and finds that government interventions are associated with greater risk-taking in the post-crisis periods. In particular, blanket guarantees, nationalizations, and

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asset management companies, whereby banks’ impaired assets are purchased by a government agency, contribute to the risk effect the most. The GFC seemingly did not overturn those results: −

−

−

−

Mariathasan et al. (2014) study a panel of 781 banks from 90 countries over the period 2001–2013 and show that banks perceived as more likely to benefit from government support tend to be more leveraged, more weakly capitalized, more heavily invested in risky assets and exposed to more severe liquidity mismatch, and also made heavier losses during the crisis. Hoque et al. (2015) use data on 378 banks over the period 2007–2011 to study the impact of bank loan regulation on their risk-taking. They find that capital regulations and private monitoring lead to less risk-taking, whereas official supervision and deposit insurance have the opposite effect. Restrictions on activities are ambiguous as they reduce risk-taking but also efficiency. Duchin and Sosyura (2014) find that recipients of the 2008 public capital injection (TARP) initiated riskier loans and shifted assets towards riskier securities after receiving support. Black and Hazelwood (2013) show that the increase in risk-taking by recipients of TARP funds was sharper in large banks, suggesting moral hazard due to government support. Regarding Europe, Gerhardt and Vander Vennet (2017) collect data on 114 banks which benefited from government support during the GFC and find that the aided banks hardly improved their performance indicators in the years following government aid.

Overall, it appears that overprotecting financial institutions is detrimental to financial stability, in line with an approach which rather advocates giving them proper incentives.

4.2 Market discipline and transparency Market discipline and transparency affect agents’ incentives. However, as they are primarily intended to support economic efficiency, they have an ambiguous impact on financial stability, especially since their implementation is most often based on the self- organization of highly concentrated activities (Chapter 1). In particular, market discipline can only play an effective role if no bailout is expected, whether a bailout of a private agent, such as a bank, or of a public agent, such as a government. The role of credit rating agencies (CRAs) (4.2.1), accounting standards (4.2.2), and governance of financial institutions (4.2.3) are analysed in turn.

4.2.1 Credit rating agencies CRAs perform useful functions (Becker and Milbourn, 2011). They disseminate information about default probabilities, allowing uninformed investors to assess

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the quality of around 10,000 individual securities, including structured financial assets, using a single and well-known scale (usually, a letter grade). Thereby, CRAs broaden issuers’ investor base beyond sophisticated investors who are willing and able to engage in complex credit analyses (Badoer et al., 2019). In addition, ratings are relied on extensively in financial regulation as well as in private contracts to measure and limit risk (Hau et al., 2013). However, the quality of the ratings was called into question with the GFC. Favourable ratings helped fuel the mortgage securitization process that fuelled, in turn, the housing bubble in the US. Moreover, CRAs were highly involved in the design of these mortgage-related securities, which subsequently required substantial downgrades, with the bust of house prices and the GFC (White, 2010). Indeed, ratings are procyclical and slow to adjust: − −

Ratings are particularly optimistic during boom periods and, correlatively, when investors are more confident (Bar-Isaac and Shapiro, 2013). Ratings are sluggish (White, 2010). According to CRAs, they rate “through the cycle” at the risk of delaying the identification of a possible structural change. However, this rigidity is also in the interest of the issuers and of the investors. In particular, if the ratings were reviewed more frequently, investors would have to make frequent and costly portfolio adjustments, notably if such changes are mandated by regulatory requirements.

Moreover, CRAs are at the heart of a conflict of interest (Bolton et al., 2012) inherent to their “issuer pays” model. The issuer pays a rating and then a fee during the life of the financial instrument in question, if he agrees to disclose the rating. Farhi et al. (2013) theoretically address the question of the transparency of the rating process. They show that it is not necessarily desirable to make the entire rating process transparent, in particular by requiring CRAs to disclose adverse ratings that have not been made public because transparency regulation always benefits issuers but need not benefit investors. In addition, CRAs perform a variety of non-rating paying services for the issuers (Baghai and Becker, 2018). This conflict of interest can lead to several distortions, detrimental to financial stability: −

−

The “issuer pays” business model appears to be conducive to more favourable ratings than the “investor pays” model. Jiang et al. (2012) exploit the fact that Standard & Poor’s adopted the “issuer pays” model in 1974 while Moody’s had already done so in 1970. They compare the ratings obtained by issuers of a comparable broad rating category before and after the change in Standard & Poor’s business model and conclude that the “issuer pays” model leads to higher ratings than if the investor had to pay. Cornaggia et al. (2017) highlight a revenue- driven upward rating bias: public finance bonds, which provide the smallest share of revenue of the CRAs, defaulted at a much lower rate than structured financial assets, CRAs’ largest revenue source.

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−

−

−

−

−

Non-rating activities seem also to be a source of conflict of interest: according to Baghai and Becker (2018), in India, issuers that hire CRAs for nonrating services receive higher ratings despite having higher default risk. Competition among CRAs reduces the effectiveness of ratings as the issuer may request the services of another CRA if they do not agree to disclose the rating given by a first one (ratings shopping). According to Becker and Milbourn (2011), Fitch’s increase in market share from the mid-1990s onwards coincided with lower-quality ratings of the two incumbent CRAs, Moody’s and Standard & Poor’s. Securitization (Chapter 2) increases the complexity of the financial instruments rated, which de facto increases the number of “naive” investors who are more dependent than sophisticated investors on the CRAs’ ratings (Pagano and Volpin, 2010). According to Hau et al. (2013), large banks and financial institutions that issue a large volume of securitized loans are rated more favourably than smaller entities that issue less. This distortion helps to perpetuate the existence of too big to fail institutions (Chapter 1). However, results presented in Badoer et  al. (2019) suggest that incentive conflicts reduce investor confidence in issuer-paid ratings when those ratings are more optimistic than investor-paid ratings or market-based indicators of credit risk.

These issues have led the Financial Stability Board (FSB; Chapter 10) to draw up principles for reducing reliance on CRA ratings in standards, laws, and regulation (FSB, 2010). The principles aim to end mechanical reliance by market participants and establish stronger internal credit risk assessment practices instead. The thematic peer review report (FSB, 2014) observes inter alia that the US and the EU have already implemented comprehensive reforms through legislation requiring the removal of references to CRA ratings in their regulatory and supervisory guidance. The key challenge is developing alternative standards of creditworthiness and processes so that CRA ratings are no more than an input to credit risk assessment.

4.2.2 Accounting standards In a completely frictionless and competitive environment, accounting is a veil (Sapra, 2008). Market prices are observable, in line with their fundamental determinants and common knowledge among all. However, in a world where trading prices may deviate from the hypothetical market prices that would be observed in frictionless markets, particularly whenever there is a shortage of liquidity (Chapter 1), accounting standards are important. The nature of the frictions considered the most significant and their consequences influence the choice of a standard. In particular, to what extent should balance sheets take into account changes in the market value of assets and liabilities? This question is all the

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more important since reporting and key supervisory ratios are based on accounting data. The two polar methods, used to record the value or the price of an asset or a liability, are historical cost and mark- to-market accounting (Heaton et al., 2010). −

−

Historical cost accounting identifies net income with realized cash flows. It ignores revaluation of assets and liabilities in reporting the performance of the firm. Mark-to-market or fair value accounting measures income as the sum of realized cash flows and the net change in the market value of assets less liabilities. Profits and losses generated by asset revaluations are recognitions at a point in time of changes in expected future cash flows.

Both methods have their advantages and drawbacks. Plantin and Tirole (2018) theoretically address the issue of optimal accounting measures. They show that the privately optimal contract trades off costs that closely mirror the debate between proponents of historical cost and fair value accounting. Financial crises are generally associated with a reconsideration of accounting standards (Heaton et  al., 2010). In the US, prior to the Great Depression of the 1930s, firms revalued assets values both up and down. Concerns about accounting manipulations led the Securities and Exchange Commission (SEC) to favour historical cost accounting. However, the Savings and Loans crisis of the 1980s – losses took years to be formally recognized because of historical cost accounting  – and the development at the same time of financial derivatives  – which cannot be measured at historical costs  –  encouraged a shift towards mark-to-market accounting. In 1999, the International Accounting Standards Committee (IASC) issued IAS 39, a standard for the valuation of financial instruments at fair value. In turn, the GFC has revived the debate on the role of accounting rules: Does fair value accounting compromise financial stability and is historical cost accounting the key to greater stability? A new accounting standard IFRS 9, replacing IAS 39 in January 2018, was issued in response to the performance of accounting standards during the GFC (Box 4.1). Without fundamentally questioning mark-to-market or fair value accounting (4.2.2.1), regulators and financial stability policymakers are considering possible perverse incentives (4.2.2.2).

4.2.2.1 Valuation at historical cost or at fair value Historical costs are, by definition, not very informative: they are based on past asset values and insensitive to market price signals. This complicates economic decisions, reduces market discipline and may lead to inefficiencies such as incentives to engage in asset sales aimed at the early realization of earnings (“gains trading”).

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On the other hand, the use of fair value accounting has clear advantages: −

In general, market prices provide the best measure of the economic value of an asset as they aggregate all available information at a given time. In a frictionless environment without information asymmetries, build-up of bubbles or liquidity issues, the market value of assets and liabilities reflects the value of future cash flows. Consequently, the gains and losses arising from changes in the value of assets and liabilities reflect the expected changes in future cash flows. Market values are observed during transactions. They are therefore hard to manipulate if the markets are active, liquid, and deep. The distinction sometimes made between mark-to-market valuation, which represents the net asset value of the entity concerned, and accounting at historical costs, which would be more relevant to its survival, is unfounded. Market value reflects the fact that in the event of a liquidation, the assets concerned would be allocated to a more efficient use. In addition, a firm that holds valuable assets but generates temporarily low current cash flows should be able to raise funds, backed by higher cash flow prospects (Heaton et al., 2010).

− −

Box 4.1 IAS 39 versus IFRS 9 Replacement of IAS 39 with IFRS 9 was the result of the GFC, as the complexity of the valuation of financial instruments and a “too little, too late” recognition of loan losses were deemed to have contributed to the severity and the spread of the crisis. However, accounting standards to identify and measure non-performing assets will continue to vary across jurisdictions.

1. IAS 39 IAS 39 provided for fair value measurement and impairment rules (“incurred loss model”). Fair value accounting is foremost relevant for the asset side of the balance sheet, in particular for traded instruments such as bond, shares and derivatives. IAS 39 defined four categories of financial assets: • • • •

Financial assets at fair value through profit or loss (financial assets held for trading) Held-to-maturity financial investments measured at amortized cost Loans and receivables (non- derivative financial assets that are not quoted in active markets and are measured at amortized costs) Available for sale financial assets (i.e. not classified under the first three categories) measured at fair value. (Continued)

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However, these criteria were not clear enough to prevent dubious reclassifications, notably during the GFC, in an attempt to alleviate the pressure on banks’ capital position by allowing transfers from the available-to-sale category to categories where the financial instruments are measured at amortized costs (European Systemic Risk Board – ESRB – 2017). Provisioning is relevant for instruments that are valued at amortized costs such as traditional bank loans (Basel Committee on Banking Supervision, 2015). The “incurred loss model” assumes that loans would be repaid in their entirety and that actual indications to the contrary – a “trigger event” – has to be identified before any impairment losses are recognized. This provisioning regime therefore increases procyclicality. In the case of an economic downturn, high credit losses occur, but the lack of available provisions increases the losses reported by the banks.

2. IFRS 9 While reaffirming the concept of fair value measurement, the G20 asked for an improvement of the standards of valuation of financial instruments and for a reduction of their complexity. Moreover, following the G20’s concerns about the timeliness of bank’s recognition of loan loss expenses, a forwardlooking method was introduced. IFRS 9 replaces the rules-based classification system under IAS 39 with a principles-based approach. The new standard applies a two-step test to classify all types of financial instruments and determine whether they are measured at fair value or amortized cost: • •

A business model test: Is the financial asset held in order to collect contractual cash flow? A contractual cash flow test: Do contractual cash flows represent solely payments of principal and interest?

For example, if an asset whose cash flows are solely payments of principal and interests is related to a hold-to- collect business model, measurement will be at amortized costs. If the asset is related to a hold-to- collect-and-sell model, measurement will be at fair value. According to ESRB (2017), surveys on the potential impact of IFRS 9 will not lead to a systematic increase in the use of fair value for financial assets among EU banks relative to IAS 39. The most important change introduced by IFRS 9 is the shift from the “incurred loss model” to a forward-looking methodology, the expected credit loss (ECL) approach. The new standard establishes the early recognition of ECLs before having objective evidence of impairment, lowering the threshold to prompt loan loss provision.

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3. Differences across jurisdictions in accounting standards Some countries do not follow IFRS, for instance, the US. The US generally accepted accounting principles (GAAP) differ from the standards applicable under IFRS (Baudino et al., 2018). The US used to follow an “incurred loss” approach conceptually similar to IAS 39. Starting in the first quarter of 2020, the US have migrated to a “current expected loss” provisioning model that is broadly comparable to IFRS 9, albeit with some key differences.

4.2.2.2 Perverse incentives? The ESRB (2017) notes that there is hardly any disagreement that fair value accounting is appropriate for trading assets as well as for liquid derivatives. Conversely, amortized cost (an example of historical cost) is most frequently considered as preferable for basic lending instruments expected to be held until maturity, so long as appropriate valuation bases are used for liabilities that support these assets. The main areas of disagreement concern the valuation of assets mainly held for the collection of cash flows, but which banks may occasionally sell to manage liquidity or interest rate risk, and illiquid assets other than loans. Indeed, fair value accounting is subject to four main objections related to its behavioural implications: discretion (4.2.2.2.1), increased volatility of earnings and short-termism (4.2.2.2.2), increased leverage procyclicality (4.2.2.2.3), and the negative feedback loop between balance sheet and funding constraints (4.2.2.2.2.4). 4.2.2.2.1 Discretion Pricing of assets with illiquid markets or of non-marketable instruments is based on models (mark-to-model) and assumptions, leaving considerable discretion to banks vis-à-vis the measurement of their assets, increasing opaqueness and reducing the comparability of accounting statements (Schwarz et al., 2014). Conversely, it can be objected that an uncertain value is more useful than a historical cost value that is certainly incorrect. 4.2.2.2.2 Increased volatility of earnings and short-termism Banks’ balance sheets and income statements could be overly influenced by temporary changes in market prices, which would not be the case with historical cost accounting. Obviously, this argument does not apply in the presence of fluctuations due to fundamental changes. Volatility of earnings could induce bank managers to favour short-term profit prospects, particularly when their compensation depends on the bank’s performance, to the detriment of longer-term strategic considerations relating to the

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quantity and quality of risks taken. Measures to make the compensation structure of financial sector employees more aligned with financial stability objectives (4.4) would mitigate this effect. 4.2.2.2.3 Procyclicality Did fair value accounting fuel the GFC by forcing financial institutions to recognize excessive losses, causing, in turn, fire sales and repayment of debt to satisfy regulatory constraints, thereby amplifying the procyclicality of leverage? According to a Committee on the Global Financial System (CGFS) report (2009), the spread of market- sensitive valuation techniques did contribute to increase the procyclicality of leverage in a context where trading activities were gaining in importance relatively to traditional bank lending. However, the empirical literature does not find clear evidence of a relation between fair value accounting and increased procyclicality (Schwarz et al., 2014; BCBS, 2015), suggesting that other factors unrelated to accounting, such as the business model of banks, their level of regulatory capital ratios, and book leverage, were at play. 4.2.2.2.4 Negative feedback loop between balance sheet and funding constraints Some theoretical models suggest that during a financial crisis, mark-to-market accounting may cause fire sales and amplify systemic risk. The empirical literature does not confirm that: −

−

Allen and Carletti (2008) analyse an illiquid market where asset prices display “short-run” fluctuations that reflect a liquidity deficit rather than future cash flows. In a context of mark-to-market accounting, a financial institution may have to sell its assets at these distressed prices to raise capital, thus dampening prices further and pushing other institutions to make further fire sales, leading to the liquidation of banks whose net asset value has turned negative. In such an environment, historical cost accounting would have avoided this downward spiral and its contagion effects. However, in his discussion, Sapra (2008) points out a trade- off: valuation at market prices may foster contagion but historical cost accounting would keep insolvent institutions alive (inefficient continuation). Plantin et al. (2008) highlight a similar trade-off. Choosing historical costs is inefficient because it ignores market price signals. Conversely, using mark-to-market accounting generates excessive volatility in prices, degrading their information content and leading to suboptimal decisions by financial institutions. Moreover, for Laux and Leuz (2010), fair value accounting played only a minor role during the run-up to the GFC. The accounting system has only a limited influence on the determination of banks’ results and capital ratios,

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with the exception of large investment banks. In addition, existing accounting rules offered a lot of flexibility: many financial institutions in the US and in Europe were following “mixed attribute” models rather than a pure fair value or historical cost accounting system. In addition, Huizinga and Laeven (2012) note that the US banks that held higher levels of mortgage-backed securities were opportunistically less likely to make timely write- downs and had less loan loss provisions than the others, which reflects either the flexibility of accounting rules or the forbearance of the auditors and regulators. Accounting statements are an important ingredient of corporate governance as they are the primary source of verified information that firms provide to their stakeholders (Plantin and Tirole, 2018).

4.2.3 Corporate governance in financial institutions Corporate governance refers to the set of mechanisms for the management and control of firms. Corporate governance mechanisms address an agency problem, i.e. the separation of ownership and control (Shleifer and Vishny, 1997). Weak and ineffective corporate governance of systemically important financial institutions has been widely cited as an important contributory factor in the GFC (Group of Thirty, 2012). Management failed to understand and control risks, boards of directors failed to grasp the risks taken on and did not assess accurately the vulnerability of their institution to shocks. Moreover, both groups were strongly encouraged by shareholders to focus on earnings prospects to the detriment of prudence. Indeed, the financial sector poses specific governance problems (4.2.3.1) and the literature shows that bank governance is important (4.2.3.2).

4.2.3.1 Specificity of financial corporate governance Corporate governance in financial institutions poses unique problems (Macey and O’Hara, 2003; Becht et al., 2011): −

−

Banks are more opaque than non-financial corporations. These greater information asymmetries are due in particular to the intertemporal divergence between effort and outcome. This is notably significant for insurance companies that collect premiums for covering sometimes very long-term risks (Plantin and Rochet, 2007), the increasing complexity of banking products and the limited observability of credit quality (SUERF, 2007). As a result, banks may hide difficulties for longer than non-financial corporations can (Levine, 2004). Limited competition: Due to their special role and lack of transparency, banks’ activities are highly regulated. However, regulation often has the effect of weakening market mechanisms that can correct the effects of banks’ opacity, in particular by limiting competition between them.

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In this context, the board of directors, which guides strategy, oversees activity and risks, is an important internal control mechanism. The effectiveness of the board of directors depends on its size, independence, and composition (Group of Thirty, 2012). De Andres and Vallelado (2008) study 69 major commercial banks from six countries (Canada, US, France, UK, Italy, Spain) over the period 1995–2005. They conclude that the relationship between the number of board members and the bank’s performance, measured by different indicators, has an inverted U- shape. There is a trade- off between the benefits of increasing the number of board members (increased human capital, better ability to supervise the activity) and the costs (difficulty of coordination and decision-making). The relationship between the bank’s performance and the proportion of independent directors, whose presence is likely to mitigate conflicts of interest, is also in the form of an inverted U, with the other directors providing internal knowledge of the bank.

4.2.3.2 Importance of governance Bank governance matters for three main reasons: −

−

−

Good governance contributes to growth – directly through greater efficiency in the allocation of resources and indirectly through financial development. For Levine (2004), banks with strong governance mechanisms select their risks better and allocate capital more efficiently. This result is confirmed by Zagorchev and Gao (2015): Better governance is negatively related to excessive risk-taking and positively related to the performance of US financial institutions from 2002 to 2009. However, Iqbal et al. (2015) stress that US financial institutions with strong but more shareholder-focused corporate governance structures and boards of directors were associated with higher levels of systemic risk from 2005 to 2010. In economies where financing is mainly bank-based, banks often play an important role in the governance of non-financial corporations (Claessens, 2006), with favourable externalities: improving bank governance helps to improve the governance of non-financial corporations. In return, the latter have easier access to credit and/or at a lower cost. Good governance contributes to financial stability by reducing information asymmetries and increasing the ability of the financial system to withstand shocks. Consequently, the identification of governance issues could be a leading indicator of a situation of financial fragility (Chai and Johnston, 2000).

Accordingly, the FSB (Chapter 10) places great importance on effective corporate governance and has designated the G20/OECD Principles of Corporate Governance, updated in 2015 to draw upon lessons from the GFC, as one of the key standards for sound financial systems. A peer review (FSB, 2017) offers a number of recommendations to FSB member jurisdictions, standard-setting

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bodies and financial institutions concerning disclosure and transparency, the responsibilities of the board, the rights and equitable treatment of shareholders, etc. Issues related to the quality of CEOs (“fit and proper”) as well as absence of conflicts of interest are also key components of supervision hence financial stability, but little academic research is available.

4.3 Taxation Two modes of taxing finance in order to promote financial stability have been proposed: a financial transactions tax (FTT; 4.3.1) and a financial activities tax (FAT; 4.3.2). The tax bias in favour of debt financing is dealt with in Chapter 9.

4.3.1 Financial transactions tax The motives to introduce FTT (4.3.1.1), then the results of empirical studies and the measures that have been adopted since the GFC (4.3.1.2), are presented successively.

4.3.1.1 Motives The proposal to create a tax on financial transactions is an old one: it can be traced to Keynes’s General Theory (1936). In Chapter XII, he compares Wall Street to a casino, making it one in a series of places which, according to him, “should in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges”. Keynes defines the term “speculation” as “the activity of forecasting the psychology of the market”, and the term “enterprise” as “the activity of forecasting the prospective yield of assets over their whole life”. He concludes that “the introduction of a substantial government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States”. A loose reference to “speculation” or “excessive volatility” can also be found in the literature that, following Keynes, supports the creation of a FTT. Since World War II, Tobin (1978) has famously proposed to introduce a proportional tax on all foreign exchange transactions (in 2001, Tobin ventured a rate of 0.5%) to curb “excessive volatility” in foreign exchange markets. That proposal was made in a specific context, the aftermath of the demise of the Bretton Woods system and in the context of a progressive relaxation of foreign exchange controls in developed economies. It also aimed specifically, by “putting sand in the wheels of a too well-functioning foreign exchange market”, at giving more autonomy to the conduct of monetary policies. In spite of those specificities, the label “Tobin tax” has since then been applied to proposed FTTs. In the spirit of such proposals, “excessive volatility” is related to the frequency of operations since, with a flat rate, the tax is more penalizing on short-term investment which is rolled over than on more inertial and passive longer-term investment.

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However, the existence of “excesses” and their relations to the effective duration of investment have to be demonstrated both theoretically and empirically. In order to establish such a link, at least theoretically, research has been developed following the stock exchange crash of October 1987 and the burst of the GFC. That line of research has investigated market microstructures and questioned the efficient market hypothesis (Fama, 1970), and has instead put forward the notion of heterogeneous financial markets. For instance, Stiglitz (1989) distinguishes four categories of participants in stock markets: (i) non-informed investors, who buy shares of indexed funds and do not try to “beat the market”; (ii) very wellinformed individuals, who, for instance, have inside information at their disposal; (iv) noise traders, identified with Midwest dentists and physicians or with Sunbelt pensioners as well as brokers who advise them and many managers of non-indexed funds; and finally (iv) other investors, labelled “partially informed”, including arbitrageurs who base their investment strategy on the observation of noise traders. Stiglitz (1989) assumes that by affecting primarily short-term operations which he considers as speculative, a FTT would reduce noise trading and arbitrage activity based on it, thereby also reducing market volatility. This is a strong assumption, seemingly predicated on the idea that, as far as financial markets are concerned, liquidity can be a bad thing, in contrast with the more frequent assumption found in most of the literature on financial stability that there is never too much liquidity (Chapter 1). Summers and Summers (1989) also question noise trading, defined in their case as relying on “something else than fundamentals” and implying endogenous mechanisms such as, for example, positive feedbacks (buying when prices rise, selling when they fall). They also put in the same category risk management practices, which have generalized since the mid-1980s, such as stop-loss orders and dynamic hedging strategies, which are both implemented on a largely automatic basis, when some price change thresholds have been reached. Assuming that negative feedback strategies would not imply frequent transactions, unlike positive feedback strategies, they support the creation of a FTT so as to reduce the liquidity of financial markets, which would in their view lead noise traders to withdraw from them, and thus reduce market volatility. More recently, theoretical models of financial markets microstructure have not come up with clear conclusions on the impact of a FTT as results vary according to the tax rate, the size of the market, the prevailing level of market volatility and the proportion of noise traders among market participants (Subrahmanyam, 1998; Dupont and Lee, 2007; Pelizzari and Westerhoff, 2009). However, Adam et al. (2015) present a stock market model in which FTTs reduce the size and length of boom-bust cycles but increase their likelihood, making FTTs overall undesirable. In the opposite direction, Vives (2017) develops a model in which, when traders react to their private information, they do not consider that they are influencing the price, which, in turn, influences the actions of other traders. In such a context, a FTT may help making the price less sensitive to surprises in fundamentals. Other recent papers compare the theoretical efficacy of a FTT and other regulatory measures aimed at curbing asset price volatility. Lensberg et al. (2015)

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compare short-selling bans (Chapter 5) with FTTs and find that both measures are neither as beneficial as some politicians believe, nor as damaging as many practitioners fear. Buss et al. (2016) compare the effects of constraints on stock positions (e.g. short- selling bans) and borrowing (leverage) constraints within a dynamic stochastic general equilibrium (DSGE) model. They find that they have similar effects on financial and macroeconomic variables. However, borrowing constraints and the Tobin tax are more successful than constraints on stock positions because they substantially reduce speculative trading (i.e. trading that reflects disagreement about the state of the economy) without impairing excessively risk-sharing trades (i.e. trades they consider as welfare improving because they allow to hedge labour income risk).

4.3.1.2 Empirical studies and measures recently adopted If theoretical research does not provide clear-cut results on the effectiveness of a FTT in promoting financial stability, empirical studies yields much clearer ones. Indeed, the bulk of that literature, surveyed by Schulmeister et al. (2008), shows that either there is a positive relationship between FTTs and short-term volatility, or no significant conclusion can be reached. Furthermore, Honohan and Yoder (2010) show that FTTs would have had little effect in discouraging the activities of the credit swap market, the market in securitized sub-prime mortgages or other derivatives-based markets whose malfunction is thought to have contributed to the GFC (Chapter 2). So, from an empirical point of view, and as far as financial stability is concerned, FTTs seem at worst counterproductive and at best of little relevance. Intuitively, this result is unsurprising: by increasing transaction costs, a FTT should decrease the volume of transactions and increase bid-ask spreads (i.e. reduce liquidity). In turn, this reduction in market liquidity could be achieved without an increase in market volatility only if it is primarily those market participants who are responsible for volatility and are ousted from the market by the adoption of the FTT, as surmised by Stiglitz (1989) and Summers and Summers (1989). However, it is not just volatility-creating financial transactions, which are hit by a FTT, but all financial transactions under the scope of the FTT. Almost all G20 countries have a FTT of some sort, which is in most cases based on transactions on secondary stock markets (issues are exempted). However, in the immediate aftermath of the GFC, those taxes were usually symbolic, consisting in stamp duties whose role was to record officially the ownership of assets rather than to allocate resources. Among the G20 countries, they represented a significant percentage of GDP only in the UK (0.2%) and in South Africa (0.5%) (Matheson, 2011). Experience tends to show a FTT can be operative in two sorts of situations: −

In countries where a high degree of financial repression (Chapter 9) prevails and/or immature markets are dominated by retail investors with little knowledge of accounting and finance. The first case is illustrated by Sweden

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−

−

in 1984–1991 when a FTT was in force. The adoption of the tax immediately led to a collapse in the volume of transactions (–60% for the 11 most traded firms’ shares; Umlauf, 1993). Afterwards, as financial innovation and liberalization gained ground, transactions shifted towards untaxed derivative products and, above all, abroad. In spite of a progressive enlargement of its base in order to counter tax evasion, the FTT which collected 0.5% of GDP in 1989, only represented 0.1% of GDP in 1991 when it was abolished. It had mainly resulted in the development of fictitious financial innovation and the relocation of financial activities abroad (Almenberg and Wiberg, 2012). The second case is illustrated by Deng et al. (2018) in their comparison of the dynamics of Chinese stocks, which are cross-listed in Hong Kong and in the Chinese Mainland. They find a significant negative relationship in the Chinese market, on average, between stamp duty increase and price volatility. However, this average effect masks some important heterogeneity, as the authors find the opposite effect when institutional investors have become a significant part of traders’ pool. They conclude that a Tobin tax may work in an immature market, but can backfire in a more developed market. In countries hosting financial centres, such as Switzerland, Hong Kong, or the UK. There are two reasons why an FTT can be levied in such cases. The first reason is that there are agglomeration rents to the concentration of financial activities, which justifies that part of those rents accrues to society which provides public infrastructures (European Commission, 2010). The second reason is that the international financial intermediation activity is in each case carefully exempted so as not to hurt the competitiveness of the financial centre (Almenberg and Wiberg, 2012). In the wake of the GFC, in September 2011, the EU Commission published a proposal aiming at creating a “genuine” and harmonized FTT. The unanimity required by the EU legislation in the area of taxation was not reached, but 11 countries decided to enforce a harmonized tax in 2015 at the earliest. So, the EU Commission proposed in February 2013 taxing transactions on shares and bonds at a rate of 0.1% as well as derivatives at a rate of 0.01%. So far, no decision has been taken at a supranational level, but France and Italy have created their own FTTs: France introduced an FTT in August 2012. The tax is levied on secondary market transactions on shares of companies headquartered in France and with a market capitalisation above €1 billion (109 companies were concerned when the tax was introduced). The tax rate was 0.1% at the start and was raised progressively to 0.3% at the beginning of 2017. Ownership transfer has to take place for the tax to be levied (this de facto exempts most high frequency trading operations). Market-making and repurchase market activities are explicitly exempted. Intraday trading has also been exempted since 2017. Meyer et al. (2015) find that the FTT has had a strong impact on trading intensity and liquidity supplier behaviour, trading volume decreasing by about one-fifth compared to the pre-event period. Colliard and Hoffmann (2017) find no support for the idea that an FTT improves market

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−

quality by affecting the composition of trade volume. Instead, their results support the existence of a liquidity effect through which such a tax worsens market quality and indirectly affects even the exempted traders. Italy has introduced in March 2013 a FTT on stocks of corporations with a market capitalization above €500 million. Primary market transactions, temporary purchases of securities (such as repurchase agreements), intraday operations, and market-making on the regulated market are exempted. Cappelletti et  al. (2017) find that on the regulated market, the FTT reduced liquidity, but it left transactions volumes unaffected. However, part of the OTC market may have migrated to the regulated market where the FTT rate is lower (the value of OTC transactions fell by 31% in the six months following the introduction of the tax, which corresponds to the period after the introduction of the FTT that the authors study).

4.3.2 Financial activities tax The introduction of a FAT has been proposed in an IMF report to the G20 (Claessens et al., 2010). The IMF prefers that tax to an FTT as it would be more neutral, just as a value-added tax (VAT) is more neutral than a sales tax. Indeed, the IMF suggests that the base of the FAT should be the sum of wages and profits of financial intermediaries, which is a proxy for VAT. The FAT would thus be similar to a VAT and would offset the fact that in many countries, the financial sector is exempted from VAT and is thus under-taxed in comparison with other economic sectors (in some countries such as France, there is however a wage tax which is specific to the financial sector to serve that purpose). The FAT suggested by the IMF would therefore not specifically target a financial stability purpose, although it would, as any tax, tend to shrink activity in the sector concerned. However, the IMF suggests that an alternative version of the FAT could apply to remunerations (wages and profits) beyond “normal” levels, so as to dissuade “excessive risk”taking. Then, of course, determining what “normal” and “excessive” mean without penalizing efficiency would be problematic, both from a general economic point of view and from a financial stability point of view (4.1; 4.4). A distinction is drawn between the theoretical motivations for a FAT (4.3.2.1) and how it can be implemented (4.3.2.2).

4.3.2.1 Motives Often dubbed “bank taxes”, although their perimeter can be wider and extend to the whole financial sector, FATs are motivated by the existence of externalities related to financial activity (4.1): a Pigouvian tax (Polluter pays) on financial intermediaries is intended to make them internalize the externalities they create. Four different sorts of externalities are at stake: −

Creditors of financial intermediaries can expect they will be bailed out in case of difficulties, thus leading to too much capital being allocated by financial

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−

−

−

institutions to too risky projects (Kocherlakota, 2010). If bailing out is unavoidable, then financial institutions should be taxed for it. Keister (2016) shows that whether bailouts are prohibited or not, a tax on financial institutions’ short-term liabilities can improve the allocation of resources and promote financial stability. Financial intermediaries contribute to systemic risk (Chapter 1). Acharya et al. (2013) propose that financial intermediaries should pay a tax based on their expected conditional loss in case systemic risk materializes. The tax would be collected for the benefit of the “survivors” and the broader economy. Perotti and Suarez (2011) suggest that the short-term debt of financial institutions should be taxed in a procyclical manner. As financial intermediaries cannot be excluded from privately trading in capital markets and they do not internalize that high asset prices force everyone to bear more risk, Di Tella (2019) proposes to implement the socially optimal asset allocation with a tax on asset holding. There are positive externalities to holding liquidity in case a bubble bursts and there are asset fire sales (Chapter 1). Jeanne and Korinek (2010) propose to tax credit granted to agents most subject to liquidity constraints (households and SMEs). The tax would vary cyclically. There is a tax bias in favour of debt (Chapter 9), whereas banks should be encouraged to limit their leverage (Chapters 1 and 6). Keen (2011) suggests the FAT rate should increase sharply at low levels of capitalization, reaching a maximum of 40 basis points, which is far above the levels set in Europe, where FATs have been implemented.

4.3.2.2 Implementation Following an agreement reached in June 2010, FATs have been created in EU countries with two broad objectives: limiting financial intermediaries risk-taking, which depends very much on how the tax is designed (4.3.2.2.1), and making financial intermediaries contribute to the cost of their bailing out, which may strengthen moral hazard (Chapter 1), depending on how the proceeds of the FAT are used (4.3.2.2.2). 4.3.2.2.1 Tax design Three features are important: −

The tax perimeter: a narrow perimeter may contribute to moral hazard, as subjected institutions would implicitly benefit from a protection from default which would be refused to other financial institutions (Claessens et al., 2010). Conversely, a large perimeter would be more neutral in terms of level playing field, but would extend the safety net to more numerous institutions. The choice would thus be between expanding moral hazard at the intensive margin (narrow perimeter) or at the extensive margin (large perimeter). In France, all resident banks with capital requirements above €500 million are subjected to the tax. In the UK, the threshold is lower (£20 million).

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−

−

In Germany, all banks are subjected to the FAT but the tax is not collected if the relevant sum is below €300 million, so de facto only big banks are concerned. The tax base: Claessens et al. (2010) suggest the base should be all liabilities, except capital (so as to penalize leverage) and insured liabilities (so as to avoid double taxation). They also advise that off-balance sheets, mainly resulting from the conclusion of derivative contracts, should be part of the base. This is the case in Germany. In France, the base is made of the capital requirements (Chapter 6). The tax rate: as Acharya et al. (2013), Claessens et al. (2010) suggest the tax should vary in accordance with the contribution to systemic risk and on average offset the subsidy that is implicit in TBTF (Chapter 1), which they value at between 10 and 50 basis points. This valuation is rather low in comparison with other valuations (e.g. Ueda and Weder di Mauro, 2012) and above all in comparison with the rates actually adopted, which lie between 4 and 8 basis points of liabilities excluding capital and insured liabilities (Keen, 2011). Dávila and Walther (2017) suggest a “size tax” of 40 basis points, over and above the Pigouvian levy that is charged to small banks, in order to curb the incentive for large banks to take more risk in anticipation of a bailout. In France, the rate was initially set at 0.25% in 2012 and raised to 0.539% in 2014; it subsequently declined and the FAT was abolished in 2019, as the contribution of banks to the European resolution fund increased (Chapter 7). In Germany, tax rates increase with bank size. In spite of revenues lower than expected, Buch et al. (2016) find evidence, for German banks, which were affected by the levy, for a reduction in lending and higher deposit rates, thus showing that the tax was useful in putting “sand in the wheels” of bank intermediation.

4.3.2.2.2 Use of the proceeds There are two possible uses for the proceeds of the tax (ECB, 2011). The tax can be collected ex ante, and go into a resolution fund, or it can be collected ex post, so as to recover the public money dedicated to past bailouts, and then go into the general budget. Earmarking the FAT to a resolution fun is the approach that was adopted in Germany and Sweden. It is supported by the IMF (Claessens et al., 2010), notably because it allows endowing an institution which is separated from the Government with an autonomous budget, thus allowing prompt intervention, provided of course the Government does not divert the fund’s resources at some point. However, it also makes the guarantee of financial intermediaries’ liabilities more explicit (Beck and Huizinga, 2011). This is the approach most commonly adopted in Europe.

4.4 Compensation The role which compensation, and in particular the incentive part of it, played in encouraging employees in the finance industry to take excessive risk in the run-up to the GFC, and how to correct a possible bias, are topics which have

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been hotly debated both in the media and in the economic literature. The issue of the level and structure of compensation in the finance industry is first examined (4.4.1), then measures which have been proposed in order to adjust compensation to make it more compatible with financial stability are discussed (4.4.2), and finally, measures which have been adopted are presented (4.4.3).

4.4.1 Level and structure of compensation Data are first presented (4.4.1.1), and then possible interpretations are put forward (4.4.1.2).

4.4.1.1 Data Philippon and Reshef (2012) compare wages in the US finance industry to those in the rest of the private sector over the long run. They find that workers in finance earned the same education-adjusted wages as other workers until 1990, but by 2006, the premium was 50% on average and 250% for top executives. Bell and Van Reenen (2014) studied the case of the UK between 1999 and 2008. They find that during that period, the shares of the top 1% and 10% in total wages and income increased by, respectively, 1.8% and 3.3%, and 2.4% and 3.6% for all workers, of which, respectively, 1.4 percentage points (p.p.) and 2.5 p.p. and 1.6 p.p. and 2.0 p.p. can be accounted for by finance. In other words, the change was led by the finance industry that took more than half of the increase in the shares of top 1% and 10% wages and income. According to more recent data collected by the European Banking Authority (EBA; Chapter 10), 3,865 European “risk-taking” bank employees earned more than 1 million euros in 2014, with an average compensation of 1.9 million. In 2017, according to filings with the Securities Exchange Commission, the CEOs of five large US banks (Goldman Sachs Group, Citigroup, JPMorgan, Bank of America Corp., and Morgan Stanley) were paid on average $25.3 million, up 17% from 2016. Regarding the structure of compensation, Bell and Van Reenen (2014) find that the entire gain in the top percentile for all workers between 2002 and 2008 resulted from increased bonus payments. There was a decline in the share of the top percentile for all workers between 2008 and 2011, but Bell and Van Reenen (2014) find that bankers in the top percentile increased their share in the total wage during that period, in the midst of the GFC. Boustanifar et al. (2018) study 23 countries over the period 1970–2011 and find that 50% of the increase in finance’s relative wages can be accounted for by trading activities. According to the 2010 pay disclosure for London banks, the average compensation of the 1,408 best-paid workers – most of them traders – was £1.9 million, of which the variable part (cash bonus, equity-based bonus, deferred cash bonus, deferred equity bonus) represented 85%. In 2017, according to the Office of the New York State Comptroller, the average compensation of a Wall Street employee was $422,500, up 13% from 2016, including an average bonus of $184,220.

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The picture that overall emerges, especially for top executives, traders, and large banks which are too big to fail (Chapter 1), is one of the high relative compensations, with a very large variable part and a loose connection with the firm’s performance.

4.4.1.2 Interpretation Regarding compensation levels, three main interpretations have been put forward: −

−

−

Managerial power theory, as opposed to agency theory. Bebchuk et  al. (2010) argue that some powerful CEOs are paid overly generous amounts at the expense of shareholders. Tian and Yang (2014) confirm that bank CEOs in the US fared much better during the crisis than their firms. Akin et al. (2016) find that the top five executives’ sales of their banks’ shares in the period prior the second quarter of 2006 predict the cross section of bank returns during the crisis period. Returns to talent: traders in that approach are “superstars” (Rosen, 1981) who create a “Pavarotti” effect. In that approach, marginally better talented traders make the firm earn much more (Célérier and Vallée, 2017). There can also be a base effect, in the sense that marginally more talent commands a substantial gain in value when applied to a large base (Gabaix and Landier, 2008). Negative externality. This approach applies in particular to traders’ compensation. Glode and Lowery (2016) propose a labour market model in which bankers help create a surplus that can be split between the firm and its counterparties, but hiring traders helps the firm appropriate a greater share of that surplus. With a fixed supply of bankers and traders, financial firms bid defensively for traders, who then earn more than bankers.

Empirically, Philippon and Reshef (2012) find that changes in earnings risk can explain about one-half of the average premium for finance employees, changes in the size distribution of firms can explain about one-fifth of the premium for executives. Boustanifar et al. (2018) relate the increase in finance relative wages to risk-taking, in particular in trading activities, which are opaque and subject to information asymmetries as well as higher concentration in the sector. Böhm et al. (2018) use Swedish administrative data, which include cognitive and noncognitive test scores as well as educational performance, and find no evidence that a changing composition of talent or their returns could account for the surge in the finance wage premium. They conclude that finance workers are probably capturing substantial rents that have increased over time. The evidence is thus supportive of the finance workers taking risk and capturing rents, especially within large banks, and creating negative externalities in the labour market rather than being extremely talented. As far as the structure of compensation is concerned, the reason for the large share of variable compensation usually put forward is moral hazard (Chapter 1) as

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the level of effort made by employees, in particular traders, is difficult to observe (Axelson and Bond, 2015). Consequently, pay has to be structured so as to align the incentives of the employees and those of the shareholders. However, in the absence of a credible resolution regime (Chapter 7), shareholders and employees can themselves shift risk on taxpayers, thus making the alignment of the incentives of employees and shareholders a source of risk (Phelan, 2009; French et al., 2010).

4.4.2 Suggested intervention Four different courses of action have been suggested, with the first three mainly focusing on levels and the fourth focusing on the structure of compensation: −

−

−

−

Structural reforms, which can aim either at putting constraints (4.1.2.1) or at enhancing incentives (4.1.2.2). Limiting the scope of banks’ activities, by separating retail and investment banking or by prohibiting proprietary trading (Chapter 5), puts constraints on them. Among structural reforms, competition policies can enhance incentives by reducing rents (Chapter 9). Regulatory reform can aim at limiting externalities on the labour market, also by constraining, for example, by putting a cap on bankers’ pay to increase banks’ values (Thanassoulis, 2012). Other approaches aim at better aligning the incentives of shareholders and managers with those of society by reducing moral hazard. They include higher capital charges, particularly on riskier activities (Bebchuk, 2010; French et al., 2010; Wolf, 2010, Chapter 6), and improved governance (4.2) through more active “say on pay”, better monitoring by the board of risky activities, although this also implies higher monitoring costs (Dicks, 2012), and the imposition of heavy fines on the principal if misbehaviour is detected (Siegert, 2014). Taxation can be used to shrink the financial sector in general (4.3). Bonuses can also be taxed over and above progressive income taxation, as proposed by Besley and Ghatak (2013). This was done in the UK in the 2009/2010 fiscal year, but it seems that the tax was de facto paid by the banks. Furthermore, the employers can react by increasing the fixed salary and/or by shifting the variable compensation towards more risk-inducing components, such as stock options (this is what occurred in the US following the increase of the taxation of the distribution of shares in 1993; Dittmann et al., 2011). Measures focusing on the structure of compensation aim at mitigating riskshifting through the introduction of deferred payment (French et al., 2010; Wolf, 2010), with malus applying to unvested deferred pay and clawback applying to vested compensation, and thus being more difficult to implement on both legal and practical grounds. However, in the presence of TBTF institutions (Chapter 1), malus and clawback are not sufficient, as risk can be shifted onto taxpayers (4.4.1.2). There are three approaches to mitigate the latter risk- shifting, taking it as exogenous. The first approach is to link the premium on publicly insured debt to the compensation structure banks choose (Phelan, 2009), or link pay regulations to capital regulation and the

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price of deposit insurance (Freixas and Rochet, 2013), which both can be hard to design. A second approach, suggested by Bolton et al. (2015), is to adjust linearly equity-based pay to the credit risk of the firm. However, Thanassoulis and Tanaka (2018) demonstrate that this scheme can be circumvented by the bank. The authors find that correcting for the too big to fail distortion can however be achieved by combining malus and clawback with a link of the bank executive’s pay to the interest rate on debt, whereby pay is reduced when the interest rate is high, and with restrictions on the curvature of pay with respect to the bank’s market value. As the authors underline, pay regulations would then need to be complemented by active monitoring of gaming of remuneration regulation. Overall, regulating the structure of compensation while retaining TBTF seems possible only at the cost of putting in place rather cumbersome regulation.

4.4.3 Measures adopted In the wake of the GFC, many countries have regulated compensation in the finance sector in the framework of bail out programs, so as to avoid giving the impression that they were rewarding bad management. In the US, the American Recovery and Reinvestment Act, passed in February 2009, put a ceiling of $500,000 on the annual remuneration of executives benefitting from a financial support provided by the TARP, passed in October 2008, could deduct from the corporate tax base. Furthermore, supported institutions had to ensure that the performance part of the compensation of their top executives was not conducive to excessive risk-taking that might threaten the value of the financial institution. In Germany, in October 2008, a ceiling of €500,000 was put on the total annual remuneration of bank executives who had received the support of the stabilisation fund put in place in favour of the sector. In both cases, one consequence was that some institutions did not wish to ask for a support or endeavoured to repay the support they had received as soon as possible. In both cases, this was not necessarily supportive of financial stability. Above all, in April and September 2009, the FSB defined Principles for Sound Compensation Practices and their Implementation  –  Principles and Standards (P&S) – which were adopted by the G20 (Chapter 10), and then at the domestic and EU level, within Capital Requirements Directives and Regulation – CRD and CRR – III and IV. The P&S foresee that: − − − − −

a substantial fraction of pay in variable form; between 40% and 60% of variable remuneration is deferred at least three years with a possibility of clawback; at least 50% of variable remuneration is in shares or other non-cash instruments; guaranteed bonuses are limited to the first year of employment; in case of a bailout, supervisors should have the capacity to restructure compensation so as to align it with a sound risk management (Financial Stability Board, 2009).

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CRD III also foresaw a limitation of variable compensation to no more than fixed salary (or double if 66% of shareholders approve). Around 28,000 bankers in the EU, dubbed “risk-taking individuals”, are concerned. According to the EBA, the average ratio of variable to fixed remuneration for those individuals fell from 204% in 2010 to 103% in 2013. Cerasi et al. (2017) show that the P&S contributed to changing CEO compensation policies: −

− −

The variable part of CEO compensation fell from an average 59% in 2006– 2007 to 49% in 2009–2014, with total compensation falling from $5.54 million to $3.4 million per CEO; Compensation policies changed more in banks in jurisdictions which implemented the P&S in national legislation than in other banks; Compensation became less linked to short-term profits and more linked to risks, with CEOs at riskier banks receiving less, by way of variable compensation, than those in at less risky banks.

Overall, at least in the years following the GFC, the P&S seem to have had the intended effects.

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Igan D., Lambert T., Wagner W., Zhang Q. (2017), “Winning Connections? Special Interests and the Sale of Failed Banks”, CEPR Discussion Paper, 12440. Iqbal J., Strobl S., Vähämaa S. (2015), “Corporate Governance and the Systemic Risk of Financial Institutions”, Journal of Economics and Business, 82, 42–61. Jeanne O., Korinek A. (2010), “Managing Credit Booms and Busts: A Pigouvian Taxation Approach”, NBER Working Paper, 16377. Jiang J., Harris Stanford M., Xie Y. (2012), “Does It Matter Who Pays for Bond Ratings? Historical Evidence”, Journal of Financial Economics, 105, 607–621. Keen M. (2011), “The Taxation and Regulation of Banks”, IMF Working Paper, WP/11/206. Keister T. (2016), “Bailouts and Financial Fragility”, Review of Economic Studies, 83(2), 704–736. Keynes J.M. (1936), The General Theory of Employment, Interest, and Money, London: Macmillan. Kindleberger C.P. (1978), Manias, Panics, and Crashes, a History of Financial Crises, New York: John Wiley and Sons. Kocherlakota N. (2010), “Taxing Risk and the Optimal Regulation of Financial Institutions”, Economic Policy Papers, Federal Reserve Bank of Minneapolis. Kroszner R.S. (1999), “Can the Financial Markets Privately Regulate Risk?”, Journal of Money, Credit and Banking, 31(3), 506–618. Kroszner R.S., Strahan P.E. (2000), “Obstacles to Optimal Policy: The Interplay of Politics and Economics in Shaping Bank Supervision and Regulation Reforms”, NBER Working Paper, 7582. Kroszner R.S., Strahan P.E. (2011), “Financial Regulatory Reform: Challenges Ahead”, American Economic Review: Papers & Proceedings, 101(3), 242–246. Laux C., Leuz C. (2010), “Did Fair-Value Accounting Contribute to the Financial Crisis?”, Journal of Economic Perspectives, 24, 93–118. Lensberg T., Schenk-Hoppé K.R., Ladley D. (2015), “Costs and Benefits of Financial Regulation: Short-selling Bans and Transaction Taxes”, Journal of Banking and Finance, 51, 103–118. Levine R. (2004), “The Corporate Governance of Banks: A Concise Discussion of Concepts and Evidence”, World Bank Policy Research Paper, n° 3404. Levine R. (2011), “Regulating Finance and Regulators to Promote Growth”, in Achieving Maximum Long-Run Growth, Kansas City, Kansas City: Federal Reserve Bank of Kansas City, 271–311. Macey J., O’Hara M. (2003), “The Corporate Governance of Banks”, Federal Reserve Bank of New York, Economic Policy Review, 9(1), 91–107. Mariathasan M., Merrouche O., Werger C. (2014), “Bailouts and Moral Hazard: How Implicit Government Guarantees Affect Financial Stability”, CEPR Discussion Paper, 10311. Matheson T. (2011), “Taxing Financial Transactions: Issues and Evidence”, IMF Working Paper, WP/11/54. Meyer S., Wagener M., Weinhardt C. (2015), “Politically Motivated Taxes in Financial Markets: The Case of the French Financial Transaction Tax”, Journal of Financial Services, 47, 177–202. Mishra P., Reshef A. (2019), “How Do Central Bank Governors Matter? Regulation and the Financial Sector”, Journal of Money, Credit and Banking, 51(2–3), 369–402. Pagano M., Volpin P. (2010), “Credit Ratings Failures and Policy Options”, Economic Policy, 25(62), 401–431.

Incentives  101

Pellizarri P., Westerhoff F. (2009), “Some Effects of Transaction Taxes under Different Microstructures”, Journal of Economic Behavior and Organization, 72(3), 850–863. Perotti E., Suarez J. (2011), “A Pigovian Approach to Liquidity Regulation”, International Journal of Central Banking, December 3–39. Phelan C. (2009), “Incentive Compensation in the Banking Industry: Insights from Economic Theory”, Economic Policy Papers, Federal Reserve Bank of Philadelphia. Philippon T., Reshef A. (2012), “Wages and Human Capital in the U.S. Financial Industry: 1909–2006”, Quarterly Journal of Economics, 127(4), 1551–1609. Pigou A.C. (1932), The Economics of Welfare, 4th ed., London: McMillan. Plantin G., Rochet J.-C. (2007), When Insurers Go Bust: An Economic Analysis of the Role and Design of Prudential Regulation, Princeton, NJ: Princeton University Press. Plantin G., Sapra H., Shin H.S. (2008), “Marking-to-Market: Panacea or Pandora’s Box?”, Journal of Accounting Research, 46, 435–460. Plantin G., Tirole J. (2018), “Marking to Market versus Taking to Market”, American Economic Review, 108(8), 2246–2276. Reinhart C. (2012), “The Return of Financial Repression”, CEPR Discussion Paper, 8947. Rosen S. (1981), “The Economics of Superstars”, American Economic Review, 71(5), 845–858. Sapra H. (2008), “Do Accounting Measurements Regimes Matter? A Discussion of Mark-to-Market Accounting and Liquidity Pricing”, Journal of Accounting and Economics, 45, 379–387. Schulmeister S., Schratzenstaller M., Picek O. (2008), A General Financial Tax; Motives, Revenues, Feasibility and Effects, Research Study by the Austrian Institute of Economic Research, www.wifo.ac.at/wwa/servlet/wwa.upload.DowloadServlet/ bdoc/S_2008_FINANCIAL _TRANSACTION_TAX_31819$.PDF. Schwarz C., Karakitsos P., Merriman N., Studener W. (2014), “Why Accounting Matters – A Central Bank Perspective”, ECB Occasional Paper Series, 153. Shleifer A., Vishny R. (1997), “A Survey of Corporate Governance”, The Journal of Finance, 52(2), 737–783. Siegert C. (2014), “Bonuses and Managerial Behaviour”, European Economic Review, 68, 93–105. Stigler G.T. (1971), “The Theory of Economic Regulation”, Bell Journal of Economics and Management Science, 2(1), 3–21. Stiglitz J.E. (1989), “Using Tax Policy to Curb Speculative Short-Term Trading”, Journal of Financial Services Research, 3(2–3), 101–115. Stiglitz J.E. (2001), “Principles of Financial Regulation: A Dynamic Portfolio Approach”, World Bank Research Observer, 16(1), 1–18. Subrahmanyam A. (1998), “Transaction Taxes and Financial Market Equilibrium”, Journal of Business, 71, 81–117. SUERF (2007), “Corporate Governance in Financial Institutions”, SUERF Studies, 2007/3. Summers L.H., Summers V.P. (1989), “When Financial Markets Work Too Well: A Cautious Case For a Securities Transactions Tax”, Journal of Financial Services Research, 3(2–3), 261–286. Thanassoulis J. (2012), “The Case for Intervening in Bankers’ Pay”, Journal of Finance, 67(3), 849–895. Thanassoulis J., Tanaka M. (2018), “Optimal Pay Regulation for Too-big-to-fail Banks”, Journal of Financial Intermediation, 33, 83–97. Tian G.Y., Yang F. (2014), “CEO Incentive Compensation in U.S. Financial Institutions”, International Review of Financial Analysis, 34, 64–75.

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5 CONSTRAINTS

Constraints on activities for financial stability purposes may be complementary to actions on incentives. They relate to the nature of activities or production processes (Chapter 4). In this chapter, for reasons of simplicity, a distinction is made between constraints imposed on institutions (5.1), practices in financial markets (5.2) as well as on the organization of financial infrastructure (5.3).

5.1 Institutions The criteria that define financial institutions, particularly banks, often correspond to constraints: the obligation to participate in a deposit insurance scheme (5.1.1) and the regulatory constraints on the scope of financial activities (5.1.2).

5.1.1 Deposit insurance The primary objective of a deposit insurance system is to compensate depositors when their bank fails. The first mandatory deposit insurance system appeared in the US in 1934 in response to the Great Depression with the creation of an agency, the Federal Deposit Insurance Corporation (FDIC), whose objective was to restore confidence in the financial system (Allen et al., 2011). The existence of a deposit insurance system has benefits and costs (5.1.1.1). The GFC led most countries to establish a deposit insurance scheme or to increase their coverage limits (5.1.1.2).

5.1.1.1 Benefits and costs of deposit insurance Deposit insurance reduces systemic liquidity risk by preventing bank runs. However, it distorts the incentives of bank managers and depositors, resulting in moral hazard issues.

104 Constraints

5.1.1.1.1 Benefits In the context of the self-fulfilling approach to bank runs used in Diamond and Dybvig’s (1983) model, it is optimal for depositors to withdraw their funds from the bank early if they expect other depositors to do the same (Chapter 1). Since only the first in line will be served, deposit insurance, financed by a tax whose proceeds make it possible to repay all creditors, avoids panic by dissuading depositors with no immediate liquidity needs from requesting repayment of their deposits. As there is no bank run, no tax is lifted: deposit insurance is viewed as credible, so it is theoretically cost-free.

5.1.1.1.2 Costs Diamond and Dybvig’s (1983) model is based on three questionable assumptions (Allen et al. 2011): banking crises are due to panic phenomena; the creation of a deposit insurance system does not change agents’ ex ante behaviour; and deposit insurance is cost-free for banks or for the insurer because it is credible. However, the GFC was largely due to the bursting of the housing bubble in the US (Chapter 2). More generally, crises are not exclusively caused by self-fulfilling phenomena such as bank runs, but also and above all by a deterioration in economic and financial conditions ( Jacklin and Bhattacharya, 1988, Chapter 1). In addition, Diamond and Dybvig’s (1983) model neglects moral hazard risks (Chapter 1) attached to any insurance. In contrast, a more recent theoretical literature points out that the existence of public deposit insurance, which protects banks and their creditors from losses, increases the propensity of managers to take risks (Dewatripont and Tirole, 1994; Freixas and Rochet, 1997) because of a weakening of market discipline. Indeed, deposit insurance may lead insured banks to take on riskier investments since benefits from higher risk-taking are privately captured by the bank and losses are socialized through the deposit insurance fund (Anginer and Demirgüç-Kunt, 2018). Moreover, depositors’ incentives to monitor banks’ performance weaken, and market discipline is then based solely on uninsured creditors. Finally, the allocation to a deposit insurance fund of the proceeds of the tax levied on institutions is only effective if banks are subject to low and idiosyncratic shocks, which are therefore predictable at the aggregate level. Otherwise, if taxes are collected ex ante, it leads to entrusting either too many resources to the fund or, on the contrary, not enough in the event of a systemic crisis. Moreover, the hypotheses of Diamond and Dybvig (1983) are all the more fragile as deposit insurance is likely to be introduced or its scope extended in times of banking instability (Demirgüç- Kunt et al., 2008). Correlatively, if the crisis is not due to a problem of coordination between depositors but to a deterioration in economic conditions, deposit insurance will have a cost, as it will have to reimburse the creditors of banks that have become insolvent.

Constraints  105

The empirical literature on deposit insurance is relatively uniform in its conclusions: −

−

−

−

Analysing a panel of 61 countries over the period 1980–1997, Demirgüç-Kunt and Detragiache (2002) conclude that deposit insurance increases banking instability, particularly when the regulatory and institutional environment is weak. However, the latter result may indicate that robust prudential regulation and supervision would be effective in countering the perverse incentives created by deposit insurance (Cooper and Ross, 2002). Demirgüç-Kunt and Huizinga (2004), who study a panel of 30 countries over the period 1990–1997, confirm this weakening of market discipline and stress the correlative importance of the characteristics of the deposit insurance mechanism. Interest rates paid by banks are all the less sensitive to their risk-taking or liquidity situation when the deposit insurance system has a broad coverage and is publicly managed. These mixed results may be due in part to a time-varying impact of deposit insurance. According to Anginer et al. (2014), more generous deposit insurance schemes increase bank risk and reduce systemic stability in non- crisis years. However, during the GFC, bank risk is lower and systemic stability is greater in countries with a more generous deposit insurance coverage. Over the full sample, however, the “moral hazard” effect dominates the “stability effect”: the impact of deposit insurance remains negative.

These considerations may lead to adjusting the design of the deposit insurance mechanism in order to reduce the distortions it is likely to create. This is all the more necessary that the monitoring of banks by their creditors cannot most often be carried out by depositors themselves because they are generally not well informed (Dewatripont and Tirole, 1994). Pricing that adjusts insurance premiums paid by banks to the risks they take (as has been the case in the US since the Federal Insurance Deposit Insurance Improvement Act or FDICIA of 1991) reduces moral hazard. However, it is complex to implement and can lead to more or less effective cross-subsidies between banks, which is undesirable (Freixas and Rochet, 1998).

5.1.1.2 Developments in deposit insurance systems since the GFC Starting in 2008, Governments expanded the scope of deposit insurance coverage, suggesting that these systems alone were not likely to preserve financial stability in their current design (Allen et al., 2011). This convergence of practices has resulted in particular in: − −

−

the establishment of an explicit deposit insurance system where it did not exist (e.g. Australia); higher coverage levels (e.g. the US or EU countries as part of a harmonization process – but some have gone well beyond the recommended ceiling of 100,000 euros); improvements in the payout process and the adoption of ex ante funding.

106 Constraints

These responses have been generally effective. However, although deposit insurance systems are now globally compatible with the Basel Committee’s core principles (2009a), significant differences persist between member jurisdictions of the Financial Stability Board (FSB: Chapter 10). The FSB (2012) points out, in particular: − − −

very high coverage limits in terms of the proportion of covered depositors; very high coverage levels (Germany, US, Japan), which could be conducive to excessive risk-taking if prudential supervision is not enhanced; moreover, these differences could facilitate regulatory arbitrage and complicate the resolution of cross-border crises.

All in all, deposit insurance is only credible if there are no expectations of a possible ex post extension of the insurance, which means that, if necessary, banks must go bankrupt. The only exception might be when the shocks are non-insurable, i.e. macroeconomic shocks originating outside the financial system (e.g. a foreign demand shock).

5.1.2 Limitations of the scope of financial activities Regulation precisely defines the scope of banking activities. Against the backdrop of these regulations, a long-standing debate has been going on about the benefits and drawbacks of universal banking (5.1.2.1). Historically, the regulations inherited from the Great Depression have gradually been relaxed (5.1.2.2), but the GFC has led to the implementation or proposal of new forms of separation between banking activities considered as fundamental (management of means of payment, collection of deposits, and distribution of credit) and those oriented towards financial markets, considered as carrying risks for financial stability (5.1.2.3). The question of possible regulation of the “shadow banking system” is also raised (5.1.2.4).

5.1.2.1 Benefits and drawbacks of universal banking For nearly a century, economists have been debating about the structure of banking institutions. For some, the diversification of banks’ activities allows them to better serve their customers and to be more profitable and efficient. For others, it can be detrimental to clients and involve risks to financial stability and the economy. 5.1.2.1.1 Benefits of universal banking Universal banking is an institution that offers its clients, directly or through its subsidiaries, all financial services. The universal banking model dominates the financial sector in the major European countries. Groups such as BNP Paribas, Deutsche Bank, or Santander offer their clients both retail and investment banking services; they can operate on their behalf on the financial markets and offer them insurance contracts. Many of the international banks, identified as Global Systemically Important Banks by the FSB (Chapter 8), operate as universal banks (Table 5.1).

Constraints  107 TABLE 5.1 Total assets of global systemically important banks (euro billions and %)

Banking group

JP Morgan Chase Citigroup Deutsche Bank HSBC Bank of America Bank of China

Headquarters

USA USA Germany United Kingdom USA People’s Republic of China Barclays United Kingdom BNP Paribas France Goldman Sachs USA Industrial and People’s Republic Commercial Bank of of China China Limited Mitsubishi UFJ FG Japan Wells Fargo USA Agricultural Bank of People’s Republic China of China USA Bank of New York Mellon China Construction People’s Republic Bank of China Credit Suisse Switzerland Groupe BPCE France France Groupe Crédit Agricole ING Bank Netherlands Mizuho FG Japan Morgan Stanley USA Royal Bank of Canada Canada Santander Spain Société Générale France Standard Chartered United Kingdom State Street USA Sumitomo Mitsui FG Japan UBS Switzerland Unicredit Group Italy

Total Total assets/GDP (2017) Assets, end of 2017 (1) % of country % of euro area GDP GDP (2) when applicable 2712 2063 1409 2169 2364 2684

16 12 43 93 14 25

1282 1820 1122 3612

55 79 6 34

2414 1880 2921

56 11 27

317

2

3019

28

791 1184 1494

131 52 65

1085 1600 910 885

147 37 5 61

9

1495 1161 639 203 1579 769 959

128 51 27 1 37 128 56

12 9

11

14

9 12

8

a Numerator of the leverage ratio at end 2017, in billion euros; source: FSB (2018 list of global systemically important banks). b Source for GDP: IMF Wold Economic Outlook database.

108 Constraints

The universal banking model traditionally allows economies of scale, which in principle lead to greater profitability and reduced risks, although empirical research generally concludes that economies of scale in banks and financial conglomerates are limited above a certain threshold – generally quite low in terms of asset levels (Chapter 1). The major banks have become “one stop shops” where customers can buy all the products they need. Universal banks thus achieve structural and staff savings, particularly in retail banking networks. This organization also allows them to develop and make the best use of their customers’ knowledge in order to offer them suitable products and prices. As Sharpe (1990) has shown, such information management is likely to stabilize the client portfolio and therefore the bank’s income. In addition, universal banking represents the culmination of the process of diversifying the activities of financial groups. Such diversification is likely to reduce financial risks. It allows a group to smooth its income and to have easier and cheaper access to financing on the markets (Liikanen, 2012). However, reviewing the benefits of diversification, Stiroh (2010) shows that the conclusions of the very abundant empirical literature on the subject are generally ambiguous. While studies simulating the impact of mergers between financial institutions show lower volatility in conglomerate results due to diversification gains, they do not take into account the endogenous nature of the level of risk: institutions take more risk in the event of diversification (Freixas et al., 2007). Thus, analyses comparing asset returns and their volatility based on institutions’ accounting data conclude that a higher weight of non-interest income sources is not associated with lower earnings volatility: it would even tend to increase it rather than the opposite, according to DeYoung and Rice (2004). Stiroh and Rumble (2006) show that activities generating non-interest income do not increase the return on bank shares and increase total risk. The benefits of diversifying the activities of banking groups are often less than the costs of increased exposure to the volatility of financial assets (Stiroh and Rumble, 2006). Baele et al. (2007) find similar results for European banks: the substitution of non-interest income for interest income increases the sensitivity of bank shares to market risk (the Capital Asset Pricing Model beta is higher) and reduces idiosyncratic risk. Indeed, the most recent literature stresses the risks from the complexity associated with diversification (Chapter 11). Finally, the stabilization of relations between clients and financial intermediaries is likely to contribute to a better allocation of resources within the economy. Schumpeter (1939) made the universal bank model one of the keys to German prosperity until World War I. Gershenkron (1962) also sees universal banking as a development factor for catching-up countries. 5.1.2.1.2 Drawbacks of universal banking The universal banking model has been the subject of recurrent criticism since the beginning of the twentieth century (Morrison, 2010). Investment and retail

Constraints  109

banking activities may give rise to conflicts of interest. For example, a universal bank may commit to a company to place debt securities or shares on the markets that it sells to its customers against their interest. This is the main argument against the universal banking model, an argument that has been around since the 1930s, as Kroszner and Rajan (1994) note. The expansion of the universal banking model in recent decades has led to the emergence of financial groups of unprecedented size. The balance sheets of the main European banking groups, which exceed €1 trillion, are comparable in size to the GDP of the countries in which they operate (Table 5.1).1 The development of universal banking can thus be linked to the emergence of banking groups that are too big to fail (Chapter 1). In addition, the emergence of Fintech firms that take advantage of technological changes in some segments of banking activities, leads to the unbundling of banking activities, as they are not facing the same staff and capital costs as incumbent banks. By nature, universal banks are particularly complex institutions (Chapter 11). The various activities are in a credit relationship with each other. The risks created by the exposure of part of the activity to a financial risk may be offset or accentuated by another activity. In addition to the fact that this complexity can generate additional costs in terms of risk management, it reduces the transparency of universal banks and makes it more difficult to rescue them in the event of a crisis (Liikanen, 2012). Internationalization can also weaken a banking group because, despite the advantages of geographical diversification, it exposes it to contagion factors and can place it in situations where, in order not to endanger its reputation, the group is led to make less than optimal economic decisions (Fiechter et al., 2011). In addition, by moving closer to the universal banking model, the world’s leading financial institutions have diversified their activities but have also converged on a common model (Goodhart and Wagner, 2012). Therefore, this diversification carries risks. More diversified banks hold similar portfolios so that major financial institutions become sensitive to similar shocks. This strong correlation between the financial situations of the main universal banks, aggravated by the interconnection between institutions, represents a significant source of systemic risk (Chapter 1). However, just because a financial system is made up of small, specialized, and independent entities does not make it more stable. If these institutions are sensitive to the same risks and highly interconnected, then they are systemic as a group (Brunnermeier et. al., 2009). The universal banking model is also subject to microeconomic criticism. According to Freixas et al. (2007), the different activities within universal banks are financially tied. As a result, while retail activities benefit from a deposit guarantee, other activities tend to take more risk than would be justified by market conditions alone. These authors therefore argue that universal banks benefiting from a deposit insurance guarantee should be subject to rules that isolate their activities covered by the public guarantee in terms of accounting and, above all, prudentially.

110 Constraints

5.1.2.2 Segmentation and limitation of banking activities The debates on the scope of banking activities and the structure of institutions are reflected in the regulations, which are marked by strong constraints inherited from the 1930s. These constraints were gradually lifted, leading to a largely deregulated system at the start of the GFC. 5.1.2.2.1 Banking reforms in the 1930s and 1940s During the nineteenth century, the development of modern financial activities took place in a context where most industrialized countries imposed strict but often incomplete regulations on financial institutions. Following the 1929 crisis, governments redesigned their financial regulations. The objectives of these reforms were already formulated in the terms of today’s debates. They were designed to protect investors from the risk of conflicts of interest, particularly between credit and securities distribution activities, in order to reduce the risk of crisis, i.e. to strengthen financial stability (Kroszner and Rajan, 1994). In addition, the question of the size of institutions was already raised. The prospect of the formation of a small number of major financial groups around universal banks raised concerns that they would crowd out competitors in the various financial markets due to their weight and access to information. Such an oligopoly situation could adversely affect economic growth and development (Rajan, 1996). In the US, the Banking Act of 1933 (known as the Glass-Steagall ­ Act) imposed for several decades a total separation between investment and retail banks. The Mac Fadden Act of 1927 had already prohibited domestic banks from opening branches in other states, which led, until its abolition in 1994 by the Riegle Neal Act, to the persistence of an atomized banking system. Economides et al. (1996) show that the states that voted for this law had a higher proportion of small banks that feared competition from domestic banks. In France, after a first banking law adopted by the Vichy regime, the law of 2 December 1945 distinguished three categories of institutions: deposit banks, investment banks and medium- and long-term credit banks. 5.1.2.2.2 The deregulation of the 1980s and 1990s The regulations introduced in the 1930s and 1940s have been criticised for two reasons: −

By segmenting the market, they limit competition and economies of scale (Chapter 9). Deregulating the banking sector allows it to restructure and adapt to the context of globalization, in line with the changes in other economic sectors. In the context of the late twentieth century, a trend towards concentration of the sector and diversification of activities within each banking group brought more benefits than risks (Mishkin, 1999).

Constraints  111

−

The arguments that justified the reforms of the 1930s and 1940s are challenged by a significant number of empirical studies (Morrison, 2010). Kroszner and Rajan (1994) argue that the customers of universal banks in the 1920s do not appear to have particularly suffered from conflicts of interest. Barth et al. (2001) show that constraining securities activities reduces bank efficiency and increases the risk of bank failures. In the light of this debate, Rajan (1996) points out cautiously that there is no decisive evidence in favour of the superiority of the universal banking system.2

In the US, the Glass-Steagall ­ Act remained in place, fuelling a long economic and legal debate until the late 1990s, despite the proliferation of exceptions and flexibilities that weakened the force of the text. In 1999, the Gramm-Leach-Bliley ­ ­ Act removed the last legal barriers to the universal banking model in the US, a movement that had begun a year earlier with the Fed’s approval of the merger of Citicorp and Travelers. This deregulation trend also led to a reduction in the rules limiting the geographical expansion of financial groups. In the US, federal and state laws that limited the creation of subsidiaries and branches outside a bank’s home state were repealed (Neely, 1994; 5.1.2.2.1 (i)). In Europe, the 1989 banking coordination directive, mentioned above, applied from 1992 onwards, considerably reduced the formalities that banks licensed in one country of the European Economic Area (EEA 3) have to fulfil in order to operate in another country of that area. This “European passport”, which also applies to insurance (its gradual implementation was achieved between the first coordination directives of the 1970s and the third set of directives in 2002), provides for mutual recognition of institutions and bodies accredited in another EEA country. They can then freely establish a branch or take advantage of the principle of free provision of financial services (FPS) in another EEA country upon simple notification. However, the opening of a subsidiary remains subject to approval by the authorities of the host country. The implementation of these rules helped financial institutions become more international, particularly in Europe. Indeed, within the EEA, these companies can operate outside the borders of the country of the head office (or the main European subsidiary) without having to locate capital in other countries, with prudential supervision being carried out at the social and group level but not at a lower level. By extending the existing arrangements between the EEA member countries on the one hand and between the US states on the other, bilateral agreements may recognize the equivalence of licensing and supervision regimes. They have facilitated cross-border investment flows in the financial sector in advanced countries.

5.1.2.3 Measures taken or proposed since 2008 The 2007–2008 crisis showed that the distinction between universal banks and specialized banks was not sufficient to identify risks to financial stability.

112 Constraints

During the GFC, many investment banks failed in the US (Lehman Brothers, Bear Stearns, Merrill Lynch) and Northern Rock was a mortgage bank, but its difficulties came from structural refinancing in the short-term interbank market. In addition, several universal banks also experienced difficulties (Fortis, ABN AMRO, Royal Bank of Scotland), but because of their own strategic choices, regardless of their business structure. In any case, the banking crisis has revived criticism of the universal banking model. Some of the concerns of the past have thus reappeared, in particular the issue of conflicts of interest. Some investment banks have been accused of selling structured products to their clients from subprime mortgages against which they themselves were speculating.4 Fecht (2018) highlights conflicts of interest in the management of securities transactions by German banks. For Kay (2010), supervisory authorities would not have the means to deal satisfactorily with the difficulties faced by an institution that is too large or too complex, such as a large universal bank. In his view, the emergence of too big to fail banks (Chapter 1) must be avoided at all costs, as it would raise conflicts with the proper functioning of democracy and the market economy. It would call for a drastic reform of the banking sector. Several proposals have thus emerged in favour of a narrow scope of banking activities (Chow and Surti, 2011) and a reduction in the maturity mismatch between assets and liabilities. For Kay (2010), it is appropriate to separate what he refers to as a “public utility” (i.e. deposit and payment activities) from what he considers to be “casino” activities. He advocates a strict separation between core of retail banking activities (deposits, mortgage loans), defined as narrow banking, and all other financial activities. To protect this traditional core business of retail banking and its clients, special capital or liquidity requirements may be imposed. However, implementing such a model would increase the cost of credit to the economy, increase banks’ operating costs and reduce diversification gains (Chow and Surti, 2011). Moreover, if narrow banking is accompanied by high liquidity requirements, this model is not an optimal solution to avoid systemic risks associated with liquidity crises (Cao and Illing, 2011). While theoretical debates continue, major banking reforms have gradually being implemented, notably in the US and the UK or in France and across the EU. The Volcker rule consisting in strictly limiting the exercise of activities considered as risky (5.1.2.3.1), the Vickers rule consisting in isolating retail banking (5.1.2.3.2) and the other proposals (5.1.2.3.3) are presented successively. 5.1.2.3.1 Strict limitation of risky activities (Volcker rule) The Volcker rule takes its name from the former President of the US Federal Reserve who called for the restoration of restrictive rules in the banking sector (Volcker, 2010). Like the Glass-Steagall ­ Act, the main justification for this rule is to combat conflicts of interest (Chow and Surti, 2011). It has been included in section 619 of the Dodd-Frank Act (DFA; Chapter 8).

Constraints  113

The Volcker rule applies to all federally guaranteed financial institutions, foreign banks, and banking groups with a branch or subsidiary in the US or any entity with strong ties to such institutions.5 It prohibits banks from conducting proprietary trading activities, which it defines as any spot or forward transaction in securities and derivatives for which the bank acts as the principal. Proprietary trading is one of the riskiest activities and is most likely to generate conflicts of interest between the bank and its clients. The Volcker rule severely restricts the ability of banks to invest in hedge funds and private equity funds. In order to avoid a flight of these activities into the shadow banking system, banks can only hold shares in hedge funds under very restrictive conditions. However, there are many exceptions. Some of them are related to the intention of the bank carrying out the transaction. Proprietary trading by banks is allowed if the transaction is concluded as part of underwriting, market-making, or risk-hedging. Transactions in certain securities are also permitted, including Treasury, state and local government securities in the US. Similarly, banks are able to intervene freely in the securities markets of federal agencies responsible for loan securitization (Fannie Mae, Freddie Mac, etc.). The activities prohibited to banks by the Volcker rule are much fewer than those of the Glass Steagall Act, but the exceptions provided for are also rarer (Chow and Surti, 2011). Those based on distinctions of intent are unanimously recognized as difficult to apply. The legislation could be circumvented. Also, the American federal agencies in charge of the issue (notably the Financial Stability Oversight Council, Chapter 8) launched many qualitative and quantitative studies to implement this rule (Tarullo, 2012), but, in the eyes of some analysts, this undertaking could be in vain. Thus, for Duffie (2012), market maker activities are by nature closely linked to proprietary trading. In addition, the impact of the Volcker rule on the functioning of financial markets is difficult to predict. Admittedly, the possibility for banks to continue to act when issuing securities (underwriting) and as market maker will prevent these activities from suffering from the US banking reform. Similarly, the planned exceptions mean that the public debt and US mortgage debt markets will be little affected. However, the liquidity and depth of other markets could be affected, thereby creating a distortion in favour of US debt securities benefiting from the exemptions provided by the DFA. Finally, as with any restrictive measure, it may encourage the development of the shadow banking sector (5.1.2.4). 5.1.2.3.2 Isolation of retail banking activities (Vickers rule) The Vickers rule is the main recommendation of the report submitted to the UK government in September 2011 by the Independent Commission on Banking (2011). It resulted in legislation, currently in place, requiring UK banks to separate retail banking services from their investment and international banking activities by 1 January 2019 (Britton et al. 2016). The UK government introduced a de minimis rule to exempt banks with less than £25 billion in deposits from this scheme.

114 Constraints

SERVICES THAT BANKS MUST ISOLATE WITHIN THE RING FENCING: • Deposits for individuals and SMEs • Overdrafts by individuals and SMEs SERVICES THAT BANKS ELIGIBLE FOR RING FENCINGCAN OFFER: • Loans to individuals and professionals • Project financing, leasing, factoring.... • Advice and sale of financial products ACTIVITIES PROHIBITED TO BANKS ELIGIBLE FOR RING FENCING (directly as well as on behalf of third parties): • • • • •

Ownership of subsidiaries not eligible for ring fencing Any activity outside the European Economic Area Investments in shares, private debt securities, or any equivalent product Transactions in derivatives markets Transactions in secondary securities markets

FIGURE 5.1

Activity breakdown according to the Vickers report.

Source: Independent Commission on Banking (2011) and Chow and Surti (2011).

This rule can be summarized in terms similar to the Volcker rule. It prohibits certain activities by certain financial institutions, but its logic is different. Indeed, it does not seek to separate the riskiest activities from the others, but aims to isolate those activities considered essential for the proper functioning of the economy (retail banking whose deposits are guaranteed) from other banking activities. The Vickers report (Independent Commission on Banking, 2011), which laid the foundations of the reform proposed to protect retail activities in dedicated, economically and operationally isolated subsidiaries (ring fenced) within banking groups. There is therefore no questioning of the diversification potential of universal banking, but recognition of the contagion effects between certain market activities and retail activities. These retail banks continue to benefit from deposit protection but, in return, their scope of activity would be significantly reduced (see Figure 5.1). In addition, banks eligible for ring fencing are subject to stricter solvency requirements, while they concentrate low-risk activities. The application of the Vickers rule first of all ensures that banks whose business continuity is necessary for the proper functioning of the economy are identified and isolated from riskier activities. It then ensures that these banks, eligible for ring fencing, are sufficiently capitalized to probably never need public support. Finally, if other financial institutions were to encounter difficulties, public authorities could refrain from intervening: the rule is supposed to place retail banks (and their customers) behind the fence, out of reach of possible contagion. The Vickers rule is not incompatible with the existence of highly diversified banking groups (it is even more permissive in this sense than the Volcker rule), but its application to universal banks requires significant efforts from the latter to adapt their legal and economic structures to these new requirements.

Constraints  115

5.1.2.3.3 Other proposals Other proposals for reforming banking structures include the Liikanen report, which aimed at summarizing previous work, and the French banking bill, which introduces a relatively parsimonious separation of activities. The High Level Expert Group on Structural Reforms of the European Union’s Banking Sector, known as the Liikanen Group, named after its Chairman, submitted its report to the European Commission in October 2012 (Liikanen, 2012). This report analyses the diversity of the banking sector in the different EU countries and notes that the debates on the different structural models do not lead to the conclusion that one model is superior to the others. In this context, the Liikanen report does not advocate aligning European banking systems with a model that would be more stable and resilient than others in the face of financial crises. It identifies five areas of work that actually extend the reforms underway at the European level, while recommending a separation between certain market and retail activities. In particular, the report recommends the segregation of proprietary trading activities and certain other trading activities into a dedicated subsidiary so that deposits and the public guarantee that protects them can no longer support these activities (Liikanen, 2012). The approach of the Liikanen report is quite similar to that of the French banking law of July 2013, entitled “law on the separation and regulation of banking activities”. This text also adapts the structure of banking groups without abandoning the universal banking model. In particular: −

− − −

It prohibits proprietary trading activities unless they are confined to subsidiaries separate from the main entity receiving deposits. The definition of proprietary trading activities is quite restrictive, so market-making would not be carried out outside of the scope of the bank. It prohibits the holding by a bank of an investment fund. It regulates the conditions under which, for management purposes, a bank may carry out operations for balance sheet hedging and cash flow management. It prohibits banks, even within subsidiaries, from engaging in certain proprietary trading activities (high-frequency trading [HFT], transactions in which the underlying asset is an agricultural commodity). However, these latter provisions do not have a straightforward link with financial stability, whether they relate to HFT (4.2.1.2) or, even more clearly, to transactions in agricultural commodities.

Compared to the Liikanen report, market-making activities, which are considered useful to ensure market liquidity in support of issuers and investors, remain permitted. The effect of the law has been to cap proprietary trading activities, although the definition of these activities remains vague. At the same time, the implementation of the measure triggered additional reporting from banks.

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All in all, more than 10 years after the GFC, many countries have implemented reforms in order to introduce some form of separation, but the initial impetus has slowed down, some countries relaxing slightly the constraints (US) or the reporting obligations. In July 2018, the EU Commission confirmed its decision to withdraw its legislative proposal for bank structural reform (Finance Watch 2017). The main reason was that recent legislation, notably the bank recovery and resolution directive (Chapter 7), has provided authorities with sweeping new powers to force banks into adopting structural changes, if necessary, to ensure that they can be resolved safely.

5.1.2.4 Issues related to regulation of the shadow banking system The question of the possible regulation of the shadow banking system (Chapter 2) has been raised several times since the GFC. Arguably, some parts of the shadow banking sector are already regulated, as it is the case for the insurance sector in the EU (Box 5.1, Chapter 6). The most “toxic” aspects of shadow banking have been significantly reduced since the GFC. This is the result of the enhanced regulation of shadow banking, although important questions remain: − −

Is it necessary to cross a “vertical” regulation that deals with actors, in particular banks, and a “horizontal” regulation on products and operations? Should the traditional banking sector be isolated from shadow banking or, on the contrary, should shadow banking be integrated into the supervision of the banking sector to better assimilate it (Claessens et al., 2012)?

The regulation of shadow banking can be based on the principle of “indirect regulation” (Nouy, 2007): by imposing strict standards on credit institutions and banking groups that are exposed to shadow banking, it is possible to influence the volume of transactions as well as standards and practices in unregulated or poorly regulated sectors to a certain extent. This requires a consolidated approach to institutions. Indeed, the first way to approach the interactions between shadow banking entities and banks is to have a clear vision of their integration into the consolidation scope of the banking groups with which they have economic links. Prudential consolidation rules make it possible to cover financial activities when one of the companies involved can be identified as controlling or being controlled by a regulated entity and particularly by a credit institution. In principle, they limit the possibility for banks to escape regulation by using shadow banking. The shocks affecting the shadow banking system can be transmitted within financial groups. There is therefore a specific regime for financial conglomerates in Europe which are characterized by the diversity of their activities in the banking, insurance6 and financial markets sectors. In general, capital requirements (Chapter 6) are applied in a complementary manner at the level of the conglomerate.

Constraints  117

Box 5.1 European regime for licensing and supervision of the activity of the insurance sector The insurance sector is subject to a specific framework for the supervision of its activities, essentially with the aim of protecting policyholders. Insurance companies must separate their activities in specialized subsidiaries and their investments are subject to more stringent prudential rules than those applied to other financial sectors. First of all, the licensing of insurance companies is granted on a parentcompany basis in accordance with harmonized rules. This licensing is governed by three principles. According to the principle of specialty, an insurance company may only carry out the insurance operations for which it has obtained authorization. The rigour of this principle is mitigated by the possibility of setting up holding companies owning several companies with different activities, based on the model of “bancassurance” groups. By virtue of the principle of specialization, the companies are authorized to carry out activities exclusively in life or non-life insurance. Nevertheless, accredited life insurance companies may also be accredited to cover health and casualties risks. Finally, the approval is granted by sector or class, these classes being defined at European Union level.10 The separation of activities by sector allows the protection of the investment accumulated by life insurance policyholders. By being isolated from the rest of the insurance business, life insurance is protected from the random nature of the P&L of non-life insurance companies. Only poor financial management or bad actuarial assumptions can therefore weaken a life insurer and, through it, savers. These rules, harmonized at European level, are only marginally affected by the Solvency II Directive. The investments of insurance companies are strictly controlled. The commitments of insurance undertakings towards their policyholders – i.e. in accounting terms their technical provisions – must be permanently matched by equivalent assets subject to specific regulations. In French law, this principle is enshrined in Article R332-1 of the Insurance Code. Previous rules regulating insurers’ risky investments with quantitative thresholds have been replaced by the “Principle of the Prudent Person”, as well the “market risk” module of Solvency II (Chapter 6). However the smaller companies are still governed by Solvency I rules, with a currency matching rule (they must be denominated or realizable in the same currency as the corresponding liabilities) and a location rule (they must be located in the territory of an EU Member State). Only certain assets may be eligible for such a matching. Securities and securities, loans and deposits, provided that their issuer or counterparty is from an OECD country as well as real estate assets located in the OECD are eligible. All other investments are excluded.11 Finally, insurers must comply with dispersion rules: the proportion of investments that can be made in certain asset categories and in securities issued by the same entity is limited.

118 Constraints

They aim to manage the risks associated with intra-group transactions and to integrate all risk management areas into a cross- sectoral vision. In the case of securitization transactions, securitized assets are excluded from the risk base subject to capital requirements when a significant volume of risks has been transferred. It is generally the supervisor’s responsibility to assess the reality of this risk management situation. At the international level, a significant strengthening of the regulatory treatment of securitization was decided by the Basel Committee in July 2009 (BCBS, 2009b) (translated at the European level into CRD 2 and CRD 3 directives, then transposed into French regulations). Increased transparency and diligence requirements and specific treatment of “re-securitizations” have been introduced to improve the assessment of the risk associated with these products. In order to eliminate regulatory arbitrage opportunities, the treatment of securitization positions held in the trading book – and which before the crisis were partly unregulated – has been aligned with that of the banking book.7 In Europe, as in the US, retention rules have been introduced to ensure alignment of interest between the “originators” – i.e. the institutions that granted the initial loans – and investors to prevent the risks associated with the “originate to distribute” model, which was challenged by the GFC. Banks, when investing in securitization products, must now verify that the originator retains an economic interest of at least 5% after securitization in order to ensure sufficient alignment of its interests with those of investors. In addition, with regard to banks as originators, there was a need to better control the effectiveness of risk transfer. European provisions (CRD 2) have thus reinforced certain rules already applied by the French regulator in this area. If the reduction in regulatory capital requirements following a securitization transaction is not justified by changes in the institution’s risk profile, the supervisor may also impose additional requirements in “pillar 2”, i.e. specific to an institution.8 In France, the Prudential Supervisory Authority exercises these powers through a validation process of upstream arrangements in the context of an indepth dialogue with the originating reporting institutions as well as through on-site supervisory missions. In addition, following the subprime crisis, special provisions were introduced to prevent credit institutions from supporting securitization vehicles whose potential losses they would de facto assume beyond their contractual obligations as originators or sponsors – i.e. the financial institution that constitutes the “pool” of loans from those provided by originators. At the invitation of the G20 leaders, the FSB, in coordination with the Basel Committee and the International Organization of Securities Commissions (IOSCO; Chapter 10), launched discussions to extend the “horizontal” regulation of shadow banking. Finally, a fundamental reform was introduced by the Basel Committee which together with the IOSCO introduced stricter rules for securitization that should be “simple, transparent and comparable”, i.e. “STC” (BCBS & IOSCO, 2015). In the EU, the Capital Market Union project fostered further progress which led to two directives in 2017 to implement STC securitization.9

Constraints  119

In addition to this “vertical” approach per institution and aimed at obtaining a comprehensive picture of the risks to which banking groups are exposed, regulatory arbitrage requires “horizontal” regulation – i.e. regulation affecting a product and binding on all financial actors – of products and transactions. Indeed, regulation is a strong incentive for financial innovation (Chapter 5). Since banks are strategic agents who can arbitrage regulation, increasing the intensity of constraints increases incentives to circumvent them. At the theoretical level, Plantin (2015) proposes a model in which tightening capital constraints on banks encourages leakage into shadow banking, which could lead to a reduction in regulatory constraints on the banking sector rather than the other way around. It could then be considered to extend the scope of financial supervision to prevent arbitrage, but this could also provide a new incentive to develop innovation. Kashyap et al. (2010) also warn against the migration effects potentially induced by tighter capital regulations. Arbitrage can also take place from one country to another, since the regulations are not uniform. It is all the more difficult to harmonize them because the institutions and activities concerned are multidimensional. Moreover, from a normative approach of regulation (Chapter 5), it is important that shadow banking can continue to play a positive role in the management of the public good of liquidity (Chapter 1). Farhi and Tirole (2020) highlight that prudential regulation and public insurance services (LOLR, deposit insurance) are complementary. With shadow banking, the government trades its exclusive ability to provide liquidity provision in extreme events, against other benefits, such as keeping the bank within the regulated sector through an access to public liquidity and to cheap deposits. Two policies are notably investigated: ring-fencing between regulated and shadow banking (as in the UK case) and the sharing of liquidity in centralized platforms (CCPs). As noted by Adrian and Jones (2018), significant progress has been achieved since the GFC, but further changes are still warranted: harmonizing retention rules, reforming rating agency practices (Chapter 4), suppressing implicit official backstops, improving the measurement of cross-border interconnectedness and regulatory arbitrage. In addition, the growth of shadow banking in some emerging countries is a source of concern.

5.2 Practices in financial markets Four main sorts of practices have in particular been discussed because of their potential impact on financial stability: short selling (5.2.1), HFT (5.2.2), the distribution of exchange-traded funds (ETFs) (5.2.3), and the reuse and rehypothecation of collateral (5.2.4).

5.2.1 Short selling Short selling is, for a market participant, committing to selling an asset they do not own at a price and a delivery date known in advance, with the hope that its

120 Constraints

price will have fallen in between, enabling her to purchase it at a lower price, and make a profit. By nature, it is thus a speculative operation. It is also a standard practice, especially in stock markets, where short selling often represents more than 20% of transactions (Boehmer and Wu, 2013). There are two categories of short sales: naked short sales, in which the seller does not take measures to hold the asset at the time of selling it, and covered short sales, in which the seller borrows the asset in the first course or takes measures to hold it at the time it will be delivered. In fact, short sales usually belong to the second category, both because the short seller in most cases does not wish to risk not being able to deliver the promised asset (they would then default), and because, in order to prevent contagion through cascades of defaults (Chapter 1), regulation very frequently prohibits naked short selling. For instance, in the case of the US, Battalio et al. (2012) indicate that the borrower of an asset deposits a guarantee, usually in the form of cash, which represents 102% of the value of the borrowed shares. Both theory (5.2.1.1) and empirical evidence (5.2.1.2) overall tend to show that restricting or banning short selling is likely to be inefficient to preserve financial stability. Yet short selling is often constrained by regulation (5.2.1.3).

5.2.1.1 Theory Miller (1977) presents a model in which, on an asset market, return expectations are heterogeneous and supply is limited. As the supply of this asset can only be absorbed by a minority of potential investors, its price is overvalued (Miller also shows that the overvaluation is all the more important as the asset is riskier, i.e. the distribution of its expected yield is and/or gets more dispersed). This market anomaly can be corrected by allowing short sales, which increase the effective supply of the asset. From a financial stability point of view, restricting short selling, particularly for riskier assets, would thus be detrimental, as the overvaluation of the asset would inevitably have to be corrected at some point in time. However, Miller’s model is static (Lim, 2011): not only is supply inelastic in that model, but it is not clear why investors accept to hold an asset which they know is overvalued, since short sales are restricted. Within a rational expectations framework, Diamond and Verrechia (1987) show that forbidding short selling cannot lead to asset price overvaluation in the long term, but rather to lesser market liquidity and slower price discovery. However, Bai et al. (2006) note that Diamond and Verrechia (1987) assume no risk aversion; if the latter is taken into account, investors should demand a higher expected yield as a result of a slower price discovery, which would weigh on the asset price. That result is opposite to the one found by Miller (1977), but Lim (2011) restores Miller’s finding of a higher asset price by introducing into Diamond and Verrechia’s model uncertainty over the degree of constraint that the prohibition of short selling puts in the price discovery process (investors are not able to distinguish whether a relative inflow of buy orders reflects a positive information or the incapacity of some participants to place sell orders). Finally, Nezafat et al. (2017) show within a model of costly

Constraints  121

information acquisition that, when investors are highly risk averse or are holding highly correlated risky assets, the distortion in private information production arising from imposing short sales constraints leads to undervaluation. So, no clear conclusions emerge from the theoretical literature on the mediumterm impact of banning short sales, but there is overall agreement that by making price discovery more difficult and reducing market liquidity, such bans should increase short-term volatility, with potentially negative consequences for financial stability. A similar conclusion is reached by the literature on the modelling of position limits (i.e. the maximum number of contracts a participant in a future or options market can hold), such as they can be found in regulated markets (see, e.g., Ap Gwilym and Ebrahim, 2013): those limits would be conducive to lower market efficiency and even to stronger market power, making attempts to fight market manipulations more difficult, contrary to their objective. However, Brunnermeier and Oehmke (2014) provide a potential justification for temporary restrictions on short selling of vulnerable financial institutions. In their model, when the stock of a financial institution is shorted aggressively, leverage constraints imposed by short-term creditors can force the institution to liquidate long-term investments at fire sale prices, resulting in a self-fulfilling decline in the stock’s fundamental value, which can be interrupted by banning short sales.

5.2.1.2 Empirical evidence Following Lehman’s bankruptcy in September 2007, bans on short sales of financial stocks were enacted in many regulated markets. Empirical evidence essentially confirms the conclusions of the bulk of the theoretical literature: the impact on the levels of prices can be found positive, negative, or indeterminate, but the impact on market quality (liquidity and depth) and on price volatility is systematically found detrimental. Furthermore, the prediction in Brunnermeier and Oehmke’s (2014) model that short selling bans would benefit more vulnerable financial institutions is not confirmed: −

−

Autore et  al. (2011) study the effects of the ban enacted by the Securities and Exchange Commission (SEC) on short sales of 797 US financial stocks between 19 September and 8 October 2008. They find that on average, spreads increased. They also find, in line with Miller (1977), that there were abnormal positive returns on those stocks where the ban was enacted and that those stocks for which the abnormal positive returns were highest during the ban also exhibited the weakest returns after it was removed. Battalio et  al. (2012) consider the same stocks as Autore et  al. (2011), but note that the impact of the ban on short sales is difficult to measure because the Troubled Assets Relief Program (TARP) in support of the banking sector was announced on 20 September 2008. They also find that overall, the prices of financial stocks increased after the ban was removed, in contrast with Miller’s (1977) model. However, the authors confirm that the short

122 Constraints

−

−

−

−

−

sale ban resulted in an increase in the cost of liquidity in option and stock markets of the financial firms they consider. Marsh and Payne (2012) study the case of UK financial stocks when short selling was banned, from 19 September 2008 to 16 October 2008, and come to conclusions very similar to those of Battalio et al. (2012). The liquidity of the markets and the volumes of transactions for those stocks decreased far more than for others stocks. Furthermore, the balances of buy and sell orders were not affected and thus the downward pressures on the prices of financial shares were not reduced. Boehmer and Wu (2013) also examine the effects of the short selling ban on US financial stocks. They find that, although shorting activity dropped by 77% in large-cap stocks, stock prices appeared unaffected by the ban and that all but the smallest quartile of firms subject to the ban suffered a severe degradation in market quality. Beber and Pagano (2013) cover, for the period from 1 January 2008 to 23 June 2009, the 30 countries that enacted short sale bans during at least part of that period on some (the financial stocks) or all of the stocks listed in regulated markets. They conclude that the impact was negative on both prices and liquidity, except maybe in the US where they signal there was a possible impact of the TARP. Bohl et al. (2016) study the empirical evidence from the German stock market between September 2008 and July 2010. They find evidence that the GFC was accompanied by an increase in volatility persistence and that this increase was particularly pronounced for those stocks that were subject to short selling constraints. Beber et al. (2018) show that even controlling for the endogeneity of the bans (i.e. that short sales bans are triggered by extreme stock returns volatility), short selling bans are associated with higher probability of default, greater return volatility and steeper stock price declines, particularly for banks. They interpret those findings as the market possibly reading the imposition of bans as a signal that regulators are in possession of more strongly negative information about the solvency of the companies than is available to the public.

5.2.1.3 Regulation Before the GFC, most financial centres could ban naked short sales of stocks, and in exceptional circumstances, also covered short sales of stocks. Furthermore, following the sovereign debt crisis which started at the beginning of 2010 in the euro area, a European regulation was enforced from November 2012, with the aim of harmonizing existing regulations, extending them beyond the usually concerned markets, and increasing transparency (Chapter 4). The main provisions of Regulation 236/2012 are the following: −

Naked short sales of shares or sovereign debt as well as naked sovereign credit default swaps (CDS)12 are banned. However, in order to limit possible interference with the hedging of positions, notably by primary dealers and

Constraints  123

−

−

−

market makers, the naked sale of sovereign debt and the naked holding of sovereign CDS remain possible in case of holding of assets or liabilities, the prices of which are correlated with those of sovereign debt, such as the securities issued by banks of the same nationality. Short sales can be adjourned till the end of the next trading day in case of sharp price falls. Thresholds, introducing a cap on negative price changes in absolute value, which act as “circuit-breakers”, are set for the different categories of financial instruments (shares, sovereign securities, corporate bonds, etc.) and depending on the degree of liquidity of their market (e.g. the threshold is 10% for the most liquid shares). National regulators can ban covered CDS in exceptional circumstances, such as a fiscal crisis or difficulties in a financial institution which is considered important for the global financial system (Chapter 6). Transparency of short positions is mandated for shares, through reporting to the relevant competent authority or disclosing to the public, when reaching given thresholds, and for sovereign debt, through reporting to the relevant authorities when reaching or crossing given thresholds.

5.2.2  High-frequency ­ trading HFT is presented (5.2.2.1); then the concerns that it has raised from a financial stability point of view and the corresponding suggestions that have been put forward to address those concerns are discussed (5.2.2.2).

5.2.2.1 Presentation HFT is a variety of algorithmic – or automated or computer – trading (AT). In AT, computers analyse relevant information, such as order books, the volumes of trades or prices, but also news related to the fundamentals, before deciding on the individual parameters of the orders (whether to initiate the order, the timing, price, and quantity of the order or how to manage the order after its submission, including its possible cancellation in the absence of counterparty in this automated “price search”). In that process, computers replace humans because they are much more rapid: it takes them a few millions of a second to make a decision and execute it. AT is widely used by institutional investors and investment banks after they have sliced large-value orders into multiple smaller orders so as to avoid destabilizing market prices in a direction which would be detrimental to them. According to ESMA (2014), HFT has the following features: − − − − −

Proprietary trading; Very short holding periods; Submission of a very large number of orders that are cancelled shortly after submission; Neutral positions at the end of the day; Use of colocation and proximity services to minimize latency.

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HFT is used by specialized firms which are not regulated, since they conduct proprietary trading as well as other market participants. From a historical point of view, HFT can be seen as a by-product of technological and regulatory development: the 2005 Regulation National Regulation System (NMS) in the US and the 2004 Market in Financial Instruments Directive (MiFID) I in the EU have put an end to the central trading exchanges’ monopoly over trading activity (Haldane, 2011). The creation of new exchanges in the following year entailed a market fragmentation to which HFT, which operates across market venues, aimed at finding a solution. ESMA (2014) collected data covering a sample of 100 stocks from nine EU countries for May 2013 in order to gauge the importance of HFT in EU share trading. Two approaches were used: a direct and institutional approach (i.e. HFT conducted by high-frequency traders – HFTs), and an indirect approach based on the lifetime of orders, be they placed by HFTs or not. The observation was that HFT activity accounted for 24% of the value traded for the HFT flag approach and 43% for the indirect approach. According to anecdotal evidence, HFT would represent at the end of 2019 approximately 50% of equity, foreign exchange, futures, and Treasuries trading in the US, and 40% of equity trading in the EU. The business model of HFTs has attracted two main criticisms: −

−

The high proportion of order cancellation (80% is a commonly mentioned percentage) and the relative opacity of HFT, with a scarcity of “hard” data on its role in financial markets, has created a suspicion of market manipulation by HFTs. By exploiting informational advantage on quotes and future flows to optimize their quotation, policy, HFTs would create adverse selection for slow traders. Furthermore, HFT is capital intensive and when investing in fast technologies, HFTs and intermediaries do not internalize these externalities. Accordingly, they overinvest in equilibrium, creating an “arms race” (Biais et  al., 2015). However, HFT is usually credited for a contribution to better price efficiency by trading in the direction of permanent price changes (Brogaard et al., 2014).

5.2.2.2 Concerns Three main sources of concern have been expressed, regarding the contribution of HFT to market liquidity (5.2.2.2.1) and the possibility of negative feedback loops (5.2.2.2.2). As HFTs mostly trade between them and aim at ending the day with neutral positions, the risk of contagion (Chapter 1) to the rest of the financial system can be considered as very low. 5.2.2.2.1 Market liquidity The contribution of HFT to market liquidity has been questioned. The standard result in the literature is that AT contributes to improving market liquidity (Hendershott et al., 2011). Moreover, HFTs trade in the opposite of transitory pricing errors, both on average days and on the most volatile days (Brogaard et al., 2014),

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and increasing the speed of market-making participants would more generally benefit market liquidity (Brogaard et al., 2014). However, the fact that HFTs impose adverse selection costs on other traders, overall and at times of stress, could lead non-HFT liquidity suppliers to withdraw from the market (Biais et al., 2015), and this could indirectly result in HFTs reducing market stability (Haldane, 2011; Brogaard et al., 2014). Furthermore, because market participants respond not only to news about fundamentals but also to market activity itself, the price efficiency gain due to HFT would come at the cost of making the real-time assessment of market liquidity across multiple venues more difficult (Dobrev and Schaumburg, 2015). However, the latter argument is not just valid for HFTs but also for other market participants, and thus amounts to an argument against market competition and fragmentation. Possibly of more concern could be the observation by Cartea et al. (2019) that ultra-fast, machine-driven activity is associated with lower market quality (greater quoted and effective spreads and lower market depth), although this lower market quality is unlikely in itself to have significant macro-financial consequences, unless it leads to negative feedback loops or contagion. Four main sorts of proposals to address this liquidity concern have been made: −

−

−

−

Imposing some form of Pigovian taxation (Chapter 4). The tax could be based on investment in fast-trading technology (Biais et al., 2015). It could also be based on transactions, as already done in France and Italy. However, Veryzhenko et al. (2017) show in the case of the French market, where a “Tobin tax” on HFT has been imposed, that it reduces transaction volumes and intensifies the deviation from market fundamentals, which, in turn, leads to a deteriorated, less- efficient market. Changing the definition and requirements of a designated market maker to include HFTs. However, Kirilenko and Lo (2013) note that such a measure would increase the costs to intermediaries of being present in the market. As a consequence, bid-ask spreads would increase and some intermediaries may also withdraw from market making. Imposing a minimum time before a quote can be cancelled (i.e. a so-called “resting period”). In the extreme, HFT could be completely banned and replaced with frequent batch auctions – e.g. every second. This is proposed by Budish et al. (2015) in order to eliminate an “arms race” which leads to wider spreads, because “fundamental” investors would take into account in their quotations the risk that their orders might not be executed as another market participant would have carried out the transaction more rapidly with an HFT, and thinner markets, as orders are “sliced”. However, HFT can itself be used by “fundamental investors”. Furthermore, as noted by Kirilenko and Lo (2013), “one indication of consumers’ preference is the fact that most batchauction markets have converted to continuous market-making platforms”. Taxing limit order cancellation, as mentioned by Aït- Sahalia and Saglam (2013). This would make the provision of liquidity by HFT more lasting, but would keep the sensitivity of this liquidity provision to market volatility.

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One measure which has been implemented by the Deusche Börse and the London Stock Exchange is to charge HFTs for high order-to-trade ratios. It comes close to the last listed proposal and also aims to address the concern of possible market manipulation. 5.2.2.2.2 Negative feedback loops The concern, which applies more to AT than to HFT, is that algorithms would react blindly to price changes. In particular, the responsibility of HFT in “flash crashes” (i.e. abrupt short-lived price swings) is systematically put forward in the media. However, Kirilenko et al. (2017) examine the flash crash that took place on 6 May 2010 in US financial markets, especially impacting the Dow Jones Industrial Average which dropped almost 1,000 points in 20 minutes. They find that the most active intraday intermediaries (classified as HFTs) did not significantly alter their inventory dynamics when prices fell during the flash crash. Adopting a broader approach which extends to AT, Bech et al. (2016) refer to the flash rally in the two-year US Treasuries on 15 October 2014, and are of the opinion that the increasing complexity of trading algorithms and their possible interactions represent a source of risk that can act as an amplifier in stress episodes. The standard instrument to avoid feedback loops is to operate circuit breakers. In 2016, according to Clapham et al. (2018), who exploit 44 responses of trading venues to the survey they have conducted, 86% of them used circuit breakers. However, as mentioned by Haldane (2011), to be effective, circuit breakers would need to span all trading exchanges and platforms. Yet, only 32% of the exchanges that make use of circuit breakers already coordinate them with other venues (Clapham et al., 2018).

5.2.3  Exchange-traded ­ funds An ETF is a type of fund that divides the ownership of the assets it holds into shares which trade like common stock on an exchange (Chen, 2019). An ETF typically tracks a stock index, a commodity, bonds or a basket of assets, as an index mutual fund does. However, ETFs differ from mutual fund in several ways (Ramaswamy, 2011; Lettau and Madhavan, 2018), although they can be established in Europe under the Undertakings for Collective Investments in Transferable Securities (UCITS) Directives, a European set of measures that also applies to mutual funds. Important differences are that: −

−

ETFs do not interact directly with markets. Instead, they issue shares in large blocks called creation units to “authorized participants” (APs), typically large financial institutions, who, in turn, interact with the markets. The APs effectively act as market makers by locking in profits intraday through arbitrage (i.e. the delivery or reception of the underlying basket of shares in exchange for the creation or redemption of shares of the affiliated ETFs). Investors do not trade with the fund directly, but rather deal with each other on an exchange, or with APs and other liquidity providers.

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Furthermore, synthetic ETFs replicate the index they track by using derivatives, such as total return swaps, as opposed to owning the physical assets, allowing to reduce costs (Ramaswamy, 2011). The implied derivatives contracts are typically concluded with the sponsor of the ETF, who is also an AP. ETFs have existed since 1993 in the US and have developed very fast since then. Assets under ETF management were $4.8 trillion in December 2018, with the biggest share invested in equity ($3.7 trillion) and the rest in fixed income ($0.9 trillion) and commodity and others ($0.2 trillion) (BlackRock, 2018). However, according to Lettau and Madhavan (2018), index funds and ETFs together represent just over 12% of the US equity universe and 7% of the global equity universe. ETFs also remain largely American with assets in US-listed ETFs representing 70% of the total (Europe: 16%; Canada: 2%; Asia Pacific: 11%) (BlackRock, 2018). Holders of ETFs are mainly institutional investors and hedge funds. Reasons for the success of ETFs mentioned by Ramaswamy (2011) are that they offer a cost- and tax- efficient alternative to mutual funds. Furthermore, the investor base of ETFs has developed and the industry has diversified, with many new ETFs representing, according to Lettau and Madhavan (2018), a blurring of the traditional line between active and passive management. Concerns have been expressed regarding ETFs, and in particular synthetic ETFs (Ramaswamy, 2011; Ben-David et al., 2016; Turner and Sushko, 2018): −

−

−

Like structured products (Chapter 2), ETFs often lack transparency and complicate the risk assessment of the end-product sold to investors. Synthetic replication schemes transfer the risk of the ETF’s return deviating from the benchmark to the swap counterparty, but there is also little transparency on how the latter replicates the index returns. Counterparty risk can be another channel for risk propagation. It can in particular arise in ETFs using derivatives, in particular synthetic ETFs, and in those engaging in securities lending (Grill et al., 2018). Sudden and large investor withdrawals triggered by market events or counterparty risk concerns could lead to funding liquidity risk and raise correlation across asset classes sharply. Ben-David et al. (2018) find that stocks with higher ETF ownership display significantly higher volatility. Conversely, Lettau and Madhavan (2018) note that cross-stock correlations have diminished significantly since 2013, despite significant increases in ETF and index assets. However, those lower correlations could reflect the influence of other factors that outweigh the role of ETFs. As in the case of HFT (5.2.2), the role of EFTs in flash crashes has also been mentioned (see e.g. Chen, 2019). Lettau and Madhavan (2018), referring to Borkovec et al. (2010), acknowledge that ETFs were disproportionately represented among the securities affected by the flash crash on 6 May 2010, but also note that other factors, such as evolving market structures and multiple market venues, have been mentioned in the case of that crash and also for other flash crashes or upswings (US Treasuries on 15 October 2014, UK pound sterling on 6 October 2016).

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5.2.4 Reuse and rehypothecation of collateral The FSB (2013; Chapter 10) defines rehypothecation as the right by financial intermediaries to sell, pledge, invest, or perform transactions with client assets they hold and the reuse of collateral as the use of securities delivered in one transaction to collateralize another transaction. Rehypothecation, i.e. the use of clients’ assets to fund the operations of financial intermediaries, has to be authorized by the client, whereas the reuse of collateral, which is more general, arises “naturally” as a result of contracts in which the ownership of the property is transferred, as is the case of most contracts between financial intermediaries. In particular, repurchase agreements (Chapter 2), which are used in securities financing transactions, imply the right to reuse the collateral received. However, the word “rehypothecation” is often used, in particular in the US, in the broader sense of “reuse of collateral” Reuse of collateral and rehypothecation is very common practice. From the 2010 International Swap Dealers Association (ISDA) margin survey, 44% of all respondents to the survey and 93% of large dealers reported rehypothecation. The European Systemic Risk Board (ESRB; Chapter 10) collected data in February 2013 covering institutions which are the main actors in the management of securities collateral in the EU (Keller et al., 2014). The data show that 94% of collateral received by the banks is eligible for reuse. Banks reuse collateral once on average, i.e. the collateral reuse factor (multiplier or “velocity” in Singh’s terms, 2011) is two. However, the reuse of collateral in the EU can only be assessed on an aggregate basis, as the ESRB study notes that surveyed institutions are unable to report on their own reuse, which “seems to suggest that i) the (generally fungible) collateral is pooled and, when used, cannot be traced back to the collateral received; ii) institutions’ risk management systems may at the current moment not enable them to assess their own re-use on a consolidated basis” (Keller et al., 2014). In other words, banks might not just reuse collateral, but also rehypothecate it, without being aware of it, and possibly even without the permission of their clients. The reuse of collateral is done mostly by a few large banks and dealers (according to Singh, 2011, there were 10–14 large banks active in collateral management globally). Those large banks and dealers intermediate between money market mutual funds, often part of the same banking group who provide liquidity, and collateral providers. Primary providers of collateral are hedge funds, for whom the provision of collateral is de facto a precondition imposed by banks to get access to credit, and insurers and pension funds seeking to optimize the management of the assets they hold. From the 2015 ISMA margin survey, cash comprised more than 90% of collateral that was eligible to be rehypothecated and over 80% of that collateral was actually rehypothecated. Government securities accounted for the second most used collateral type. By permitting liquidity to flow where it is most needed, the reuse of collateral improves resource allocation (Andolfatto et al., 2017). As Singh (2011) puts it, it

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helps “lubricate the global financial system”. It also increases when collateral is scarce (Fuhrer et al., 2016), helping to meet the demand for safe assets and lowering traders’ funding liquidity needs (Chapter 1). However, reuse of collateral can also amplify market strains through two channels (Monnet, 2011): it reintroduces counterparty risk in case a trader fails, and it increases the linkages between traders, and thus the risk of contagion (Chapter 1). The first channel arises because reuse of collateral de facto de-collateralizes the transactions that were previously entered into using the same collateral, which seems justified only if the de-collateralization leaves bilateral credit exposures unchanged (i.e. following a transaction in opposite direction to the previous one with the same counterparty that pledged the collateral, the latter is returned to her/him). The second channel can lead to a credit market freeze, as exemplified in the wake of Lehman’s default. Singh (2011) reckons that post-Lehman, the decline of the overall supply of collateral, taking into account its possible reuse, amounted to $4–5 trillion. Using a data set from the Swiss franc repo market, Fuhrer et al. (2016) also find that reusing collateral was most popular just before the GFC, when it peaked at almost 20% of the outstanding volume of repo market transactions secured with reused collateral, but that it suddenly declined at very low levels in 2008. Rather surprisingly, whereas the reuse of collateral can create negative externalities and thus can be seen as a “polluting” activity (Chapter 4), there seems to have been no proposal so far to tax it, or at least to tax rehypothecation, while it could be considered that, when a collateral has been acquired to hedge a credit exposure, the initial collateralization is lost if the collateral is reused. In fact, rather than proposing to tax the reuse of collateral, Andolfatto et al. (2017) note that a measure which confers a regulatory premium on cash holdings can have a welfare-improving effect. As far as further official proposals are concerned, the FSB (2013) makes three recommendations regarding rehypothecation. It recommends that (i) financial intermediaries provide sufficient disclosure (Chapter 4) to clients in relation to rehypothecation of assets so that clients can understand their exposure in the event of a failure of the intermediary; (ii) in jurisdictions where clients assets may be rehypothecated for the purpose of financing client long positions and covering short positions, they should not be rehypothecated for the purpose of financing the own account activities of the intermediary (in another words, the bank’s and its clients’ assets should not be comingled); and (iii) only entities subject to adequate regulation of liquidity risk should be allowed to engage in the rehypothecation of client assets. The FSB (2013) also makes recommendations regarding cash collateral reinvestment (i.e. reuse), inter alia that “a minimum portion of the cash collateral to be kept in short-term deposits (with high- quality financial institutions), held in highly liquid short term assets (such as high-quality government treasury bills and bonds), or invested in short tenor transactions (such as overnight or open reverse repos backed by highly liquid assets) that can be readily converted to cash over short horizons, such as one day and one week, to meet potential recalls of cash collateral”. As a whole, those FSB recommendations do not aim at creating heavy constraints on rehypothecation or reuse of collateral.

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5.3 Financial market infrastructures Financial intermediaries and market participants can also be constrained in their use of financial market infrastructures (FMIs), with the purpose of reducing systemic risk and increasing transparency. A FMI can be defined as “a multilateral system among participating institutions, including the operator of the system, used for the purposes of clearing, settling, or recording payments, securities, derivatives, or other financial transactions” (BIS-IOSCO, 2012). According to BIS-IOSCO (2012), this definition covers key types of entities: − − − −

−

A payments system transfers funds between or among participants; A central securities depository provides securities accounts, central safekeeping services and asset services; A securities settlement system enables securities to be transferred and settled by book entry; A central counterparty (CCP) interposes itself between counterparties to contracts traded in one or more financial markets, becoming the buyer to every seller and the seller to every buyer; A trade repository maintains a centralized electronic record of transactions data.

In September 2009, as CCPs had performed well during the GFC, the G20 (Chapter 10) asked that they be used for the clearing of standardized OTC derivatives contracts, so as to make the functioning of derivatives contracts markets safer and more transparent.13 By contrast, as of end-June 2008, American International Group (AIG) had managed to take on $446 billion in notional credit risk exposure as a seller of credit risk protection via CDS, without having the financial resources necessary to cover potential payments (Cecchetti et al., 2009). As a result of the creation of a new constraint on the use of that type of FMI, the focus is here on CCPs. The role of CCPs is first described (5.3.1), then the concerns they raise are exposed (5.3.2), and finally, regulation which has been enacted or proposed to address those concerns is presented (5.3.3).

5.3.1 Role CCPs have benefits and costs (5.3.1.1). Whether the benefits outweigh the costs largely depends on their efficacy in managing risk (5.3.1.2).

5.3.1.1 Benefits and costs A CCP provides several benefits (ECB, 2005; Cecchetti et al., 2009; Biais et al., 2013): −

By interposing itself between the transacting parties, a CCP can reduce the interconnectedness of banks, thus acting as a “firewall” (Wendt, 2015), and offer insurance against default. It can mutualize credit and market risk all the

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−

−

more efficiently when it has a large number of participants – called “clearing members” – and pools many risks. However, as noted by Biais et al. (2013), a CCP cannot insure against aggregate risk. By performing multilateral netting, a CCP can reduce the number of transactions as well as the credit exposure of the clearing members, thus potentially helping save collateral. Cecchetti et al. (2009) indicate that multilateral netting of new CDS trades reduces gross notional exposures by approximately 90% and that, as more counterparties start using the CCPs, the benefits could be even larger. Also, Duffie et al. (2015) use an extensive data set of bilateral CDS positions and find that the requirement of central clearing significantly mitigates the impact on collateral demand of the introduction of dealer-to-dealer initial margin requirement (endnote 2 in this Chapter): in fact, system-wide collateral demand is lowered, provided there is no proliferation of CCPs. Being placed at the centre of a network of financial transactions, a CCP has an information advantage that can be used to improve transparency by allowing the collection of high-frequency aggregate information on trading activity and reporting it to markets and supervisors.

However, a CCP has also costs: −

−

There are direct costs resulting from the participation of clearing members in the CCP (fees, operational costs and potentially collateral costs at an individual level). More importantly from a financial stability point of view, a CCP concentrates risk and the insurance it provides can create moral hazard (Chapter 1), encouraging imprudent behaviour and creating an issue of incentive compatibility (Biais et al., 2013). As noted by those authors, imprudent behaviour can occur on two levels: clearing members can become imprudent and fail to monitor the default risk of their counterparty; the CCP itself could become imprudent, especially if it is TBTF (Chapter 1), and fails to monitor the default risk of its clearing members. Moral hazard is mitigated by putting in place a strict CCP risk management system (5.3.1.2) and supervising and regulating CCPs (5.3.3).

5.3.1.2 Risk management CCPs manage risk by selecting their members, by imposing limit credit exposures on them and above all, by limiting their own credit exposure vis- à-vis their members. In order to enhance their risk-bearing capacity, CCPs use a variety of financial resources for protection (ECB, 2005; Faruqui et al., 2018): −

CCP participants are required to post collateral (“margins”) in the form of cash or other assets usually of a sort considered as liquid and safe. There are two sorts of margins. Initial margins are posted to the CCP when a

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− − −

participant opens a position and their amount varies according to the volatility of the price of the underlying asset. Variation margins are posted when the previously opened position varies (participants whose open positions have lost value post collateral to the CCP which redistributes it to the participants whose positions have gained value). CCP participants usually contribute to a pool of collateral known as “default fund”. Some CCPs buy insurance against losses or have contingent claims on a participant’s resources or on the resources of a parent’s company. CCPs have own capital, which represents “skin in the game” since it encourages the CCP to be prudent and thus mitigates moral hazard on the part of the CCP.

Those resources give rise to the “default waterfall” in case a CCP participant defaults, forcing the CCP to take on its obligations. The CCP first draws on the defaulting clearing member’s initial margins. Then, if they are insufficient, it draws on the member’s contribution to the default fund. It can also activate the insurance contract it has subscribed or the contingent claims it holds. The next “line of protection” in the waterfall is the CCP’s own capital. If it is not sufficient, the CCP can draw on the contributions of the no-defaulting (“surviving”) members to the default fund. Finally, on top of those pre-funded or pre-committed resources, the CCP can ask for supplemental funds from its surviving members or apply haircuts to their initial margins (variation margin gains haircuts – VMGH), thus retaining them partly or totally.

5.3.2 Concerns Concerns regarding CCPs derive from the fact that they can be a source of systemic risk (Chapter 1) by concentrating risk and creating interconnectedness in the first course (5.3.2.1), and by eventually transmitting risk in the second course (5.3.2.2), thus shifting it rather than properly eliminating it (Rochet and Tirole, 1996).

5.3.2.1 Risk concentration and interconnectedness CCPs could become victims of their own success. As indicated by Faruqui et al. (2018), according to statistics collected by the Bank for International Settlements (BIS) which can be considered as highly representative at the global level, the clearing rate has risen from around 20% in 2010 to at least 60% in 2017 for OTC interest rate derivatives and from roughly 10% to around 40% for CDS. Faruqui et al. (2018) also report that the degree of concentration among CCP users, with the top five clearing members contributing around one-half of prefunded resources for credit derivatives and more than one-third for interest rate derivatives. For example, at Q2 2018, the notional amount of JPMorgan’s OTC derivatives exposures to CCPs was about $30 trillion and the one of Citybank was above $24 trillion (however, those amounts largely overstate the genuine levels of credit risk exposure).

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As a consequence, CCPs and a few of their clearing members are tightly interconnected. More generally, there are strong interdependencies among CCPs at the global level (BIS, 2018): −

−

Prefunded resources are concentrated at a small number of CCPs, with the two largest CCPs (as measured by prefunded resources) accounting, as of October 2017, for nearly 40% of total prefunded resources provided to all CCPs, compared to 32% in September 2016. Exposures to CCPs are concentrated among a small number of entities. The largest 11 of the 306 clearing members (as measured by prefunded resources provided to the CCP) are connected to between 16 and 25 CCPs.

As an illustration of that global interconnectedness, Berner et al. (2019) analyse an index based on the weighted average sum of each clearing member’s conditional capital shortfall (SRISK, Chapter 8). They find that the Chicago Mercantile Exchange (CME) and the London Clearing House (LCH), two among the largest CCPs in the world, would likely come under stress simultaneously, as many of the clearing members of both CCPs are the same.

5.3.2.2 Risk transmission Risk transmission can occur either via a domino effect (the losses resulting from the default of a clearing member are such that they trigger defaults of other participants in the same CCP or in another one), or via a contagion effect (the actions taken by the CCP or by the surviving clearing members following the default of a clearing member result in falls in asset prices which, in turn, impose losses on other participants and eventually make them default). Domino effects depend on the size of the shock and on CCPs’ financial resources (Domanski et al., 2015). They can take place if, because initial margins and the CCP’s own capital have not proved sufficient in the face of a clearing member default, losses are imposed on the surviving members, either on their contributions to the default fund or through VMGH. Contagion effects can occur as a by-product of the CCP’s risk management procedures, even in the absence of an initial clearing member default, as variation margins can play a procyclical role in the face of a financial market shock, causing participants in CCPs to liquidate assets precipitously as they have to post more collateral in the form of cash. Gorton and Metrick (2012) explain that variation margins have played an amplifying and propagating role in the US repo markets during the GFC, as a result of the use of that market by investment banks for managing their leverage. In that regard, Domanski et al. 2015) note that CCPs have become huge players in reverse repo markets. This suggests that they reuse collateral (5.2.4). Contagion effects can also take place if, following the exhaustion of all its prefunded financial resources, the CCP makes supplemental cash calls, instead of or in conjunction with VMGH. Furthermore, VMGH creates a moral hazard as the CCP’s managers can become more imprudent if they expect to be bailed out by the clearing members (Wendt, 2015).

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5.3.3 Regulation The existence of a systemic risk provides ground for a public intervention which relies on supervision and the enactment of standards defined at a global level (5.3.3.1). Additional measures have been proposed (5.3.3.2).

5.3.3.1 Supervision and definition of standards As a result of the G20 move in favour of clearing OTC derivative contracts through CCPs, and in order to limit regulatory arbitrage by the large financial intermediaries that dominate OTC derivatives markets, the BIS and the IOSCO have published a report setting principles for financial market infrastructures – PFMIs (BIS-IOSCO, 2012; Russo, 2013). Those principles are not binding (Chapter 10), but they have been passed into law in Europe through the MiFID 2, the Market in Financial Instruments Regulation (MiFIR) and the European Market Infrastructure Regulation (EMIR), and in the US through the DoddFranck Act. Regarding CCPs, the PFMIs in particular recommend that: −

−

−

CCPs which are involved in activities which have a more complex risk profile, or which are systemically important in multiple jurisdictions, should maintain at a minimum financial resources to cover the losses of the two participants and their affiliates (i.e. “sub-participants” which are represented in CCPs by clearing members) that would cause the largest credit exposure to the CCP (the previous CPSS-IOSCO recommendations for CCPs only required the coverage of the largest single exposure and did not consider affiliates). A FMI, and thus a CCP, should maintain sufficient liquid resources in all relevant currencies to effect the settlement of payment obligations generated by the default of the participant with the largest liquidity obligations for the FMI. In order to limit procyclicality, initial margin methodologies should be such that they do not only consider “normal” market conditions, but also extreme events that occurred in the past as well as simulated data projections that would capture plausible events outside of the historical data, especially for new products.

5.3.3.2 Other measures proposed Several proposals have been put forward to limit the probability and the impact of a CCP’s failure: −

Increasing its risk buffers and in particular “skin in the game”. Biais et al. (2013) propose having the CCP owned by its users in order to reduce moral hazard at the level of the CCP. Regulators and supervisors could also consider risk of CCPs and their users together, since they are tightly interconnected (Faruqui et al., 2018). Domanski et al. (2015) note that the capital of CCPs tends to be quite modest compared with their other prefunded resources,

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− −

their gross exposures and the scale of their potential losses. Lin and Surti (2015) assess the sensitivity of risk buffers to a range of model inputs and find that capital requirements are highly sensitive to whether key model parameters are calibrated on a point-in-time versus stress-period basis. They suggest that there would thus be considerable benefits from prudential authorities adopting a more prescriptive approach to CCPs’ risk buffers. Developing international coordination, in particular in situations of distress, to take global interconnectedness of CCPs into account (5.3.2.1). Effectively implementing resolution frameworks, distinguishing them from resolution plans (Singh and Turing, 2018), to mitigate moral hazard at the level of both the CCP and its users.

Conversely, there are doubts in the literature regarding the possibility to use competition (Chapter 9) as a way to improve the governance of CCPs and reduce moral hazard (Biais et al., 2013). The reason is that there are large economies of scale in the industry of CCPs (Duffie and Zhu, 2011) and that splitting CCPs could also increase the need for collateral (Duffie et al., 2015).

Notes 1 Arguably, European banks have a much smaller weight if they are compared to euro area GDP, which may be viewed as comparable to the US (single currency, single monetary policy, single supervisory, and resolution authorities; the only missing piece is the absence of a single deposit insurance fund). 2 For more details on this controversy, reference can be made to Morrison’s (2010) article, which refers to many articles published in the 1980s during the debates on the reform of the Glass- Steagall Act. 3 EU countries, plus Iceland, Liechtenstein, and Norway. 4 In the Abacus case, Goldman Sachs was fined $550 million for packaging mortgage loans in CDOs and selling them to investors, without informing them that one of its largest clients was taking a trading position in order to benefit from a fall in the US house prices index ( Jill Treanor, The Guardian, 16 July 2010). The fact that institutional investors were affected is evidence that conflicts of interest occur not only for universal banks but also for corporate and investment banking. 5 The criterion adopted by the law is more than 25% control by common shareholders. 6 See Box 1 for the framework for insurance activities at European level. 7 Accounting and prudential standards lead to the classification of securities in banking portfolios into different categories according to the holding period. Securities held for the short term are recorded in the trading book (Chapter 6). 8 The Basel II reform introduced the concept of three pillars: (1) minimum capital requirements, (2) prudential supervision processes, and (3) market discipline (Basel Committee, 2004, and Chapter 6). 9 Regulation (EU) 2017/2402 of December 2017, which defines an overall framework for securitization, with general rules, due diligence, retention. It develops a specific framework for ABS/ABCP that are STC. In addition, regulation (EU) 2017/2401 amends CRR (Chapter 6) and defines more favourable prudential requirements for STC securitizations. 10 Union law distinguishes 18 sectors in non-life and 6 sectors in life insurance. 11 This exclusion is justified by criteria of security (buildings outside the OECD), liquidity (furniture and works of art) or intrinsic profitability (precious metals).

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12 A naked CDS is holding a CDS without holding the underlying asset: the holder of the CDS thus does not wish to hedge an open position and rather speculates that the issuer is going to default. Salomao (2017) shows that, as a result of the ban, the decrease in the CDS levels during the crisis led to higher spreads and higher probability of default, the opposite of what regulators intended with the ban. He concludes that the 2012 CDS naked ban is a welfare-reducing policy. 13 The G20 also asked that the transactions in those contracts be reported to trade repositories, thus facilitating access by supervisors to information, which is particularly important in case a clearing member defaults or is on the brink of defaulting. In order to increase incentives to use CCPs, the G20 also stipulated that non-centrally cleared contracts should be subject to higher capital requirements and that margining standards should be developed for non-centrally cleared trades (on margining in CCPs, see 5.3.1.2).

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138 Constraints

Budish E., Cramton P., Shim J. (2015), “The High-Frequency Trading Arms Race: Frequent Batch Auctions as a market Design Response”, Quarterly Journal of Economics, 130(4), 1547–1621. Cao J., Illing G. (2011), “Endogenous Exposure to Systemic Liquidity Risk”, International Journal of Central Banking, 7, 173–216. Cartea A., Payne R., Penalva J., Tapia M. (2019), “Ultra-fast Activity and Intraday Market Quality”, Journal of Banking and Finance, 99, 157–181. Cecchetti S., Gyntelberg J., Hollanders M. (2009), “Central Counterparties for OverDerivatives”, BIS Quarterly Review, September, 45–58. the-counter ­ Chen J. (2019), “Exchange-Traded Fund (ETF)”, Investopedia, https://www.investopedia. com/terms/e/etf.asp. Chow J.T.S., Surti J. (2011), “Making Banks Safer: Can Volcker and Vickers Do It?”, IMF Working Papers, WP/11/236. Claessens S., Pozsar Z., Ratnovski L., Singh M. (2012), “Shadow Banking: Economics and Policy”, IMF, Staff Discussion Note, 12/12, 4 December 2012. Clapham B., Gomber P., Haferkorn M., Jentsch P., Panz S. (2018), Circuit Breakers – A Survey among International Trading Venues, House of Finance, SAFE Working Paper, 197, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3120370. Cooper R., Ross T.W. (2002), “Bank Runs: Deposit Insurance and Capital Requirements”, International Economic Review, 43(1), 55–72. Demirgüç-Kunt A., Detragiache E. (2002), “Does Deposit Insurance Increase Banking System Stability? An Empirical Investigation”, Journal of Monetary Economics, 49, 1373–1406. Demirgüç-Kunt A., Huizinga H. (2004), “Market Discipline and Deposit Insurance”, Journal of Monetary Economics, 51, 375–399. Demirgüç-Kunt A., Kane E., Laeven L. (2008), “Determinants of Deposit Insurance Adoption and Design”, Journal of Financial Intermediation, 17, 407–438. Dewatripont M., Tirole J. (1994), The Prudential Regulation of Banks, Walras-Pareto Lectures, Vol. 1, Cambridge, MA and London: MIT Press. DeYoung R., Rice T. (2004), “How do Banks Make Money? The Fallacies of Fee Income”, Economic Perspectives, Federal Reserve Bank of Chicago, 4, 34–51. Diamond D.W., Verrechia R.E. (1987), “Constraints on Short- Selling and Asset Price Adjustment to Private Information”, Journal of Financial Economics, 18, 277–311. Diamond D.W., Dybvig P.H. (1983), “Bank Runs, Deposit Insurance and Liquidity”, Journal of Political Economy, 91(3), 401–419. Dobrev D., Schaumburg E. (2015), “The Liquidity Mirage”, Federal Reserve Bank of New York, Liberty Street Economics, 9 October, https://libertystreeteconomics. newyorkfed.org/2015/10/the-liquidity-mirage-.html. ­ ­ Domanski D., Gambacorta L., Picillo C. (2015), “Central Clearing: Trends and Current Issues”, BIS Quarterly Review, December, 59–76, https://www.bis.org/publ/qtrpdf/ r_qt1512g.pdf. Duffie D. (2012), Market Making Under the Proposed Volcker Rule, Standford, CA: Standford University Press. Duffie D., Scheicher M., Vuillemey G. (2015), “Central Clearing and Collateral Demand”, Journal of Financial Economics, 116, 237–256. Duffie D., Zhu H. (2011), “Does a Central Clearing Counterparty Reduce Counterparty Risk?”, Review of Asset Pricing Studies, 1(1), 74–95. Economides N., Hubbard R.G., Palia D. (1996), “The Political Economy of Branching Restrictions and Deposit Insurance: A Model of Monopolistic Competition among

Constraints  139

Small and Large Banks”, Journal of Law and Economics, University of Chicago Press, 39(2), 667–704. ESMA (2014), High-frequency Trading Activity in EU Equity Markets, Economic Report, 1, https://www.esma.europa.eu/sites/default/files/library/2015/11/esma20141_-_hft_ activity_in_eu_equity_markets.pdf. European Central Bank (2005), “Central Counterparty Clearing Houses and Financial Stability”, Financial Stability Review, December, 177–182, https://www.ecb.europa.eu/pub/ pdf/fsr/financialstabilityreview200512en.pdf?5264b93e7ec1d0b0d0461f1a93e9e4f9. Farhi E., Tirole J. (2020) “Shadow Banking and the Four Pillars of Traditional Financial Intermediation, NBER Working Papers, 23930, October 2017, Revised in February 2020. Faruqui U., Huang W., Takáts E. (2018), “Clearing Risks in OTC Derivatives Markets: The CCP-Bank Nexus”, BIS Quarterly Review, December, 73–90, https://www.bis. org/publ/qtrpdf/r_qt1812h.pdf. Fecht F. (2018), “Is Proprietary Trading Detrimental to Retail Investors?”, Journal of Finance, 73 (3), 1323–1361. Fiechter J., Ötker-Robe I., Ilyina A., Hsu M., Santos A., Surti J. (2011) “Subsidiaries or Branches: Does One Size Fit All?”, International Monetary Fund, Staff Discussion Note n°11/04. Finance Watch (2017), “Too-Big-To-Regulate: The EU’s Bank Structural Reform Proposal Failed”, 25 October 2017 https://www.finance-watch.org/press-release/ too-big-to-regulate-the-eus-bank-structural-reform-proposal-failed/ ­ ­ ­ ­ ­ ­ ­ ­ ­ ­ Financial Stability Board (2012), Thematic Review on Deposit Insurance Systems, Peer Review ­ Report, https://www.fsb.org/wp-content/uploads/r_120208.pdf?page_moved=1. Financial Stability Board (2013), Strengthening Oversight and Regulation of Shadow Banking – Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, http://www.fsb.org/wp-content/uploads/r_130829c.pdf. ­ Freixas X., Lóránth G., Morrison A. (2007), “Regulating Financial Conglomerates”, Journal of Financial Intermediation, 16, 479–514. Freixas X., Rochet J. (1997), Microeconomics of Banking, Cambridge, MA: MIT Press. Freixas X., Rochet J. (1998), “Fair Pricing of Deposit Insurance. Is it Possible? Yes. Is it Desirable? No”, Research in Economics, 52, 217–232. Fuhrer L.M., Guggenheim B, Schumacher S. (2016), “Re-Use of Collateral in the Repo Market”, Journal of Money, Credit and Banking, 48(6), 1169–1193. Gershenkron A. (1962), Economic Backwardness in Historical Perspective, Cambridge, MA: Harvard University Press. Goodhart C., Wagner W. (2012), “Regulators Should Encourage More Diversity”, VoxEU.org, www.voxeu.org/article/regulators-should-encourage-more­ ­ ­ ­diversity-financial-system. ­ ­ Gorton G., Metrick A. (2012), “Securitized Banking and the Run on Repo”, Journal of Financial Economics, 104(3), 425–451. Grill M., Lambert C., Marquardt P., Watfe G., Weistroffer C. (2018), “Counterparty and Liquidity Risks in Exchange-Traded Funds”, European Central Bank, Financial Stability Review, November, 15–168, https://www.ecb.europa.eu/pub/pdf/fsr/ecb. fsr201811.en.pdf. Haldane A. (2011), “The Race to Zero”, 8 July, www.bankofengland.co.uk/Pages/home.aspx. Hendershott T., Jones C.M., Menkveld A.J. (2011), “Does Algorithmic Trading Improve Liquidity?”, Journal of Finance, 66(1), 1–33. Independent Commission on Banking (2011), Final Report Recommandations (Vickers Report).

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International Monetary Fund (2013), “Deposit Insurance”, Technical Note, Financial Sector Assessment Program European Union, March. Jacklin C., Bhattacharya S. (1988), “Distinguishing Panics and Information-Based Bank Runs: Welfare and Policy Implications”, Journal of Political Economy, 96,568–592. Kashyap A., Stein J., Hanson S. (2010), “An Analysis of ‘Substantially Heightened’ Capital Requirements on Large Financial Institutions”, Mimeo, May 2010, chifl.shufe.edu. cn/upload/htmleditor/File/120916100241.pdf. Kay J. (2010), “Should We Have Narrow Banking?”, in Adair Turner and others (eds.), The Future of Finance: The LSE Report, London School of Economics and Political Science, London, 217–234, harr123et.files.wordpress.com/2010/07/futureoffinancechapter81.pdf. Keller J. (Chair), Bouveret A., Picillo C., Liu Z., Mazzacurati J., Molitor P., Söderberg J., Theal J., de Rossi F., Calleja R. (2014), “Securities Financing Transactions and the (Re)Use of Collateral in Europe”, European Systemic Risk Board, Occasional Paper Series, 6, https://www.esrb.europa.eu/pub/pdf/occasional/20140923_occasional_ paper_6.pdf. Kirilenko A.A., Kyle A.S., Samadi M., Tuzun T. (2017), “The Flash Crash: HighFrequency Trading in an Electronic Market”, Journal of Finance, 72(3), 967–998. Kirilenko A.A., Lo A.W. (2013), “Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents”, Journal of Economic Perspectives, 27(2), 51–72. Kroszner R.S., Rajan R.G. (1994), “Is the Glass- Steagall Act Justified? A Study of the U.S. Experience in Universal Banking before 1933”, American Economic Review, 84(4), 810–832. Lettau M., Madhavan A. (2018), “Exchange-Traded Funds 101 for Economists”, Journal of Economic Perspectives, 32(1), 135–154. Liikanen E. (2012), Final Report of the High-Level Expert Group on Reforming the Structure of the EU Banking Sector, ec.europa.eu/internal_market/bank/docs/high-level_ ­ expert_group/report_en.pdf. Lim B.Y. (2011), “Short- Sale Constraints and Price Bubbles”, Journal of Banking and Finance, 35(9), 2443–2453. Lin L., Surti J. (2015), “Capital Requirements for Over-The- Counter Derivatives Central Counterparties”, Journal of Banking and Finance, 52, 140–155. Marsh I.W., Payne R. (2012), “Banning Short- Sales and Market Quality: The UK’s Experience”, Journal of Banking and Finance, 36(7), 1975–1986. Miller E.M. (1977), “Risk, Uncertainty, and Divergence of Opinion”, Journal of Finance, 32(4), 1151–1168. Miller M., Zhang L., Li H.H. (2011), “When Bigger Isn’t Better: Bail Outs And Bank Behaviour”, CEPR Discussion Paper, n° 8602. Mishkin F. (1999), “Financial consolidation: Dangers and Opportunities”, Journal of Banking and Finance, 23, 675–691. Monnet C. (2011), “Rehypothecation”, Federal Reserve Bank of Philadelphia, Business Review, Q4, 18–25, https://www.phil.frb.org/-/media/research-and-data/publications/ ­ ­ ­ business-review/2011/q4/brq411_Rehypothecation.pdf. ­ Morrison A.D. (2010), “Universal Banking”, in A.N.Berger, P. Molyneux, J.O.S. Wilson (eds.), Oxford Handbook of Banking, Oxford: Oxford University Press, 171–194. Neely M.C. (1994), “Going Interstate: A New Dawn for U.S. Banking”, The Regional Economist, Federal Reserve Bank of Saint-Louis, July 1994, www.stlouisfed.org/ publications/re/articles/?id=1885. Nezafat M., Schroder M., Wang Q. (2017), “Short- Sale Constraints, Information Acquisition, and Asset Prices”, Journal of Economic Theory, 172, 273–312.

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Nouy D. (2007), “Indirect Supervision of Hedge Funds”, Banque de France, Financial Stability Review, n° 10, 95–104, https://fondation.banque-france.fr/sites/default/files/ medias/documents/financial-stability-review-10_2007-04.pdf. ­ ­ Plantin G. (2015), “Shadow Banking and Bank Capital Regulation”, Review of Financial Studies, 28(1), 146–175. Rajan R.J. (1996), “The Entry of Commercial Banks into the Securities Business: A Selective Survey of Theories and Evidence”, in A. Saunders and I. Walters (eds.), Universal Banking: Financial System Design Reconsidered, Chicago, IL: Richard D. Irwin, 282–302. Ramaswamy S. (2011), “Market Structures and Systemic Risks of Exchange-Traded Funds”, BIS Working Paper, 343. Rochet J.-C., Tirole J. (1996), “Controlling Risk in Payment Systems”, Journal of Money, Credit, and Banking, 28(4), 832–862. Russo D. (2013), “CPSS-IOSCO Principles for Financial Market Infrastructures: Vectors of International Convergence”, Banque de France, Financial Stability Review, 17, 69–78, https://publications.banque-france.fr/sites/default/files/medias/documents/ ­ financial-stability-review-17_2013-04.pdf. ­ ­ Salomao J. (2017), “Sovereign Debt Renegociation and Credit Default Swaps”, Journal of Monetary Economics, 90, 50–63. Schumpeter J.A. (1939), Business Cycles: A Theoretical, Historical and Statistical Analysis of the Capitalist Process, New York: McGraw-Hill. Sharpe S.A. (1990), “Asymmetric Information, Bank Lending, and Implicit Contracts: A Stylized Model of Customer Relationships”, Journal of Finance, 45(4), 1069–1087. Singh M. (2011), “Velocity of Pledged Collateral: Analysis and Implications”, IMF Working Paper, WP/11/256, https://www.imf.org/external/pubs/ft/wp/2011/wp11256. pdf. Singh M., Turing D. (2018), “Central Counterparties Resolution – A n Unresolved Problem”, IMF Working Paper, WP/18/65, https://www.imf.org/en/Publications/WP/ Issues/2018/03/20/Central-Counterparties-Resolution-An-Unresolved-Problem­ ­ ­ ­ ­ 45727. Stiroh K.J. (2010), “Diversification in Banking”, in A.N. Berger, P. Molyneux, J.O.S. Wilson (eds.), The Oxford Handbook of Banking, 1st ed., Oxford: Oxford University Press, 146–170. Stiroh K.J., Rumble A. (2006), “The Dark Side of Diversification: The Case of US Financial Holding Companies”, Journal of Banking and Finance, 30(8), 2131–2161. Tarullo D.K. (2012), “The Volcker Rule”, Hearing by the Subcommittee on Capital Markets and Government Sponsored Enterprises and the Subcommittee on Financial Institutions and Consumer Credit, Committee on Financial Services, House of Representatives, United States, January 12. Turner G., Sushko V. (2018), “What Risks do Exchange-Traded Funds Pose?”, Banque de France, Financial Stability Review, 22, 133–144, https://publications.banque-france. fr/sites/default/files/medias/documents/financial_stability_review_22.pdf. Veryzhenko I., Harb E., Louhichi W., Oriol N. (2017), “The Impact of the French Financial Transactions Tax on HFT Activities and Market Quality”, Economic Modelling, 67, 307–315. Volcker P. (2010), “How to Reform Our Financial System”, New York Times, 31 January 2010. Wendt F. (2015), “Central Counterparties; Addressing their Too Important to Fail Nature”, IMF Working Paper, WP/15/21, https://www.imf.org/external/pubs/ft/ wp/2015/wp1521.pdf.

6 CAPITAL AND LIQUIDITY STANDARDS

It is not straightforward to assess capital (or solvency) and liquidity requirements from an economic point of view, given the multiplicity of channels through which they operate. On the one hand, they provide incentives to shareholders to better monitor managers, which reduce moral hazard (Chapter 1), and hence appear as instruments acting on incentives (Chapter 4). On the other hand, they are financial constraints (Chapter 5), imposed onto regulated financial institutions in order to limit financial fragility (Chapter 1). In addition, they appear as management standards for individual institutions, taking the overall economic environment as given. This corresponds to the microprudential approach, which is essential but needs to be complemented both by the crisis management and resolution approach (Chapter 7) and by the macroprudential approach (Chapter 8) – which studies the interactions between individual financial institutions, the financial system, and the real economy. Like every regulation, solvency and liquidity standards have costs and benefits (6.1). In addition, regulation can be improved or evaded, and its implementation should be progressively phased in with the view of avoiding any source of instability. Hence, the need for liquidity regulation only appeared during the GFC, in the wake of the excessive reliance of some institutions, like Northern Rock, on wholesale funding, which is more likely to vanish once a crisis breaks out (Chapter 2). Regarding capital requirements, Basel I and II, agreed upon by supervisors in the Basel Committee,1 may have contributed to the rise of the shadow banking system and to the procyclicality of the financial system (6.2). Discussed as the implementation period of Basel II was not yet over, Basel III was felt all the more useful once the GFC broke out. It has been going one step forward, addressing some of the limitations of Basel II (6.3). But financial stability also depends on the actual application of these regulations, as monitored by supervisory authorities (6.4). Finally, insurance companies may also contribute to systemic risk

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(Chapter 1) and, as far as capital is concerned, are subject to a specific regulation in Europe, called Solvency II (6.5).

6.1 Costs and benefits of capital and liquidity requirements Tighter financial regulation, in particular regarding capital requirements, in the aftermath of the GFC gave rise to a debate that opposed the financial industry to public authorities (central banks, supervisory authorities, and international financial institutions) as well as the academic profession regarding the assessment of the effectiveness of the overall regulatory framework. The debate was particular lively in the immediate years following the GFC, but new contributions also appeared ten years after the GFC.2 Summarizing the theoretical and operational dimension of the debate, the main issues in the literature are presented (6.1.1) as well as their main results (6.1.2).

6.1.1 Main issues At the core of the debate is the concern that the tightening of prudential regulation may have a negative impact on financial intermediation by raising the cost of funding (6.1.1.1). Given the existence of financial imperfections, the reduction in intermediated loans might induce a cut in financial resources available in the economy, hence a fall in production, all else being equal (6.1.1.2). However, from a normative cost-benefit analysis (Chapter 4), the cost in foregone output from the reform should be compared to the expected reduction in the cost of financial crises (6.1.1.3).

6.1.1.1 Impact on financial intermediation Broadly speaking, the tightening of capital and liquidity regulation should induce, when the regulation is binding, a change in the structure of financial intermediaries’ balance sheet. Such an impact differs across regulation types, but the main channel of transmission is the increase in the cost of intermediation. Most studies assume a pass-through to lending rates, or an effect on credit supply. 6.1.1.1.1 Capital requirements From a normative point of view (Chapter 1), the regulation of capital standards aims at addressing market failures and providing shareholders and managers the incentives to contain risk-taking. For many years, its objective was mainly microprudential, i.e. targeted at individual institutions with a view of increasing the solvency of each one of them. From that perspective, the role of prudential regulation is to protect banks’ depositors, which are less sophisticated than financial institutions, and have little incentive to individually monitor their own bank, given the existence of deposit insurance (Dewatripont and Tirole, 1994, Chapter 5); by protecting the latter, it protects also taxpayers. There is a vast economic literature discussing the effectiveness of capital regulation from a microeconomic

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point of view. Besanko and Kanatas (1996), Hellmann et al. (2000), and Repullo (2004) show that in partial equilibrium, capital requirements reduce risk-taking, as they reduce leverage.3 Indeed, shareholders bear significant losses in case of a bank’s failure, which induces them to monitor closely managers’ actions. Conversely, from a risk-return perspective, economic literature highlights the perverse effects of higher capital requirements: from an accounting point of view, it reduces return on equity, ceteris paribus; institutions may therefore attempt to offset this effect by taking on more risk, all the more since shareholders enjoy limited liability. Nevertheless, Freixas and Rochet (2008) show that banks’ incentives to reduce risk can be restored if capital requirements are proportional to the amount of risks they face (7.2). This is consistent with the conclusions of Merton’s (1974) model: the level of own funds needs to be sufficiently high in order to protect the bank’s debtholders given asset risks (Goodhart, 2011). In a general equilibrium setting, Van den Heuvel (2008) uncovers a negative impact of capital regulation on welfare, but one may question the model’s ability to properly measure the effects of a reduction in the risk of failure. To properly assess the effectiveness of a tightening of capital requirements, it is important to determine whether it has an impact on the cost of funding. Higher capital requirements should translate into an increase in the share of capital (own funds) in the bank’s balance sheet, or a decrease in the leverage. In the case of a bank’s liquidation, shareholders are junior to debtholders: the former only rank second in the allocation of bank’s profits or remaining assets, so that shares are more risky and shareholders should command a higher ex ante return. From an accounting point of view, higher capital requirements should imply a higher weighted average cost of capital (WACC), where capital is defined as own funds and liabilities. However, this contradicts Modigliani and Miller’s (1958) theorem, according to which the firm’s WACC does not depend on the structure of the balance sheet (and the share of own funds and debt). Indeed, as the share of own funds increases in total funding, the firm becomes less risky, so that the cost of funding obtained from both shareholders and debtholders should decrease, allowing a stability of the WACC, since shares still receive a higher return than liabilities. However, Modigliani and Miller mention the existence of distortions that prevent the direct application of their result. In this respect, they mention the tax deductibility of interest, whereas dividends are not deductible, which leads to a bias in favour of indebtedness (Chapter 9). On the other hand, with regard to banks, Miller (1995) mentions another distortion resulting from the fact that the pricing of deposit insurance is not always linked to the risks taken by the institutions (Chapter 5). In addition, the largest institutions also benefit from the implicit guarantee of the government on their other debts (“too big to fail”, Chapter 1). As a consequence, the studies listed here most often assume that the remuneration of resources other than shares does not decrease following the increase in capital ratios.4 As regards equities, the degree to which Modigliani and Miller’s argument tempers the mechanical effect on the average cost of funding (known as Modigliani and Miller “offset” in the literature) varies according to the authors. It is total for Admati et al. (2013), who adopt a social welfare point

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of view making strengthening the capital requirements a “free lunch”. In their analysis, the increase in the total remuneration paid to the shareholders is a cost for the company but not for the whole society (the latter is even wealthier after the reform, to the extent that financial crises become less costly). The same is true for the increase in corporate tax resulting from the decrease in indebtedness (this last argument is echoed by Miles et al. (2013) in the scenario they favour). These authors, in the same scenario, retain a degree of compensation of 45% based on the “CAPM beta” of British banks. Modigliani and Miller “offsets”, used in most studies, are essentially bimodal: they are 0 or about 50%. Elliot et al. (2012) include a 50% offset based on the observation of US bank share prices. However, no Modigliani and Miller effects are retained by the BCBS (2010b and c), or by Slovik and Cournède (2011). Finally, the Institute of International Finance (IIF, 2011) only introduces a weak “offset” for banks with Tier 1/risk-weighted assets (RWA) capital ratios above 7%; below this level, the downward pressure on share prices exerted by banks’ issuance is, on the contrary, supposed to increase the cost of capital, a hypothesis which implicitly assumes major market imperfections. 6.1.1.1.2 Liquidity requirements Theoretically, prudential requirements for liquidity serve several purposes. On the one hand, they force institutions to internalize the consequences of a market failure and to hold ex ante assets that can be mobilized or realized in these circumstances. On the other hand, they aim to reduce the opacity of bank balance sheets, the latter encouraging risk-taking (Tirole, 2006). According to Calomiris et al. (2011), the accumulation of liquid assets reduces the bank’s expected cost of bankruptcy by avoiding the liquidation of longer-term assets. Liquid assets are generally less complex, more easily recoverable and less risky than long-term assets: constraining banks to hold liquid assets complements solvency regulation. By the same token, liquidity regulation reduces asset risk, secures stable funding and lowers financing costs (see also the European Central Bank [ECB], 2012). The existence of a liquidity buffer also protects the central bank: provided it is constantly informed (Chapter 8), it has more time to assess the bank’s situation and to decide whether it wishes to provide liquidity to the troubled institution (Goodhart, 2011). In the studies cited in BCBS (2016), the liquidity requirements increase the cost of intermediation because the remuneration of financial assets normally increases with maturity. As a result, the intermediaries are penalized on both sides of their balance sheets, by the lengthening of the average maturity of liabilities and by the shortening of the maturity of assets.

6.1.1.2 Impact on output and credit supply Two types of assessment of the impact of regulation on macroeconomic variables are available: the impact on (i) loan spreads or (ii) directly on credit supply. In the first case, the impact on production is generally derived from that on financial intermediation (Elliot et al., 2012, is an exception). The most common method is

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to use a comprehensive model of the economy, with or without a banking sector (rising cost of credit reduces investment and consumption, reducing the level of steady-state production). Sometimes reduced-form models link production to the cost of credit, as in Miles et al. (2013): the increase in the weighted average cost of bank capital is passed on to the economy in proportion to the intermediation rate, leading in the long run to a substitution of labour for capital and a decrease in production relative to a reference scenario. In some cases, where studies use global models (NIGEM for the IIF, OECD’s New Global Model for Slovik and Cournede, 2011), international spillovers are integrated, accentuating the shortrun recessionary impact of reforms (the decline in production among trading partners accentuates that recorded in different countries). Finally, as in some of the models used by the BCBS (2010 b and c), the very accommodative monetary policy since the crisis softens the recessionary effect of the reform (Cecchetti, 2014). In all cases, the level of production is reduced compared to the reference scenario. The second type of approach, mostly found in academic literature, assesses the impact of capital regulation directly on credit supply and not on spreads. The survey by Birn et al. (2020) overall points to a small positive effect of bank capitalization on bank lending when there is a crisis. That is, banks that are best capitalized before the crisis occurs, have increased their supply of loans relatively more (or reduce their supply by less) compared with other banks when the crisis occurs. The evidence is more mixed for higher capital in normal times, despite a fraction of studies exhibiting a positive sign on loan supply. Regarding liquidity regulation, BCBS (2016) highlights several potential effects of liquidity regulation on credit supply. The introduction of the Liquidity Coverage Ratio (LCR; 6.3) increases the opportunity cost of holding illiquid assets, which may translate into higher loan rates to offset higher funding costs or loweryielding liquid assets. It may reduce the proportion of loans on banks’ balance sheets (as well as contingent credit and liquidity facilities; Cornet et al., 2011) as well as reduce the average maturity of bank loans. The LCR may also reduce the proportion of private bonds and increase the proportion of government debt held by banks. At the same time, bank credit may contract less in reaction to funding shocks, due to the existence of a liquidity buffer (Acharya and Viswanathan, 2011). Empirically, Banerjee and Mio (2018) find no significant effect on credit supply in the UK. Bonner (2015) for the Netherlands as well as the European Banking Authority (EBA; 2014 and 2015) for LCR and Net Stable Funding Ratio (NSFR; 6.3) find similar results. Whereas the existing empirical analyses find no significant impact of liquidity regulation on credit, some papers using DSGE model simulations suggest a negative impact of liquidity requirements on lending (see Covas and Driscoll, 2014, as opposed to de Bandt and Chahad, 2016, with a weak effect).

6.1.1.3 Reduction in the cost of crisis Besides the short-run costs, there are also expected benefits from regulation, even if they are difficult to quantify and may only materialize in the long run. They are key elements in order to assess the net expected benefits of regulation,

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defined as the difference between expected benefits and costs (BCBS, 2010b; Miles et al., 2013; among others). Expected benefits are mainly defined as the reduction in the probability of crisis and the lower impact of a crisis occurring, both being difficult to measure.

6.1.1.3.1 Reduction in the probability of crisis There are two ways to get estimates of the effect of regulation on the probability of crisis. The “top- down” method uses country-level data to estimate the relationship between crisis indicators and banking system capital. In contrast, the “bottom-up” method estimates the relationship between capital and failure at the bank level and then extrapolates to the banking system/crisis level in various ways. Neither method is necessarily better: top- down is simpler and more direct, and bottom-up is more micro-founded but involves estimation and simulation. Most studies, including BCBS (2010b), use both methods for robustness. The typical top-down model estimates the probability of a crisis as a function of banking system capital and various financial control variables that might also affect crisis risk. Typical controls include bank liquidity, credit/GDP, volatility index (like the VIX index, Chapter 3), house prices and trade balance.5 In general, the probability of a crisis is found to decline when banking system capital is higher, though the size and statistical significance of the effect varies across studies. The bottom-up method involves estimating the distribution of bank-level losses, then using simulations to estimate the probability of such losses reaching crisis levels by depleting banking system capital to crisis proportions. The study by the Federal Reserve Bank of Minneapolis (2017), for example, converts peak nonperforming loans that are observed in crises to equivalent capital losses, and then estimates the marginal benefit of additional capital in averting a crisis or bailout. In the bottom-up approach by Miles et al. (2013) annual variations in the GDP of a large sample of countries are computed over the long period (1821–2001) in order to estimate a distribution function. The function is asymmetric (there are sharper declines in GDP than increases) and has thick tails (extreme events are much more frequent than in a Gaussian law). In addition, the authors assume that a crisis is characterized by losses on bank assets at least equal to their capital and that the value of these assets varies with permanent shocks to the GDP (the relative depreciation of bank assets is equal to that of the GDP). Under these conditions, banks must, for example, have a capital adequacy ratio of at least 15% to cope with a fall in annual GDP of the same magnitude, which occurs every 80 years. New findings by Jordà et al. (2017) shift attention from the crisis prevention effects of capital to the cost containment benefits. They study the benefits of bank capitalization using data on 90 banking crises in 17 OECD countries over the 1870–2013 period. They conclude that while countries with better capitalized banks before a crisis suffer less severe recessions after, bank capital does not predict the probability of a crisis. This latter result was subsequently disputed by Cochrane (2017) on the account that the analysis did not take into account that bank capital is endogenous.

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6.1.1.3.2 Reduction in the loss of output BCBS (2010b) and later studies all measure the cost of a crisis by the resulting loss of output (GDP), discounted to present value terms. That narrow economic “accounting” makes measurement tractable, but it also ignores human aversion to uncertain and fluctuating income as well as non-economic costs (e.g. political instability) associated with crises (Chapter 11). Measuring the economic costs of a crisis is challenging: the sample of crises is small, the duration of their impact on GDP is arguable and the appropriate rate to discount those future costs is debatable as well (Chapter 2). The cost of a crisis can be broken down into two parts: i) A transitory impact corresponding to the fall in production during the shock and the time needed to regain the previous growth path. As a result, the BCBS retains a discounted production loss of 19% of pre- crisis GDP. Miles et al. (2013) assume that GDP initially falls by 10% and that three- quarters of this decline is recovered in five years. ii) A (possibly) permanent impact. To evaluate this, the BCBS retains a median of the effects calculated in different academic studies, leading to a total discounted cost, including the transitional impact, of 63% of the pre- crisis GDP. Miles et al. (2013), assuming that a quarter of the initial loss is never recouped, arrive at a much higher figure, in discounted terms and including the transitional impact, of 140% of pre-crisis GDP. In addition, Jordà et al. (2017), already mentioned above, and others suggest that while higher bank capital may not reduce significantly the risk of crisis, it does significantly lower their cost by sustaining bank lending during the resulting recession. However, in normal times, bank capital does not seem to be negatively correlated with loan growth or GDP growth. Furceri and Mourougane (2012) estimate permanent declines in GDP between 1.5% and 2.4% following the short-term effects. They arrive at those figures by first estimating potential GDP per country (assuming a Cobb-Douglas production function) and use that estimate as the dependent variable in a single equation (univariate autoregressive) model of GDP growth.6 Combining the shorter- and longer-term crisis cost estimates from those two studies, Firestone et al. (2017) estimate expected crisis costs in the US to be between 40% and 100% of GDP. This range is consistent with the median estimate of 63% in BCBS (2010b). Crisis cost estimates in the other studies reviewed range widely but overall lie slightly above the 63% (median) estimate in BCBS (2010b). Clerc et al. (2015) provide a stylized theoretical model highlighting the tradeoff between, on the one hand, the cost of bank failure in terms of foregone aggregate wealth in the economy, which is calibrated in the model, and, on the other hand, the opportunity cost from higher capital. However, actual regulatory constraints are not considered as banks do not face any liquidity constraint. Boissay and Collard (2016) introduce both liquidity and solvency regulations and highlight a trade-off between the effect of higher regulatory requirements on the reduction in the supply of credit and the allocation of credit towards more productive uses.

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6.1.2 Expected impact of regulatory changes A summary of the meta-analysis carried out by Birn et al. (2020) is presented in Table 6.1.7 Admati et al. (2013), for which the cost of higher capital is zero, are excluded from the table; however, IIF (2009) has been added. The table reveals strong differences between the IIF assessments and the others. These divergences can be explained by the authors’ approach (6.1.2.1) but also, more or less explicitly, by different assessments (6.1.2.2).

TABLE 6.1 Impact of the tightening of financial regulation (basis points or % points)

Costs

Benefits

Increase in loan spreads (basis points)

Cost of higher spreads on GDP (percentage points)

Decrease in crisis probability (annual, %)

Crisis impact (discounted annual GDP, %)

13 14–25

–0.09 –0.08 to –0.15

1.6

63 range: 19–58

27–38

–0.17 to –0.24

MAG (BCBS, 2010c) 16–19

–0.15 to –0.26

NA

NA

BCBS (2010b)  Capital requirements  Liquidity requirements  Capital and liquidity requirements

Central Banks and Supervisory authorities in Birn et al. (2020)

mean: 7.4; range: 2–13

mean: –0.073 mean: 0.8 range: mean: 78 range: range: –0.01 to 0.03–1.7 41–180 –0.16

Academic literature mean: 0.15 mean: 0.5 range: mean: 1 range: in Birn et al. range: –0.25 –2 to 4 0.5–1.5 (2020) to 0.25 (lending growth) IIF (2011)

364

–3.2

NA

NA

NA

DSGE Models (BCBS, 2016)  De Nicolo et al. NA (2014)  Covas and Driscol +11 (2014)  de Bandt and Chahad +2.6 (SMEs) (2016) +5.8 (large corp)

–0.26 (lending) –0.3 wrt steady state –0.15 first year –0.08 after four years

Note: The table presents the impact of a 1% increase in capital ratio from different sources (DSGE use specific implementation scenarios). For the academic literature, column 3 “impact on GDP” is measured by the percentage change in the loan supply, not GDP.

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6.1.2.1 Differences in approach In addition to the above-mentioned differences in reasoning, the most significant of which relate to the fact that a Modigliani and Miller effect (1958) is taken into account or not, and to the assessment of the cost of crises, the main differences in approach are related to the following elements: −

−

−

−

−

−

−

Time horizon: Most of the studies focus on a medium-term horizon defined loosely – from four to almost nine years – although they indicate that uncertainty at this time is important because of the difficulty in anticipating the reaction of the financial markets to the strengthening of banks’ own funds and the behaviour of the institutions during the phasing-in of the reform. Capital indicator used to assess regulation: BCBS (2010b) defines capital ratios as tangible common equity to Basel II risk-weighted assets (RWA). In more recent studies, capital ratios are defined as Tier 1 or Common Equity Tier 1 (CET1) to RWA, where RWA definitions are based on Basel III definitions. Scope of the measures: The strengthening of capital requirements is systematically taken into account, as is often the case with the liquidity requirements, but national provisions, such as the Dodd-Frank Act in the US are sometimes too. As acknowledged by Birn et al. (2020), some of the evaluation studies also incorporate other (non-capital) reforms like the Total Loss Absorbing Capacity and resolution reforms (Chapter 7) into their assessment of optimal capital. In principle, these non-capital reforms provide independent (of capital) stabilizing effects and so, all else equal, they could lower optimal capital. These conclusions are surrounded by a high level of uncertainty as the impact of these additional reforms remains still unknown (Chapter 7). In addition, the details of the impact of each type of measure are not always provided. Country coverage: BCBS (2010b) covered all BCBS member countries while later studies are country- specific (the UK for Miles et al., 2013), but may be extended to a large number of countries. Reform implementation scenario: The baseline is provided by the situation of the institutions at the end of 2009 in earlier studies, but the target may be to meet the minimum regulatory requirements (BCBS, 2010c) or to maintain room for manoeuver (Slovik and Cournède, 2011; Elliot et al., 2012), on the grounds that they would be imposed not by regulation but by considerations of sound management or expectations of the financial markets. Institutional behaviour: Beyond a mechanical pass-through of the rise in the average cost of credit, it is sometimes assumed that institutions make cost reductions and reallocate their portfolios to less risky assets (IIF, 2011). In addition, the studies emphasize that seeking to meet capital requirements by anticipating regulatory deadlines could significantly increase the cost of reform (BCBS, 2010c; Elliot et al., 2012). Ability to distinguish supply effects from demand effects, and more generally the exogenous nature of shocks affecting regulatory ratios. For a survey

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of the literature, see Peydro-Alcade (2010) for the regulation of solvency and Khwaja and Mian (2008) for the one on liquidity. In the latter case, the authors use a truly exogenous event, such as unanticipated nuclear tests in 1998, which had effects on liquidity, to observe a genuinely exogenous change in the regulation and deduce a measure of the effects on supply credit.

6.1.2.2 Differences in assessment Implicitly, the studies provide an assessment of the merits and extent of the reform through their cost estimates. This is more apparent when they compare this cost with the expected benefit (BCBS, 2010b, 2019; Miles et al., 2013) or when they criticize official evaluations (IIF, 2011). BCBS (2010b) shows that the net benefits of the reform would level off and then fall beyond capital ratios of 11%–12% under the assumption of no permanent effect of crises on output (13%–15% under the opposite hypothesis). The addition of liquidity requirements does not substantially modify these results. It can be inferred that, for BCBS (2010b), the reform is beneficial even when adopting conservative assumptions about the gains it provides since the requirements defined by Basel III are close to 11%. This diagnosis is even clearer in Miles et al. (2013), which, because of a more favourable assessment of the decrease in the cost of crises, show a net benefit of capital ratios of 16%–20% even if protection against extremely adverse events is not sought. Birn et al. (2020) confirm BCBS (2010b), while noting a significant amount of uncertainty around the estimates However, for the IIF, the reform would strengthen the resilience of the financial system to shocks, but it is not certain that the likelihood of a crisis will decrease. Indeed, several factors would work in the opposite direction: disintermediation towards unregulated entities; the constraint exerted on monetary policy by the negative impact on financial intermediation; the regulatory distortion, perpetuated in Basel III, in favour of government securities for which the crisis in the euro area has revealed a credit risk; and the possibility of a run on the securities issued by the banks if their holders risk in the future to be forced to contribute in case of default. In addition, the IIF considers that the cost of crises is overstated by BCBS (2010b), insofar as the latter does not relate these crises to their true causes, such as poor management of public finances or unrealistic pegs of exchange (meaning conversely that banking crises can strain the sustainability of public finances; Chapter 9). The conclusion of the IIF is that macroprudential policies (Chapter 8) would be more effective than capital and liquidity requirements in providing financial stability.

6.2 Basel I, Basel II, and procyclicality The GFC erupted in August 2007 at a time when most countries had not fully implemented Basel II. In fact, to manage the risks of the transition from Basel

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I to Basel II, so-called advanced risk measurement approaches have been introduced gradually, with Basel I continuing to apply during this transition period (Caruana and Narain, 2008). Thus, the directive that transposed Basel II into the legal system (Capital Requirement Directive 2 [CRD2]) came into force in the EU at the beginning of 2007 with the adoption by banks of the standard approach (SA) (6.2.2). In accordance with the associated implementation schedule, the advanced approach (6.2.2) was only applied in early 2008. US banks could request the authorization to run in a parallel the SA and the advanced approach for three years before adopting the latter in 2011. Only Japan implemented Basel II effectively in 2007. As the GFC started under Basel I (6.2.1), the performance of Basel II must be appreciated conservatively and prospectively (6.2.2).

6.2.1 Basel I In order to limit risk-taking by banks and to avoid the incentive problems related to the lack of coordination at the international level, the banking authorities of countries where the banking system had a global reach agreed in 1988 on a number of capital recommendations. This approach was not conducted as the result of an international treaty, but resulted from a number of rules based on the moral suasion of partner countries (Gordy and Heitfield, 2010; Chapter 10). Basel I defined a solvency standard: the ratio of the regulatory capital of a credit institution to the total of its RWA, including, from the mid-1990s, on its off-balance sheet commitments, should not be less than 8% (Cooke ratio). Thus, for 100 euros of risk-weighted exposures, compliance with the Cooke ratio assumed that the institution would be funded through at least 8 euros by its own funds and 92 euros by deposits of customers, loans, interbank financing, etc. The definition of eligible own funds in the numerator was broad, as it included not only the share capital and reserves, which formed Tier 1, but also subordinated debt and a share of unrealized gains constituting Tier 2 and Tier 3, mainly consisting of subordinated loans intended exclusively to cover market risks (Chapter 5). The Cooke ratio was intended to put an end to the continuing deterioration of the relationship between the capital of the banking system and its risks, and to eliminate distortions of competition arising from the fact that some if not all jurisdictions provided an implicit and unlimited guarantee of support to their banks in case of default. Indeed, the leverage of major banks with an international reach had increased considerably in previous years in most countries, particularly in Japan, in order to partially offset the decrease in profitability in a more competitive environment (Chapter 9) and the development of financial innovation. The purpose of the reform was to encourage banks to select their liabilities on the basis of their expected profitability relative to the need for regulatory capital. In fact, the entry into force of Basel I led to the recapitalization of major international credit institutions and a reduction of distortions in competition, with the implementation of the new standards in many countries (Rochet, 2008). However, the Cooke ratio had a number of weaknesses, notably weights used to measure RWA were constant over time and applied to very broad risk

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categories, which may have contributed to the accumulation of imbalances in the financial sector, the development of the shadow banking system and the outbreak of the crisis (Caruana and Narain, 2008). In particular, it is possible to mention the following elements: −

−

−

−

Only credit risk was taken into account, the other risks – operational and market risks – being ignored in the regulation. Credit risk was apprehended in a summary manner, disconnected from the individual risk of default and its assessment by banks and investors. The weighting ranged from 0% (government bonds) to 100% (companies), depending on the institutional characteristics of the borrower or the issuer of the security (government, non-financial enterprise, bank, OECD or not). Basel I offered regulatory arbitrage opportunities that could lead, during the downturn in the business cycle, to a severe credit crunch as it was less costly in terms of equity to buy government securities from an OECD state than to lend to a firm or household (Peek and Rosengren, 1995; Freixas and Rochet, 2008). The simplicity of the Cooke ratio, which initially constituted its strength, became a weakness afterwards. In particular, its summary nature in the assessment of credit risk may have favoured the distribution of credit to risky debtors at higher margins, to the detriment of higher-quality debtors with lower margins but requiring the same capital charge. Another type of regulatory arbitrage is that Basel I did not adequately treat securitization but encouraged banks to move low-risk, lower-paying outstanding assets off their balance sheets. As a result, the average risk of outstanding assets remaining in the balance sheet rose without the capital charge rising as well. The emergence of credit derivatives at the end of the 1990s has certainly made it easier to cover at low cost the risks associated with outstanding assets remaining in the balance sheet. However, the use of securitization may also have contributed to a distorted view of the bank’s profitability prospects as it was accompanied (Chapter 2) first by loss preservation mechanisms to protect investors and by the setting up of off-balance sheet liquidity lines, hardly penalized in regulatory capital.

Basel I’s deficiencies led to the development of Basel II, adopted in June 2004 by the Basel Committee and published in June 2006 (6.2.2.1). Basel II has also been criticized (6.2.2.2).

6.2.2 Basel II 6.2.2.1 Main features of Basel II Designed as a framework that goes beyond the minimum capital requirements, Basel II has three interdependent pillars.

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6.2.2.1.1 Pillar I Pillar 1 specifies the minimum capital requirements. Under Basel II, regulatory capital must continue to represent, as under Basel I, at least 8% of the RWA. Moreover, at least half of it must be made up of Tier 1 capital and half of Tier 1 capital must be made up of common shares. In addition, Pillar 1 increases, relative to Basel I, the sensitivity of banks’ regulatory capital to their effective risk, which includes credit risk, operational risk and market risk resulting from their activities. For each risk, an amount of equity is estimated to cover the bank’s losses at a certain horizon (one year for credit risk) with a certain probability (99.9% for credit risk). Three approaches are proposed for measuring credit risk, the “standard approach” (SA), which is based on the external ratings of specialized agencies (when they are not available, the capital charge is set at 8%), and an advanced approach, which combines two methods that rely on the risk parameters derived from internal models of banks subject to their validation by the supervisory authority: the “foundation internal rating (based)” (FIRB), which is relatively simple, and the “advanced internal rating” (AIRB), which is more complex. Whichever approach is adopted, the capital charge (K) per unit of exposure is calculated for each borrower category according to the following formula, which measures the difference between “unexpected losses” with a probability of 0.1% and the expected losses (PD × LGD) omitting the maturity adjustment term:8   1 R K = LGD × N  × G(PD) + × G (0,999) − PD × LGD, 1− R  1− R  with − − − −

PD: the one-year ahead probability of default LGD: the Loss Given Default R: the correlation between the loan portfolio and the macroeconomic risk factor G(u) = N −1 (u) is the quantile function (or inverse function) of the cumulative disx 1 t2 tribution function of the standardized normal law N(x) = exp − dt . 2π 2

∫

∫

−∞

Basel II relies on more sophisticated risk management techniques. It thus brings together the approaches of “economic capital”, used by banks to estimate their capital requirements according to their own appreciation of their risks (via their “internal models”), and the models of “regulatory capital” imposed by the supervisor. Compared to Basel I, Basel II allows banks to better assess and cover, in prudential terms, liabilities arising from market risks (KTR below) and operational risk (KOR below). For the first, a specific calculation of regulatory capital for credit risk transfer transactions such as securitization and credit derivatives is planned under Pillar 1. Based on the actual nature of the

Capital and liquidity standards  155

transfer of risk and the significance of this transfer, the treatment of securitization in Basel II applies to banks acting as distributors, investors, and sponsors (Chapter 2).  1  RWA =  s 0.08  

∑ i

 ki EADi + KTR + KOR  ,  

where EADi measures the amount of the exposures at default and an adjustment factor to prevent the changeover to Basel II from leading to a reduction in capital requirements while giving incentives to banks to implement the best risk management tools. 6.2.2.1.2 Pillar 2 Pillar 2 is designed to cover additional risks that are specific to a given institution. It defines the essential principles of prudential supervision, with the supervisory authority confronting its analysis of a bank’s risk profile with that of the bank itself, which is encouraged to improve its monitoring and management techniques. One of Basel II’s objectives is to promote stress tests conducted by institutions as a tool for risk management and measurement. These cross- examinations may lead the supervisor to increase the capital requirement under Pillar 1 if the risk profile of the bank so justifies. 6.2.2.1.3 Pillar 3 Pillar 3 is about strengthening market discipline. It relies on better financial communication from banks on own funds and risks, including securitization transactions, some of which must be published by banking.

6.2.2.2 Criticisms addressed to Basel II Two issues raised particular attention: the risk of procyclicality and the definition of some regulatory weightings. 6.2.2.2.1 Risk of procyclicality Basel II’s closer link between capital requirements and the risks faced by banks has raised fears that the new agreement might have procyclical effects, a recurrent theme in regulatory discussions between regulatory authority and the financial industry.9 Procyclicality refers to the dynamic interactions between the financial and real sectors of the economy. These mutually reinforcing interactions tend to amplify the fluctuations of the business cycle and cause financial instability or exacerbate it (Financial Stability Forum, 2009). The minimum capital requirements have a procyclical effect: banks suffer more losses on their credit portfolio during the lower phases of the business cycle, reducing the numerator of their

156  Capital and liquidity standards

solvency ratio, own funds. If banks’ capital is no longer higher than the regulatory minimum and if it is difficult and expensive to raise capital in the markets, which is generally the case at the bottom of the cycle, the lending capacity of the banks is diminished, which amplifies the recession. To this extent, Basel I, which was characterized by uniform weightings by credit types and invariant to the cycle stage, was procyclical. With Basel II, the capital requirements increase with the weights for calculating the RWA, the PD, and the LGD, estimated for each borrower. However, these weights are likely to increase in the lower phase of the cycle. Conversely, in the high phase, banks, which would then have a high capital against regulatory requirements decreasing due to lower risk, could increase their distribution of credit, fuelling asset price bubbles and overheating the economy. 6.2.2.2.2 Definition of regulatory weightings An additional limitation of Basel II is the definition of regulatory weightings regarding SMEs and sovereigns. Both may have an impact on financial stability. −

−

With respect to corporate credit risk, the regulatory weightings introduce safety margins, which can accentuate the procyclical effect. There is indeed evidence of such a safety margin in the regulation. Dietsch and Fraisse (2013) measure, for the main banking groups operating in France, (i) the capital requirements on residential credit portfolios, based on a single-factor model, against (ii) measured economic capital benchmarks using a multifactor portfolio credit risk model. They show that regulatory requirement formulas do not underestimate portfolio credit risk. Similar conclusions were highlighted by Düllman and Koziol (2013) on German SMEs: because of a lower risk cyclicality in observed data than in the regulatory formulas, the latter lead to higher requirements than necessary for a given level of confidence. Both studies confirm the validity of the transposition of Basel III (see below) in the EU, which was implemented with a “SME- supporting factor”, whereby RWA are reduced by 24%.10 At the same time, Dietsch et al. (2018) only find limited evidence that the supporting factor increases loan supply to French SMEs. The issue of sovereign exposures also took more prominence during the GFC and its aftermath. The Basel Committee and the EU have been discussing ways to reform the current preferential treatment benefiting sovereign exposures. In the standardized approach, a zero weight is applied when sovereign bonds enjoy an AAA or AA rating, or when they are issued in the domestic currency of a sovereign EU member state. In the IRB approach, a low but non-zero risk weight is applied (Nouy, 2012, for EU banks). The Regulation on Capital Requirements (CRR) in the EU is supplemented by the Delegated Regulation of 10 October 2014 defines the LCR in the EU (see below), based on the model defined by a Basel standard of January 2013. This ratio classifies the exposures on a Member State of the Union or a third country with a credit quality Tier 1 of High- Quality Liquid Assets (HQLA),

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which encourages banks to hold sovereign debt. Finally, sovereign exposures are exempted from the large- exposure regime, whereby a bank cannot be exposed to more than 25% of its eligible capital on the same beneficiary or group of related beneficiaries. Such exemptions are supposed to take into account the taxation power of the government. However, local authorities would have less room to increase taxes. In addition, the European crisis provided evidence of the “bank-sovereign nexus”. In that regard, proposals have been made to mitigate this “nexus” (Chapter 9). With the exception of sovereign risk, which has not been dealt with so far, these uncertainties have been addressed in the Basel III reform.

6.3 Basel III The GFC has revealed the inadequacies of the regulatory framework provided by Basel II. Indeed, both the quality and quantity of capital present in the banking system as a whole as well as the liquidity requirements have proved insufficient to cope with severe economic shocks (ECB, 2010). In many countries, central banks and public authorities intervened by massively injecting liquidity and providing equity support and guarantees to institutions in difficulty. In response to the crisis, supervisors proposed a new prudential framework (Basel III) to strengthen the resilience of banking institutions and systems (BCBS, 2010a and 2010c). Basel III in particular strengthens the rules on equity and introduces rules on liquidity. The Basel Committee published the Basel III framework in December 2010. The system was hailed as providing a response to certain Basel II limits, in particular as regards the strengthening of prudential supervision over market activities, the better comparability of requirements between authorities by greater harmonization of concepts and taking into account liquidity risk.11 However, it has been criticized for its complexity (Haldane, 2012). At the European level, the new Basel III regime has been implemented in a coordinated way by the CRD IV, which was transposed into national law, and by the CRR, which was immediately applicable.12 Whereas the goal was to achieve a “single rule book”, a number of provisions were introduced in order to take into account the specificities of European banking systems and leave the possibility for national supervisors to adopt higher requirements. CRD deals with issues of licensing, governance, oversight, and sanctions, while CRR contains provisions for pillars 1 (quantitative requirements) and 3 (financial transparency). The risk-weighted capital ratio (6.3.1), leverage (6.3.2), and liquidity (6.3.3) ratios and their interactions (6.3.4) are studied successively.

6.3.1 Risk-weighted capital ratio Basically, the CET1 ratio includes equity in the numerator and risks in the denominator. The ratio is defined as:

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Common equity + surplus related to common stock + retained earnings – Deductions13 (defined as: financial participations (banks and insurance companies) + minority interests + goodwill + net deferred tax assets) Credit risk and securitization + market risk + operational risk + counterparty risk

> 4,5% (+ 2,5% capital conservation buffer)

Basel III has led to a redefinition of own funds which results in higher demands on their quality (6.3.1.1) and their quantity (6.3.1.2). The crisis had highlighted the following deficiencies in the definition of own funds: − Fuzzy boundaries between different components of regulatory capital. For example, between basic own funds and instruments classified as Tier 1 capital, such as preference shares. − Inappropriate definitions and application of certain deductions (e.g. goodwill). In addition, there was no harmonized list of these regulatory adjustments, which lead to diverging practices. − Low transparency on regulatory capital levels. Indeed, banks’ publications of their regulatory capital base generally lack in detail and quality, making them difficult to analyse or compare internationally. In order to improve the quality and quantity of capital instruments, the Basel Committee has taken action on both the different components and the deductions. All capital instruments must now be able to absorb losses at least in “gone concern” situation, i.e. in the event of insolvency and liquidation of the institution (Chapter 7). Among these capital instruments, Tier 1 capital must be able to absorb these losses in “going concern” situation, i.e. when the institution is still solvent. This is why the focus on common equity is important. In addition to the change in the numerator of the risk-­weighted capital ratio, in terms of quality (6.3.1.1) and quantity (6.3.1.2), the denominator was also affected. Although credit risk was affected to some extent (6.3.1.3), the most significant change was introduced for market risk (6.3.1.4).

6.3.1.1  The strengthening of qualitative requirements for capital The quality of the elements constituting the Tier 1 capital has significantly improved. A much greater emphasis is put on CET1, i.e. ordinary shares and reserves. Deductions are standardized and generally apply to CET1 and not to the whole Tier 1 capital. The objective of the reform is to increase significantly the loss Absorbing property of capital instruments. The substance will prevail over the form: an instrument may be eligible for Tier 1 capital if it verifies certain criteria, in particular be completely subordinated to any other liability in liquidation, with a principal which is perpetual

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and classified as liability under accounting and solvency requirements, but carries neither redemption obligations nor serves discretionary dividends. Preference shares are no longer taken into account in CET1. Hybrid instruments that can be redeemed will no longer be recognized as Tier 1 capital. The Tier 2 capital class is simplified by removing the distinction between the “upper” and “lower” parts. The Tier 3 category disappears.

6.3.1.2 The strengthening of quantitative requirements for capital Starting from the initial proposal, the ratios have been gradually re- evaluated during the transition phase (2013–2019). All in all, banks have been constrained by three risk-weighted ratios, whose thresholds on 1 January 2019 are (Table 6.2): −

−

−

CET1 ratio ≥ 4.5% (+ 2.5% capital conservation buffer, or CCB). The CCB constrains the institution’s dividend policy when the solvency ratio lies within the 4.5%–7.0% range. Tier one ratio (core capital) ≥ 6.0% (+ 2.5% CCB). The threshold has been raised (it was at 4% under Basel II) and the conditions for inclusion in the Tier 1 category have been tightened. Overall capital ratio ≥ 8.0% (+ 2.5% CCB). The level required under Basel II was also 8.0%.

Banks will therefore have to maintain a CET1 ratio of 7% against 2% under Basel II, which, given the stricter definition of capital under Basel III, represents a sevenfold increase in the highest quality capital requirements (Hannoun, 2010).

TABLE 6.2 Comparison between risk-weighted capital requirements in Basel II and III

Common Equity Tier 1 or CET1 Additional Tier 1 or AT1 Tier 1= CET1 +AT1 Tier 1 or T2 (subordinated instruments with initial maturity higher or equal to five years) Own Funds T1+T2 Capital Buffers

Pillar 2 a See Chapter 8.

CRD IV (transposition of Basel III)

CRD I–III (transposition of Basl I-II)

Minimum 4.5%

2%

Maximum 1.5% 6% Maximum 2%

2% 4% 4%

8% Depend on the macroeconomic environment a Bank specific

8% Do not exist in CRD3

Bank specific

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Institutions will also have to meet additional macroprudential requirements (Chapter 8) that add up to the above thresholds: −

−

Countercyclical buffer (+0%–2.5%): This is a capital requirement that increases in the upper part of the cycle to prevent deleveraging during the subsequent downturn in the economy. The level of the buffer is defined by each national supervisory authority. Systemic buffer (+0%–2.5%): This is an additional capital requirement defined individually to take into account the structural components of systemic risk, notably moral hazard related to systemic institutions (Chapter 8).

These measures, which relate to the overall supervision of the banking system, or macroprudential supervision (Chapter 8), are a major novelty in the Basel III prudential framework. Basel II focused on individual supervision of institutions or microprudential supervision.

6.3.1.3 Credit risk The fundamental approach of credit risk is unchanged in Basel III, with respect to Basel II. However, a debate took place highlighting excess variability in risk weights (also called “risk density”) across banks, namely that when comparing banks using A/FIRB approach, “similar” exposures received different weights across banks or jurisdictions. To some authors, this was evidence that some banks using internal models were “manipulating” risk weights. After a review of the literature, recent regulatory changes designed to address the issue of excess volatility of risk weights are presented. There is indeed a rather large post- crisis literature, still ongoing, which is not fully conclusive: −

Some papers conclude to the existence of strategic behaviour by banks when computing risk weights. Mariathasan and Merrouche (2014), analysing a panel of 115 banks from 21 OECD countries that were eventually approved for applying the IRB to their credit portfolio, find that risk-weight density is lower once regulatory approval is granted. Furthermore, the decline in risk-weights appears to be particularly prevalent among weakly capitalized banks. Behn, Haselmann and Vig (2016) use loan-level data from Germany to show that internal models systematically under-predict actual default rates  –  that defaults and losses are higher for loans originated under the model-based approach and carrying low risk weights and that banks had priced those loans in accordance with their higher actual risk. Doeme and Kerbl (2018) find that a large share of risk weight variability can be explained by differences in the underlying risk, but there are statistically significant and economically important differences relating to the country in which

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−

−

the bank is headquartered. This provides evidence that standards are implemented differently from jurisdiction to jurisdiction. Other papers look at granular data sets across several dimensions to understand heterogeneity. Using data published as part of the transparency exercise by the EBA, Turk-Ariss (2017) using granular EBA data documents substantial variations in bank risk weights across asset classes by country of counterparty exposure. He shows that corporate risk weights are sensitive to firm fundamentals but not to market-inferred probabilities of default. Yet, under non-extreme but severe hypothetical scenarios, he concludes that counterfactual capital ratios would not breach Basel III’s minimum regulatory requirements if more harmonized risk weights were applied to the corporate, mortgage, and retail portfolios for the same country of counterparty exposure. EBA (2017) concludes that geography, associated macroeconomic conditions and the portfolio mix effect explain around 61% of Global Charge14 variability observed in the data. The remaining 39% may be due to differences in bank- specific factors, such as risk management practices. In addition, Dietsch et al. (2015) show that the disparities in weighted asset rates are primarily due to the heterogeneity of LGDs. It is also explained by differences between banks in terms of collateral policy and how to take them into account as well as differences in the efficiency of recovery processes in the event of default.

The finalization of Basel III in the December 2017 agreement by Governors and Heads of Supervision of the BCBS was influenced by this debate: − −

−

First, the scope of portfolios for which internal models are accepted has been reduced: the SA approach is the only way possible for equities. Second, the A-IRB approach is no longer allowed for modelling the LGD and Credit Conversion Factor (CCF) of banks, financial institutions, and large corporate portfolios. Third, restrictions are imposed on the admissible value of parameters for PD, LGD, and CCF (“input floors”). Fourth, the lower level of RWAs when implementing A/FIRB is constrained to remain above a certain threshold defined as 72.5% of the SA approach (“output floor”, progressively implemented from 50% in 2022 to 72.5% in 2027).

6.3.1.4 Market and counterparty risk Over the period 2004–2009 leading to the financial crisis, BIS calculations have shown that the 50 largest banks internationally had seen their total assets grow faster than their total weighted risks (Hannoun, 2010). During that period, these banks were also developing their market transactions for which capital requirements in Basel II, which focused more on credit risk, were low.

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BCBS (2019) also stresses that the definition of the regulatory boundary between the banking book and the trading book15 relied solely on the bank’s intent to trade an instrument, and proved to be a key design weakness. It left open the possibility for a bank to move instruments between its trading book and its banking book in pursuit of lower capital requirements, in particular during crisis times. With Basel III, regulators committed to better cover market and counterparty risks. This took place in several steps: Basel 2.5, the introduction of Credit Valuation Adjustment (CVA) credit provisions in Basel III, and the fundamental review of the trading book. First, with Basel 2.5, the capital requirements for market risks increased significantly: institutions had to calculate a “stressed” Value-at-Risk (VaR) and new requirements were added, such as the so- called “incremental” risk charge or IRC, which was supposed to cover the risks of default and migration (or transition) of credit ratings, which was not already covered. Second, Basel III established a minimum capital charge to capture the potential mark-to-market losses faced by a bank as a result from the deterioration in a counterparty’s solvency. Basel III also introduces additional counterparty risk requirements, in particular for the CVA risk provisions: this is the risk of market losses related to the deterioration of a counterparty, particularly in over-thecounter markets.16 Indeed, the Basel II rules did not allow the treatment of losses in market value due to an increase in the PD. These CVA losses accounted for two-thirds of total counterparty credit losses in the 2007–2009 crisis compared to only one-third for counterparty default (Hannoun, 2010). Third, the main changes introduced with the Fundamental Review of the Trading Book are summarized by BCBS (2019): − −

− −

Stricter criteria for the assignment of instruments to the trading book versus banking book. Overhaul of the internal models approach to better address risks that were observed during the crisis, notably liquidity risks (redefinition of more granular liquidity horizons) and tail risk. The VaR indicator is replaced by Expected Shortfall (ES)17 as the main measure of market risk. Strengthening of the supervisory approval processes for the use of internal models: stricter validation process, which takes place at the trading desk level. Introduction of a new, more risk- sensitive standardized approach (i.e. the framework for the non-model-based approach to determining capital requirements).

6.3.2 Leverage ratio Another novelty of Basel III is the comeback of a leverage ratio. Its simplicity (the ratio between an institution’s own funds and its total exposures) had made it, in most countries, the first measure to force banks to have a minimum level of capital. Then, from Basel I (1988), the approach of weighting the risks attached

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to the assets of a bank was imposed. However, the GFC paved the way for the return to a simple measure as a complementary backstop to risk-weighted solvency ratios (6.3.2.1). However the implementation of the leverage ratio has been subject to an evaluation phase of its impact (6.3.2.2).

6.3.2.1 Arguments in favour of the return to a simple measure In comparison with Basel I, Basel II introduced greater sophistication in the weighting framework, notably through the possibility for banks to use their internal risk management models (6.2.2.1). However, this evolution has also introduced new risks: “risks on the risk assessment” to use the expression of Hildebrand (2008). The complexity of the system has exacerbated the information asymmetry that exists between the bank and the supervisor and contributed to the mispricing of risks (Hannoun, 2010). Indeed, in the run-up to the crisis, many banks had strong Tier 1 (risk-weighted) ratios, while at the same time enjoying significant leverage on the balance sheet and off-balance sheet (Hannoun, 2010). The weighted asset approach has not been able to overcome these dynamics. These considerations led the Basel Committee, when revising the prudential framework, to introduce a minimum leverage ratio of 3% as backstop measure. Leverage Ratio = 

Own funds (Tier  1)  ≥ 3% Total exposures (On − and off − balance sheet)

This ratio is defined as the ratio of Tier 1 capital to total on- and off-balance sheet exposures.18 The inclusion of off-balance sheet is an indirect way to take into account banks’ shadow banking exposure (Chapters 2 and 4) and reduce the risk of regulatory arbitrage that would push banks to transfer activities to their off-balance sheet. The leverage ratio complements the risk-based capital requirements. Indeed, insensitive to risk, this indicator has the advantage of limiting the capital savings resulting from risk modelling adopted by banks and to serve as a guarantee against model risk. One of the conclusions of the literature is the optimal nature of the combination of the two ratios, namely capital requirements based on weighted risk and leverage ratio (Blum, 2008); the latter acts as a backstop in the event of a risk assessment error. In addition, it mitigates, by limiting excessive debt, the procyclical effect of leverage, thus mitigating the risk that its reversal has a destabilizing effect on the financial system and the economy. Furthermore, an additional leverage surcharge for GSIBs has been introduced. This surcharge takes the form of a buffer proportional to the corresponding buffer on RWAs with a factor of 50% and a mechanism of automatic restriction of dividend distributions. This surcharge has taken effect as from 1 January 2020.

6.3.2.2 Implementation and impact After a phase of assessment and calibration between 2013 and 2017, in particular regarding the definition of the exposure measure, the leverage ratio migrated

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from Pillar 2 to Pillar 1 on 1 January 2018. The related public disclosure requirements have been in effect since 1 January 2015. The Basel Committee has paid particular attention to the impact on the calculation of the leverage ratio of different accounting standards and practices. Concerns have been raised (Noyer, 2008) about the difficulty of comparing a leverage ratio calculated with US GAAP standards and a European ratio calculated under IFRS (Chapter 4). The GAAP method, which allows derivatives to be netted, tends to reduce total assets compared to the IFRS method that does not apply this offsetting. For example, Rugemintwari et al. (2012) cite a study by Standard & Poor’s (2010), which estimates the total assets of Deutsche Bank at the end of 2009 at 891 billion euros according to the US GAAP method against 1,501 billion with the IFRS method. Regarding the impact of the leverage ratio, several additional dimensions need to be considered that have implications for financial stability: −

−

−

−

−

Interaction with the solvency ratio: The effects of “risk-shifting” (incentive to invest in riskier assets) are more theoretical than verified in the facts or studies on the subject. Acosta et al. (2017) conclude that the leverage ratio, by its insensitivity to risk, can encourage banks to invest in riskier assets, but this phenomenon is largely offset by the positive impact of the strengthening of their capital base on their crisis resilience (reduced likelihood of bankruptcy). According to their analysis, there would be no significant problem of risk-shifting to expect. Impact on the repo market: For the leverage ratio, the netting of repo transactions is limited to cash received and paid according to strict criteria. The leverage ratio repo exposure may be well above the accounting value of exposures or that for the solvency ratio. However, if market participants expected the leverage ratio to be the main constraint of the post- crisis regulation, its negative impact on the repo activity of banks has not yet materialized. Indeed, banks’ repo portfolios have not declined significantly in parallel with the entry into force of the leverage ratio; Risk of window dressing: BCBS (2018) expresses concerns regarding heightened volatility (especially reduction in transaction volumes) in various segments of money markets and derivatives markets around key reference dates (e.g. quarter- end dates). This may have resulted in the reporting and public disclosure of elevated leverage ratios. Such potential regulatory arbitrages may undermine the constraint from the leverage ratio. Interaction with monetary policy: The inclusion of reserves in the denominator of the leverage ratio would hinder the transmission of monetary policy or the use of central bank facilities. Indeed, monetary and prudential policies should use their instruments separately so that each one can pursue its objectives (Chapter 9). The same argument applies to the interaction between the liquidity ratios and monetary policy (6.3.3). Direct impact on financial stability: Controlling the expansion of banks’ balance sheets is an expected beneficial effect of regulation, as the accumulation

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of leverage via repo transactions was a major factor in the 2008 crisis. The leverage ratio can limit, ex ante, shocks related to the abrupt movements of balance sheet reduction that occur in times of financial crisis. The backstop role of solvency requirements also makes it possible to mitigate any weaknesses in internal models.

6.3.3 Liquidity ratios If in terms of solvency, Basel III corrects many of Basel II flaws, then in terms of liquidity requirements, the establishment of quantitative liquidity standards19 is a novelty for most countries. With the introduction of the LCR (6.3.3.1) and NSFR ratios (6.3.3.2), the Basel Committee for Banking Supervision put in place international and harmonized liquidity standards, complementary to capital requirements.20 These ratios have come into effect after an observation phase to assess their impact, which is more fully discussed (6.3.3.3).

6.3.3.1 Liquidity coverage ratio to regulate liquidity at a one-month ­ horizon The purpose of the LCR (6.3.3.1.1) and its computation (6.3.3.1.2) are presented. 6.3.3.1.1 Purpose and definition As a short-term liquidity ratio, the LCR aims to ensure that banks will have sufficient HQLA to meet cash outflows in an acute stress scenario (funding shortfall) that would last for 30 days. This stress scenario is defined by the prudential authorities and replicates to some extent the shocks observed during the 2007 crisis, including a significant deterioration of credit ratings, a run on deposits and a loss of access to wholesale uncollateralized financing (BCBS, 2010d and 2013b). LCR =  

Total outstanding of  HighQuality Liquid asssets ≥ 100% Total net cash outflows over the next  30 days

Banks must be able to maintain a ratio above 100% at all times. 6.3.3.1.2 Numerator and denominator Assets eligible to the numerator are assets that can be immediately and easily converted into liquidity without losing their value during a crisis. Among these assets are those classified as “Level 1”, i.e. considered as “risk free” (cash, central bank reserves, and government securities), and those of lower quality referred to as “Level 2”, where a 15% haircut is applied, with a limit of 40% of the numerator. The denominator reflects the amount an institution would have to fund in a liquidity stress situation. Total net cash outflow is obtained after netting the outflows (e.g. leakage of deposits, drawdown of off-balance sheet lines) by the

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inflows (claims due within a month), whose contractual maturity is less than 30 days. Outstanding amounts that will generate outflows within 30 days are taken into account.

6.3.3.2 Net stable funding ratio to regulate maturity transformation The objective of the NSFR is described as well as its computation. 6.3.3.2.1 Objective and formula The NSFR is a long-term (one-year) ratio designed to induce banks to finance their assets in the medium and long terms. It limits the transformation activity (Chapter 1). The ratio also intends to deter banks from circumventing the LCR by financing their liquid assets with liabilities maturing just beyond 30 days (BCBS, 2010d). Available Stable Funding NSFR = > 100% Required Stable Funding

6.3.3.2.2 Numerator and denominator All on- and off-balance sheet items are taken into account to ensure that, over a one-year horizon, the stable resources (numerator) are at least equal to the stable funding requirements (denominator). Items entered in the numerator (including equity, liabilities over one year or demand deposits) and the denominator (including liquid assets, securities with a residual maturity of less than one year, sovereign and corporate debt or equity) receive weightings that depend on the numerator of their stability and on the denominator of their liquidity.21

6.3.3.3 Implementation and further impact The LCR has been progressively implemented since 2015. The first target level was set at 60% from 2015, then 100% as from 2018, i.e. one year before the full implementation required by Basel III in 2019.22 Later, US authorities promoted further changes with the Crapo law (Economic Growth, Regulatory Relief, and Consumer Protection Act) from May 2018, modifying the Dodd Frank Act (Chapter 8). This law introduced substantial reductions in LCR and NSFR for banks considered as non-active internationally – up to a total exemption for some institutions with assets between $100 and $250 billion. Switzerland also decided in November 2018 to postpone the application of the NSFR in order to preserve the level playing field between international banks. For the NSFR, the final standard was published in October 2014 by the Basel Committee. It came into effect as a Pillar 1 standard as of 1 January 2018. At the

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European level, the NSFR, which is now subject to a simple reporting requirement by banks, is subject to an observation phase. The European Commission submitted a legislative proposal to the European Parliament and the Council on 23 November 2016 to introduce the NSFR as a binding standard at European level. An observation phase is scheduled before the implementation of each of the ratios in order to monitor the effects of its application on the financial markets, lending activity, or economic growth in order to avoid unintended consequences. Beyond the impact of the LCR and NSFR on GDP (6.1), it is also important to assess the impact of liquidity regulation on financial markets. The LCR provides incentives to banks to hold very large amounts of central bank and government securities (see de Bandt and Chahad, 2016), which could potentially lead to a significant concentration (these securities are otherwise exempt from the requirement to diversify the buffer of liquid assets) and limiting direct financing to the economy. More generally, regarding the possibility to use the liquid asset (i.e. Goodhart (2010)’s “last taxi argument”23), the ECB (2012) made several proposals for the implementation of the LCR. In its view, it is essential that, for example, the stock of liquid assets can be used during periods of stress, in the same way as countercyclical cushions for capital requirements, even if this leads the institution to remain temporarily below the required 100% threshold.

6.3.4 Interactions across regulatory requirements Beyond the complexity of the constraints to be met by banks in terms of solvency and liquidity, the finalization of the Basel III package led to rather vivid discussions on the multiplicity and the consistency of the different regulations. The first issue, more relevant from an operational perspective, is how banks can implement these different constraints simultaneously, and whether this will have an effect on their activity. Birn et al. (2017) develop a non-linear optimization model to assess how banks’ balance sheets should have adjusted between 2011 and 2014, absent any external factor other than the new regulations. They find that the increase in capital observed during this period was far larger than that predicted by the model, thus suggesting that banks may have faced pressures from financial markets to recapitalize beyond capital requirements. Another issue is the nature of interactions between the different regulations and whether they cover different risks. This includes interactions between capital and liquidity requirements (BCBS, 2016), but also between risk-weighted capital ratio and leverage. Greenwood et al. (2017) stress in particular the issue of the level playing field, each institution being constrained by a specific ratio, as well as between LCR and NSFR (Cecchetti and Kashyap, 2016). One particular question is whether these instruments are actually complementary or substitutable in order to reduce financial stability, or whether their joint implementation may have unintended effects. No definitive answer to these questions has yet been made.

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6.4 Objectives and constraints of banking supervision The role of banking supervision is to ensure the application of prudential regulation in the banking sector (6.4.1). Banking supervisory authorities have specific modes of action (6.4.2) in order to contribute to financial stability (6.4.3)

6.4.1 Role of banking supervision Banks often form complex entities; moreover, they are subject to a complex set of rules: − − − − − − −

licensing rules, including qualification of the bank’s board members; prudential rules: capital requirements, liquidity, risk diversification; requirements in terms of internal organization and risk management; various requirements (data transmission to the supervisor or publication of data); regulation of financial markets when they participate in them; rules relating to non-banking activities of banking groups (insurance companies, etc.); and consumer protection rules.

Banking supervision is the responsibility of public authorities, sometimes delegated to special independent public agencies. The role of supervision is to identify and address any practices or conditions at a bank that could threaten its immediate health or long-term viability. Supervision ensures compliance with law and regulation, as described above, monitoring for unsafe or unsound practices, and enforcing remediation of such practices or failures to comply with regulation (Eisenbach et al., 2015). As such, supervision is complementary to, but distinct from, regulation. Supervisory authorities generally have administrative powers of information gathering, control, investigation, and sanction. Due to the interpenetration of banking and other financial activities, banking supervision is generally associated with the supervision of other financial sectors (Chapter 8).

6.4.2 Forms of intervention of banking supervision authorities Banking supervision can take different forms: general (overall supervision of an institution) or specialized (on a particular business area), individual or transversal (on several institutions simultaneously, for example, on a type of activity). But the distinction that has the greatest impact on the organization of supervision is based on the difference between off- site supervision and on- site investigations. Off-site supervision relies on the analysis of all the documents that the banks transmit to the supervisor (6.4.2.1). On- site investigations allow inspectors to verify on-the-spot that the operations of the institution comply with the

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regulations. These fact-finding missions usually focus on a specific point of the regulation (6.4.2.2). A further outcome of supervision is the definition of individual requirements (6.4.2.3).

6.4.2.1  Off-site ­ supervision Off-site supervision has evolved considerably in the 20 years preceding the crisis. Changes in the banking landscape, new regulations, and developments in information technology have made this form of supervision more technical and complex than in the past. 6.4.2.1.1 Banking sector developments have impacted supervision practices The concentration movement of the 1990s and 2000s (Chapter 1) reduced the number of medium-sized banking groups. In most developed countries, there are currently two categories of banks: large and diversified groups with significant staff resources to manage their operations and their risks on the one hand, and small institutions specialized in private banking or financing companies in “niche” markets on the other hand. Both types of institutions require the implementation of targeted supervision strategies. In addition, historical or legal specificities may have an influence on the implementation of supervision. In France and Germany, mutual groups maintain a decentralized organization that preserves the autonomy of the local banks. In Spain and Germany, local public banks are closely linked to local governments. Finally, highly internationalized groups such as BNP Paribas, Deutsche Bank, HSBC, Unicredit, or ING can no longer be supervised solely at the national level. For this reason, the EU law has created boards of supervisors whose secretariat is provided by the supervisor of the country of the bank’s headquarters (home) and in which the supervisors of the countries where the subsidiaries are located (hosts) participate. These boards have gained an important role in controlling these institutions. By bringing together the supervisors of all the countries where the group is active, they allow a better circulation of information and exchanges on the risks that the group must face and the control strategies to be promoted. Furthermore, and more decisively within the euro area, as of January 2014, the creation of Single Supervisory Mechanism, associating the staff of the ECB and the National Supervisory Authorities, significantly increased the efficiency of supervision of cross-border groups in Europe (Chapter 10). 6.4.2.1.2 The way prudential supervision operates has profoundly changed The banking sector has long criticized the formalism of the rules of supervision and argued in favour of taking due consideration of the profile and the expertise of each individual institution to define prudential requirements. The argument

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put forward was that more prudent institutions that invested in sophisticated risk-management system would expect in return a lighter supervisory burden. These requests have been taken into account in the Basel II and Basel III agreements, which allow technically best- equipped institutions to develop under the supervision of the supervisory authorities internal risk models for determining the level of requirements (6.2.2.1). One criticism is that only the biggest institutions can afford these models. Above all, banks’ growing involvement in financial markets has exposed them to potentially larger and more sudden liquidity and asset price shocks than in the past. As a result, banking supervision intervenes less and less to establish ex post compliance with regulatory ratios on the basis of backward-looking financial accounts. It puts more emphasis on ex ante risk detection (thematic reviews, comparative analyses, in- depth dialogue with institutional risk managers, stress tests). It intervenes more and more to validate ex ante the management of risks within the institutions and monitor the day-to- day use of internal models. In addition, the judgement of the supervisor has an increasingly important role (e.g. for the validation of internal systems). Supervision integrates both more technical elements (models) and more qualitative elements (reports on internal control). The use of internal models has, however, been subject to two other types of criticism: −

−

The first type of criticism relates to the principles governing the development of these models, in particular the procyclicality of internal models (6.2.2.2). Thus, from the consultations prior to the Basel II agreements, the importance given to VaR has been called into question by some economists. For Danielsson et al. (2001), it introduces an exogenous assessment of the risk and availability of liquidity that is not valid in times of crisis. This type of criticism was taken into account, at least partially, during the revision of the Basel II rules and implemented with Basel III (6.3.1.3). The second type of criticism focuses on the consequences of introducing the adoption of “tailor-made” prudential rules under the monitoring of the supervisor. This approach encourages banks to engage in a systematic process of regulatory arbitrage (Mishkin, 2000, 6.3.1.3). In addition, when validating internal models, supervisors may be encouraged to reduce their requirements so as not to disadvantage groups within their jurisdiction in international competition. This hypothesis is difficult to test empirically. However, it is consistent with the strong heterogeneity of the models and their assessment of RWA as identified by the Basel Committee (2013).

6.4.2.1.3 Information and communication technologies have changed the daily work of supervisors Information technology has changed the way off- site supervision is performed. Most supervisory authorities now receive accounting and prudential information

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from institutions in the form of secure data transmission. This allows for the implementation of automated controls when receiving data. In addition, supervisors have developed risk assessment methodologies and standardized processing of information provided by institutions. As a result, the tendency of the new prudential standards to promote “supervisory judgement” has not diminished the scope and intrusive nature of supervision.

6.4.2.2  On-site ­ inspections On-site inspections are carried out by teams of supervisors who visit the premises of the institution in order to have direct access to documents and information systems, to observe the procedures applied or to conduct interviews with the institution’s staff. It allows supervision to be intrusive enough to deter institutions to take excessive risk. By having direct access to the information necessary for the exercise of its functions, the supervisory authority is freed from the filter exercised by the governing bodies and the internal control of the bank on the information transmitted to supervisors. An on-site inspection also makes it possible to analyse elements that are sometimes difficult to formalize or whose reality is partially beyond the management of the institution (e.g. in terms of organization and procedures). Although bank supervisors still occasionally perform comprehensive missions, especially in smaller institutions, on- site investigations are now more and more often thematic and targeted. They can focus on a single institution or be carried out in a horizontal way in order to allow comparisons. They are then part of an auditing programme and their purpose is identified in advance. This is usually a field of regulation (e.g. the fight against money laundering) or the analysis of the management of certain risks (e.g. market risk). On- site investigations can also be a prerequisite for validating internal risk models (as it allows assessing the governance of risk management, beyond the estimation of a model) or be conducted as a result of an incident or crisis experienced by the institution. In many countries, it is common practice to call for immediate responses by the institution once the mission is completed and before observations are formally transmitted: institutions can provide a written response to the inspection report. The report and the responses of the establishment enrich the documentation that off-site supervisors may use. It is obvious that the capacity of analysis of a small team of on-site supervisors contrasts with the human and technical resources that banking groups can rely on. However, on-site controls are essential to the success of supervision, allowing it to limit information asymmetries. Several empirical studies confirm their importance. According to Barth et  al. (2004), the collection of information is the only area where the strengthening of the action of the regulatory and supervisory authorities has a significant positive impact on the soundness of the banking system. This essential role of information and of its quality is confirmed by Demirgüç-Kunt et al. (2008). Finally, for Peek et al. (1999), the privileged and confidential information from prudential supervision is also of great interest

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to the central bank, to whom it confers an informational advantage over other economic and financial agents. Furthermore, Hirtle et al. (2016), using a confidential database on the numbers of hours spent by US supervisors on individual banks (which is interpreted as a proxy for supervisory attention), demonstrate that supervisors record more hours at the largest banks in a district, even after controlling for size and other characteristics. Relying on a matched sample approach, they also show that these “top” banks are less volatile, hold less risky loan portfolios and engage in more conservative provisioning practices, so that supervision appears to have a distinct role from regulation. In addition, to be truly effective, the organization of on-site missions needs to be optimized. Costly in human resources, it is only fully effective if it extends regular off-site supervision over the most sensitive issues. If it merely duplicates the work of internal documentation or allows only a formal contact between the auditor and the audited firm, it is of little use. The question of the usefulness of on-site missions has given rise to empirical work during the 1980s and 1990s, notably from the reflections of Pettway and Sinkey (1980). As a follow-up to this work, the streamlining of programmes of investigations and methods used in the course of investigations has been initiated and the use of sampling or consistency checking methods has become widespread. In this area, which remains rather largely informal, the strengthening of cooperation between national authorities could help standardize good practices (IMF, 2013).

6.4.2.3 Assessment of Pillar II requirements As a result of supervision, banks may be subject to additional capital requirements, on an individual basis, defined as “Pillar 2” (6.2.2.1.2). These requirements may be supported by the results of stress tests, but also by other information gathered by the supervisor. The first layer of information is the review and validation of the Internal Capital Adequacy Assessment Process (ICAAP) of banks and their Internal Liquidity Adequacy Assessment Process (ILAAP), i.e. banks’ own assessment of their risks. Supervisory stress test results are primarily used by supervisory authorities to challenge them. In the US, capital plan decisions, made in so-called Comprehensive Capital and Analysis Review exercises, have both a quantitative element based on the results of a supervisor-run stress test as well as a qualitative evaluation of the firm’s capital planning processes. Other stress-testing requirements are outlined in the DoddFrank Act, which contains forward-looking quantitative evaluation and are used by the Federal Reserve to assess banks’ capital plans (Federal Reserve Board, 2019). The European Pillar 2 decision-making process, beyond the aforementioned bank’s ICAAP and ILAAP is legally defined by the Supervisory Review and Evaluation Process. It includes two components: (i) the Pillar 2 Requirements (P2R), on the basis of the bank’s individual risk profile not covered by Pillar 1 requirements, as well as (ii) an additional amount of capital (Pillar 2 Guidance), based notably on supervisory stress tests.

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However, making the nature of the risks that can be addressed by P2R more explicit and refocusing P2R on its microprudential nature still remain discussed. Another issue is the possible overlap between P2R which accounts for cyclical variation in risks and its effects on individual institution on the one hand, and the countercyclical capital buffer (Chapter 8) which addresses macroprudential risks on the other hand.

6.4.3 Financial stability depends on effective prudential supervision The application of a complex regulatory framework requires specialized teams of supervisors. When there are many rules, which can be an obstacle to their overall consistency, there can be sources of regulatory arbitrage. In addition, the complexity and opacity of credit institutions makes it difficult for investors to exercise market discipline (Chapter 4). The effectiveness of banking supervision also depends on the prevention of possible forbearance. Banks may be tempted to accommodate customers’ difficulties in order to protect market shares (long-term relationships, which imply softer conditions in adverse situations for the borrower, are ways to reduce competition; see Boot and Thakor, 2010) even if it weakens their solvency. The existence of effective banking supervision makes this tolerance more difficult. However, bankers and supervisors may, in turn, see their interests converge at the expense of financial stability. A supervisor may therefore have an interest in not denouncing certain risky practices or in tolerating a deterioration in the solvency of its domestic banks to avoid being seen as having failed in their mission (“regulatory forbearance”; see also Chapter 10). Such tolerance generally manifests itself in the valuation of outstanding bank assets. By not identifying its bad debts in its accounts, a bank improves its balance sheet and therefore its ability to refinance, especially in times of crisis. A supervisor who wishes to maintain the apparent soundness of the institutions he supervises may be encouraged to turn a blind eye to such practices. The Advisory Scientific Committee of the European Systemic Risk Board (2012) mentions the existence of such practices, both in developed countries (the US in the 1980s during the Savings and Loans crisis and Japan in the 1980s) and in emerging economies (especially in Mexico and Asia in the 1990s). This behaviour poses a threat to financial stability. By concealing the unrealized losses in the accounts, it makes the costs of a crisis more difficult to assess and creates a doubt about the actual solvency situation of all the institutions in a given market. It also tends to increase the time needed to clean up bank balance sheets, as in Japan during the 1990s. These negative consequences of forbearance justify the vigilance of the supervisory authorities and the strengthening of cooperation at the international level, for example, through peer reviews. In the US, early action by supervisory authorities is organized as part of a Prompt Corrective Action implemented since the 1991 Federal Deposit Insurance Improvement Act

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that addressed some of the deficiencies observed in the 1980s. Nieto and Wall (2007) explain the conditions for success of such an initiative, including the need to close banks whose capital falls below a certain threshold.

6.5 The Solvency II directive for insurance in Europe For several decades, insurance law has been the subject of successive harmonizations within the EU. The gradual harmonization took place initially sector by sector. The novelty of Solvency II has been to have a consistent legal text applicable to the entire insurance and reinsurance sector and to adapt it to economic developments (Figure 6.1). This overhaul also created an opportunity to implement ambitious reforms: the Solvency II Directive24 and the technical texts that govern its implementation introduced more detailed prudential rules that are more risk-sensitive than the previous rules (“Solvency I”) (6.5.1); the qualitative requirements and the rules of insurance and reinsurance undertakings were also strengthened (6.5.2). Nevertheless, the implementation of Solvency II will take time, consistent with the long-term nature of insurers’ commitment (6.5.3). Some elements of the possible revision of Solvency II are finally discussed (6.5.4). Improvement in the supervision of Insurance Groups

Implementation for the 3 pillars of consolidated supervision taking into account diversification and risks that are specific to the group Designation of a group supervisor, supported for international groups by a board of supervisors

Pillar I Quantitative requirements

Assessment of assets and liabilities according to market value Definition of new prudential ratios (SCR and MCR) allowing insurance firms to use internal models New rules on investment and eligible own funds

FIGURE 6.1

Pillar II Prudential Surveillance and Qualitative requirements Stengthened governance rules Definition of rights and obligations of supervisory authorities Own Risk and Solvency Assessment (ORSA) freely defined by the insurance firm Assets invested according to the "Prudent Person" Principle"

Pillar III Communication and Market Discipline Public disclosure of the Solvency and Financial Condition Report (SFCR) and the accompanying public Quantitative Reporting Templates (QRTs) Disclosure to the supervisor of data and qualitative information (notably ORSA report)

Structure of reforms implemented with Solvency II

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6.5.1 New quantitative prudential rules A new accounting framework (6.5.1.1) and new requirements (6.5.1.2) have been defined.

6.5.1.1 A new accounting framework to assess the solvency of insurance and reinsurance companies Solvency II has led to a change in the accounting framework. The accounting logic of historical costs is replaced by a new logic of economic valuation of assets and liabilities, with a much stronger component of market value accounting than before (“market consistency”):25 assets must be valued at market value (Chapter 4). As regards liabilities, the assessment of technical provisions can take two forms. If the flows they cover can be replicated using financial instruments that have a reliable and observable market value, the insurer must estimate them at this market price. Otherwise, technical provisions must be calculated by performing a “best estimate” enhanced by a risk margin. The best estimate is the probability-weighted average of future cash flows discounted on the basis of a relevant risk-free interest rate curve. This calculation is based on up-to-date and credible information and realistic assumptions. However, given the long-term nature of insurers’ products, the pricing of liabilities is in practice performed by generating a large number of stochastic scenarios using financial models called “economic scenario generators” that include many assumptions (Gourieroux and Monfort, 2015). Own funds are divided into basic and ancillary own funds (AOFs).26 Only the basic funds, consisting of excess of assets over liabilities and certain subordinated debt, are eligible for unlimited compliance with capital requirements. Solvency II therefore introduces a classification of capital according to eligibility criteria, similar to the Basel regulation for banks (Basel III).

6.5.1.2 New prudential requirements In order to guarantee insurance commitments, insurers must meet two levels of capital requirements. The Solvency Capital Requirement (SCR) is the target capital requirement. It must be covered at least by half with basic own funds. The minimum capital requirement (MCR) cover is a necessary condition for keeping the insurance licence. The MCR can be covered with basic own funds and AOFs approved by the supervisor. The SCR is the estimate of the highest level of recordable loss in a year with a probability of 1/200. It is therefore a 99.5% VaR at a one-year horizon. It is calculated for each risk category or “module” (market, counterparty, life, non-life, etc.). The different SCRs calculated for each risk category are aggregated taking into account the variance- covariance structure between the different risks. With prior approval of the supervisory authority, companies may decide to use a total or partial internal model to estimate the SCR.

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The MCR is calculated using a simpler formula, based on premiums collected and technical provisions. It cannot be less than 25% or more than 45% of the SCR.

6.5.2 Qualitative requirements have been strengthened Pillar II of Solvency II has considerably strengthened requirements in terms of governance and internal control. In particular, it imposes a clear identification of decision-making processes, with a goal to ensure transparency and efficiency. Solvency I required insurance organizations to allocate their investments in such a way as to respect relative quantitative limits. Solvency II substitutes a governance criterion for these rules. The investment management strategy must respect the “prudent person principle”, which means that the organization must ensure the safety, quality, liquidity, profitability and availability of assets. On a regular basis (at least annually) as well as before any major strategic decision, the insurance organization will have to launch an Own Risk and Solvency Assessment (ORSA). On this occasion, the organization must put into perspective its risk profile, its level of solvency and the allocation of its capital. Pillar III of Solvency II creates new requirements in terms of publication or transmission to the supervisor of numerous quantitative data as well as reports. Organizations routinely report to the supervisory authority and provide the public with a Solvency and Financial Condition Report for the organization. The ORSA approach also results in a report to the supervisor. The data to be transmitted to the controller are harmonized at the European level. Overall, the transparency of the insurance organizations vis-à-vis policyholders and the public is increased.

6.5.3 Implementation and preliminary assessment of impact The implementation of Solvency II is presented (6.5.3.1), before discussing its impact (6.5.3.2).

6.5.3.1 Implementation of solvency II regulation The Solvency II Directive is a technical regulation for the financial sector. As such, it forms part of the so- called “Lamfalussy” process, a procedure which allows the adoption of highly technical EU regulations, whereby only a framework directive, laying down the general principles, is debated by the European Parliament and the Council under the ordinary legislative procedure (Level 1). The technical implementing rules are then adopted by the Commission in the delegated legislation procedure (Level 2). The European Insurance and Occupational Pensions Authority (EIOPA; Chapter 10) informs the work of the Commission by acting as a technical committee and involving the national supervisory authorities. The implementation of the Directive is itself harmonized (Level 3).

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Depending on the nature of the subject and the Level 1 and 2 texts, this harmonization may be binding, or based on the “comply or explain” principle or even be limited to the promotion of good practices. Finally, the Commission and EIOPA are responsible for monitoring the proper application of the Directive and Level 2 and 3 texts (level 4). The Solvency directive (Level 1) was adopted in 2009. However, the financial crisis has called into question certain elements of the directive, notably the role of market value in Solvency II. In addition, the text of the directive did not take into account the overhaul of the European financial regulatory institutions that took place at the end of 2010 (Chapter 8). As a result, a new draft Level 1 text was launched. The so- called “Omnibus II” directive27amended Solvency II by introducing the so- called “long term guarantee package” (see below). This new discussion of a Level 1 text delayed the adoption of Level 2 and Level 3 application texts. The Solvency II Directive was therefore revised even before it had been implemented. It was finally scheduled for 1 January 2016, with some elements nevertheless applied as early as 2015.

6.5.3.2 Preliminary assessment of the impact of Solvency II regulation Regarding the impact of Solvency II, one can note several positive aspects, notably the risk-sensitive nature of the new framework. However, there are areas where supervisors should be more vigilant in terms of risks to financial stability: the volatility of prudential balance sheets, the unlevelled playing field across countries following the Long-Term Guarantee package and the assessment of the “best estimate” of technical provisions. 6.5.3.2.1 The volatility of prudential balance sheets The application of the fair value principle to both assets and liabilities implies that the insurer’s prudential balance sheet is influenced by the economic fluctuations of its investments. Compared with the use of historical value, the use of fair value is a breakthrough, especially in terms of comparability, transparency, risk sensitivity, and reflection of the actual economic situation of the company, but the dependence established between financial market information and the solvency ratio makes the latter more volatile. This volatility, often mentioned, can be a source of procyclical behaviour of insurers. In the event of a turnaround in the financial markets (e.g. a stock market crash or a significant increase in the spreads of nonfinancial corporate bonds), an insurance organization may wish to dispose its depreciated assets, in order to limit the drop in solvency ratios, weighing down on prices (see Rae et al., 2018, for a similar view). This could in particular be the case if it respects the solvency requirements only by a small margin and/or if it has a short-term investment strategy.

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6.5.3.2.2 Differences across countries with the long-term guarantee package When finalizing the Solvency II regime, the so- called “long-term guarantee package” measures were introduced under the Omnibus Directive, in order to limit the volatility of balance sheets and thus avoid the potential procyclical behaviour of insurance organizations. Most of these measures mitigate the volatility of insurers’ balance sheets by applying adjustments to the discount rate curve.28 EIOPA (2017) reports the use of these measures by 30% of European insurers in terms of technical provisions. The transitional provision on technical provisions – which smooths the transition from technical provisions in S1 standards to technical provisions in S2 for over 16 years – is quite widespread. The impact of the measures on solvency ratios is significant, allowing insurers in a few countries (UK, Portugal) to post a level of solvency compliant with the regulations. The use of long-term guarantee measures is, however, subject to a double discretion: on the one hand, the insurance company may choose not to use these measures; on the other hand, some of these measures require an agreement by the supervisor. As a result, the interpretation of solvency ratios and cross-country comparisons can only be done with caution. In this respect, the importance of the transparency of the new prudential regime, in particular with regard to the use of a long-term guarantee package, should be stressed: for example, if an insurance institution uses one or more of these measures, it must report annually the impact of these measures on the coverage ratio in its public report on solvency and financial position. In this context, the information available will make it possible to ensure better comparability between insurance companies, irrespective of the use of the measures in the long-run package, although a period of adaptation of investors to the new communicated information was granted to companies.29 6.5.3.2.3 The assessment of the “best estimates” of technical provisions One of the characteristics resulting from the economic assessment of the balance sheet is that Solvency 2 prudential capital is estimated on the basis of the difference between the total value of the assets and the total value of the liabilities – in the first place, the technical provisions. This makes the SCR coverage ratio very volatile, given the importance of leverage.30 The calculation of the Best Estimate, i.e. the insurer’s best estimate of cash flows to policyholders, is generally based on numerous actuarial assumptions. Among these assumptions, there are technical elements related to insurance contracts (e.g. mortality assumptions), elements representing the management of the organization (cost modelling, modelling of future management actions), but also modelling choices (e.g. the determination of the projection horizon of the contracts). The choices underlying Best Estimate modelling are all the more difficult to determine when it comes to modelling future management actions of the organization. These elements include the modelling of the behaviour of the insurance

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firm in the revaluation of life insurance contracts, a key assumption because it determines the share of future profits that will be attributed to policyholders. This modelling requires determining, which will be the choice of managers based on the economic conditions modelled (including the level of the risk-free rate) and expectations of customers. Once this management action is modelled, it is necessary to assess what will be the behaviour of the customers following the revaluation of their contracts, and in particular what will be the proportion of policyholders who buy their life insurance policy if the revaluation is not in accordance with their expectations. Indeed, Borel-Mathurin et al. (2017) show that the results of stress tests are indeed dependent on these hypotheses. The SCR is defined as the difference between, on the one hand, the basic (gross) SCR – directly related to the risk assessment, thus to the extreme quantiles (6.5.1.2) – and on the other hand, the loss absorbing capacities (LAC), including in particular management actions which enable insurers to preserve profitability. As an illustration, in the life insurance sector, depending both on market conditions (interest rates, stock prices, etc.) and on the level of the minimum guarantees granted to the insured, the undertaking running the best- estimate simulation might gain or lose some degree of freedom with respect to the volume of discretionary bonuses they may wish to pay to customers. Using data from the 2014 EIOPA stress test data, the authors show that the downward revision of the LAC actually contributed the most to the upward revision of the SCR. Moreover, Borel-Mathurin et al. (2017) provide a model to assess the ex post revision of the SCR in case of a shock. In particular, how would a new record loss (e.g. a natural disaster that occurs unexpectedly) modify the tail quantiles and the tail probability distribution? In many cases, an adverse shock leads to a reduction of the corresponding portfolio, hence a reduction of the SCR (and possibly a counterfactual increase in the SCR coverage ratio K/SCR). A conservative assumption during supervisory stress tests exercises is therefore to ask insurance firms to aim preventively at a higher SCR amount. Indeed, regarding how a new recorded loss would modify the tail quantiles and the tail probability distribution, the authors show using Extreme Value Theory that the value of SCR should indeed increase (and the SCR coverage ratio decrease).

6.5.4 The review of Solvency II After a few years of application, the Solvency II package is likely to be reviewed by the regulator in order to correct a few flaws, but no major overhaul is expected. Several issues are likely to be discussed: –

First, the risk-weight charge of equity investments by life insurance in the initial Solvency II regulation (49% for non- quoted shares, 39% for quoted shares) may be changed in order to provide more incentives to insurers to invest in these assets, although the actual weight on shares is already lower

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− −

than the facial regulatory weight, as the definition of the SRC includes a covariance component (6.5.1.2). Second, the Standard formula is also expected to be recalibrated. Third, on the measures of the long-term guarantee package, EIOPA will have to provide annually a public report presenting the impacts of the measures, their effects on the market and the behaviour of insurers as well as the perception of these measures. The report will include possible amendment proposals to the Commission. The idea would be to ensure that all contractual commitments and legal obligations of insurers are recorded in their liabilities according to their actual economic cost.

Notes 1 The role of the Basel Committee is described in Chapter 9. 2 See notably Birn et al. (2020) 3 According to Goodhart’s (2011) now popular expression, the behaviour of banks’ shareholders is affected in the right direction, as they have « skin in the game ». 4 For an opposing view, see Gambacorta and Shin (2018), who find that a 1% point increase in the equity-total assets ratio is associated with a 4 basis point reduction in the cost of debt financing and with a 0.6% point increase in annual loan growth. 5 Rapid credit growth (high credit/GDP) is invariably a highly significant, positive predictor of crisis in top- down models. That is notable, if not surprising, because slower credit growth is considered a cost or drag from higher capital requirements, i.e. credit growth enters both sides of the costs and benefit calculation. 6 Both stages use data from OECD countries from 1960 to 2008. 7 See also Boissay et al. (2019) for an update of the literature review. 8 Own funds are designed to protect the lending institution from the extra risk beyond expected risk, while expected risk is already covered by provisions (PD × LGD). 9 Such a discussion also appears regarding accounting norms, notably with the introduction of IFRS9; see Abad and Suarez (2018) and Chapter 4. 10 “Capital requirements for credit risk on exposures to SMEs shall be multiplied by the factor 0,7619.” European Capital Requirement Regulation, CRR), Article 501, January 2014. 11 Basel Committee on Banking Supervision High-level summary of Basel III reforms December 2017 https://www.bis.org/bcbs/publ/d424_hlsummary.pdf 12 CRDV (Regulation (EU) 2019/876) and CRR2 (Directive (EU) 2019/878) were published on 7 June 2019 in the Official Journal of the EU. 13 The purpose of the deductions is to consider that some elements of own funds may not be available when needed. In particular, cross-holdings in other financial institutions could lead to double counting of own funds. A more favourable treatment of insurance participations by bancassurance groups is introduced in CRD4. It is justified by the good resilience of these groups during the GFC. 14 The global charge (GC) measures the sum of expected loss (EL) and unexpected loss (UL) for IRB exposures. 15 The banking book records most transactions in the medium and long terms and gives rise to a capital requirement for credit risk; the trading book includes all positions in financial instruments and commodities held for short-term trading purposes or for the purpose of hedging other trading book items and resulting in a capital requirement under market risks. Most of the derivatives are included in the trading book (forward financial contracts, interest rate or currency exchange contracts, options on securities, etc.). 16 The CVA is an element of fair value recognition of losses on derivative contracts. It is a provision for future losses on an OTC derivative in the event of counterparty default, since this loss will have a negative effect on the result. Capital requirements

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17 18

19 20 21 22

23

24 25 26 27 28

29

are required since Basel 2.5. In practice, the CVA is calculated as the discounted cash flow difference of a derivative, with or without default. When a party makes a positive profit on a derivative, such as an interest rate swap, this gain must be provisioned to hedge against the risk of default by the counterparty. The capital requirement takes into account the volatility of the CVA: the risk will be greater if the spreads on the counterparties are volatile. While the VaR measures the minimum amount of loss on a portfolio at a q% level, say 10%, ES is the expected loss in the worst 10% of cases. It is more sensitive to the shape of the tail of the loss distribution. Off-balance sheet exposures are calculated at notional value using a uniform credit conversion factor of 100%. However, revocable loan commitments that can be cancelled by the bank, at any time and without notice, benefit from a conversion factor of 10% instead of 100%. Exposures associated with repo transactions (SFT) and derivative exposures are also included. The Basel Committee published the “Principles of Sound Liquidity Risk Management and Monitoring” (BCBS, 2008). These ratios are computed at the highest level of consolidation, but also at the individual level. In the denominator, on- and off-balance sheet items are weighted as a decreasing function of liquidity (the more easily tradable without haircut, the lower the weight). In Europe, on the basis of two reports from the EBA, the Commission adopted a Delegated Regulation in October 2014. This Regulation, applicable to credit institutions, introduced the LCR into the EU, adapting the Basel system to the specificities of the European economy. A corrigendum from the European Commission (DG FISMA) supplementing the current delegated act was published in the Official Journal of the EU on 30 October 2018, for a planned date of implementation on 30 April 2020. It presents a series of adjustments to overcome the shortcomings of the previous version, and reflect more recent developments in the regulatory framework. Ch. Goodhart (2010) stressed that the temporary use of the buffer is akin to allowing the last taxi available at the taxi stand to take travellers, even if some local regulation may force taxi drivers to remain at all times at the taxi stand in order to be available in case of emergency. Directive 2009/138/CE of the European Parliament and the Council on 25 November 2009 on access to insurance and reinsurance activities. Market value accounting was also one major feature of the Swiss Solvency regime (SST) introduced 10 years before Solvency II. AOFs are a new form of capital introduced by Solvency II; they are an unfunded form of capital that comes on top of available equity, hybrid debt and Tax Deferred assets. Prior agreement by the supervisor is required. DIRECTIVE 2014/51/UE of the EU Parliament and Council on 16 April 2014 modifying directives 2003/71/CE and 2009/138/CE and regulations (CE) no. 1060/2009. The main components of the long-term package are the extrapolations of the forward interest rate structure (i.e. the long-term component of the yield curve of the risk-free rate used to discount insurers’ long-term commitments). A set of four provisions (the forward rate, the volatility correction, the equalizing adjustment and the extension of the recovery period) and two transitional measures (technical provisions and interest rates) were added with a duration of 16 years to soften the impact of the entry into force of the new regime. Above all, the level of interest rates at 30 years or more was arbitrarily set at 4%, a level much above market values and thus not in line with markto-market principles (6.5.1.1), helping insurance companies to underestimate their very long-term liabilities. Plantin and Rochet (2008) point out that, due to the lower weight of financial debts (as opposed to technical provisions which also appear as liabilities) in insurance companies than in banks, the supervisor of insurance companies substitutes its technical expertise to that, generally insufficient, of policyholders and financial markets to

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discipline the shareholders. Transparency is therefore essential so that interested parties can better understand the financial situation of insurance companies. 30 For the numerator of the SCR coverage ratio  K / SCR, as Assets = K + BE (BE is the best estimate of technical provisions), the uncertainty on BE is compounded. Indeed, if the uncertainty around BE is x% (say 5%), the uncertainty over own funds (K) is  BE   BE   = 9), hence for the SCR ratio. x%. % (or 45% for  K  K 

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Basel Committee on Banking Supervision (2016), “Literature Review on Integration of Regulatory Capital and Liquidity Instruments”, Bank for International Settlements, BCBS Working Paper, 30, March 2016. Basel Committee on Banking Supervision (2018), “Statement on Leverage Ratio Window- dressing Behavior”, 18 October 2018, https://www.bis.org/publ/bcbs_ nl20.htm. Basel Committee on Banking Supervision (2019) “Explanatory Non the Minimum Capital Requirements for Market Risk”, January 2019. Behn M., Haselmann R., Vig V. (2016), “The Limits of Model-Based Regulation”, Working Paper Series, 1928, European Central Bank. Besanko D., Kanatas G. (1996), “The Regulation of Bank Capital: Do Capital Standards Promote Bank Safety?”, Journal of Financial Intermediation, 5, 160–183. Birn M., de Bandt O., Firestone S., Girault Gutiérrez M., Hancock D., Krogh T., Mio H., Morgan D., Palvia J., Scalone V., Straughan M., Uluc A., von Hafften A.H., Warusawitharana M. (2020), “The Costs and Benefits of Bank Capital – A Review of the Literature”, Journal of Risk and Financial Management, 13(4), https://www.mdpi. com/1911-8074/13/4/74 also available as Bank for International Settlements, BCBS Working Paper n° 34, 2019. Birn M., Dietsch M., Durant D. (2017), “How to Reach all Basel Requirements at the Same Time?”, Banque de France-ACPR, Débats Economiques et Financiers, n° 28. Blum J.M. (2008), “Why ‘Basel II’ may need a Leverage Ratio Restriction”, Journal of Banking and Finance, 32(8), 1699–1707. Boissay F., Cantu C., Claessens S., Villegas A. (2019), “Impact of Financial Regulations: Insights from an Online Repository of Studies”, BIS Quarterly Review, March 2019, 53–68. Boissay F., Collard F. (2016), “Macroeconomics of Bank Capital and Liquidity Regulations”, BIS Working Paper, 596, December. Bonner C. (2015), “Preferential Regulatory Treatment and Banks’ Demand for Government Bonds”, CentER Discussion Paper no 2015–056, Tilburg University. Boot A.W.A., Thakor A.V. (2010), “Can Relationship Banking Survive Competition?”, Journal of Finance, 55 (2), 679–713. Borel-Mathurin F., Loisel S., Segers J. (2017), “Reevaluation of the Capital Charge in Insurance After a Large Shock: Empirical and Theoretical Views”, Autorité de Contrôle Prudential et de Résolution, Débats Economiques et Financiers, n°32, December 2017. Calomiris C., Heider F., Hoerova M. (2011), “A Theory of Bank Liquidity Requirements”, Twelfth Jacques Polak Annual Research Conference, International Monetary Fund, Washington, DC, 10–11 novembre 2011, http://www.imf.org/external/np/ res/seminars/2011/arc/pdf/hss.pdf. Caruana J., Narain A. (2008), “Capital Requirements”, Finance and Development, June, 24–28. Cecchetti S. (2014), “The Jury is in”, CEPR Policy Insight n° 76. Cecchetti S., Kashyap A.K. (2016), “What Binds? Interactions between Bank Capital and Liquidity Regulations”, Mimeo, Revised November 2016. Clerc L., Derviz A., Mendicino C., Moyen S., Nikolov K., Stracca L., Suarez J., Vardoulakis A.P. (2015), “Capital Regulation in a Macroeconomic Model with Three Layers of Default”, International Journal of Central Banking, 11(3), 9–63. Cochrane J. (2017), Capital Cause and Effect. Blog. April, johnhcochrane.blogspot. com/2017/04/capital-cause-and-effect.html. ‌ ‌ ­ ­ ­ Cornet M.M., McNutt J.J., Strahan P.E., Tehranian H. (2011), “Liquidity Risk Management and Credit Supply in the Financial Crisis”, Journal of Financial Economics, 101(2), 297–312.

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European Central Bank (2010), “Basel III”, Financial Stability Review, December, 125–132. European Central Bank (2012), “Liquidity Regulation as a Prudential Tool: A Research Perspective”, Financial Stability Review, June, 116–124. European Systemic Risk Board (2012), “Forbearance, Resolution and Deposit Insurance”, Advisory Scientific Committee, Report n°1, July 2012, http://www.esrb.europa.eu/pub/ pdf/asc/Reports_ASC_1207.pdf?12e472cf6fdd5fa028752f98aac26b33. Federal Reserve Bank of Minneapolis (2017), “The Minneapolis Plan to End Too-Big­ To-Fail”, December. Federal Reserve Board (2019) “Comprehensive Capital Analysis and Review and Dodd Frank Act Stress Tests: Questions and Answers”, March 2019, https://www. federalreserve.gov/publications/files/CCAR-QAs.pdf. ­ Financial Stability Forum (2009), “Report of the Financial Stability Forum on Addressing Procyclicality in the Financial System”, http://www.financialstabilityboard.org/publications/ ­ r_0904a.pdf. Firestone S., Lorenc A., Ranish B. (2017), “An Empirical Economic Assessment of the Costs and Benefits of Bank Capital in the US”. Federal Reserve Board, Finance and Economics Discussion Series Working Paper, 2017–34. March, doi.org/10.17016/FEDS.2017.034. Freixas X., Rochet J.-C. (2008), Microeconomics of Banking, 2nd edition: Cambridge, MA: MIT Press. Furceri D., Mourougane A. (2012), “The Effect of Financial Crises on Potential Output from OECD Countries”. Journal of Macroeconomics, 34(3), 822–832. Gambacorta L., Shin H.S. (2018): “Why Bank Capital Matters for Monetary Policy”, Journal of Financial Intermediation, 5, part B, 17–29. Goodhart C.A.E. (2010) “How Should We Regulate the Financial Sector?”, in A. Turner et al. (eds.), The Future of Finance and the Theory That Underpins It, The LSE Report, London: London School of Economics and Political Science, 165–185. https://harr123et. files.wordpress.com/2010/07/futureoffinance-chapter51.pdf. ­ Goodhart C.A.E. (2011), “The Ratio Controls need Reconsideration”, Mimeo, Financial Markets Group, London School of Economics. Gordy M. B., Heitfield E.A. (2010), “Risk-based Regulatory Capital and Basel II”, in A. Berger, P. Molyneux and J.O.S. Wilson (eds.), The Oxford Handbook of Banking, Oxford, UK: Oxford University Press, 357–376. Gourieroux C., Monfort A. (2015), “Economic Scenario Generators and Incomplete Markets”, Mimeo, CREST. Greenwood R., Hanson S.G, Stein J.C., Sunderam A. (2017), “Strengthening and Streamlining Bank Capital Regulation”, BPEA Conference Drafts, September 7–8, 2017. Haldane A.G. (2012), “The Dog and the Frisbee”, Speech Delivered at Federal Reserve Bank of Kansas City, 36th Economic Policy Symposium, The Changing Policy Landscape, Jackson Hole, Wyoming, 31 August 2012. Hannoun H. (2010), “The Basel II Capital Framework: A Decisive Breakthrough”, BoJBIS High Level Seminar on Financial Regulatory Reform: Implications for Asia and the Pacific, https://www.bis.org/speeches/sp101125a.pdf. Hellmann T., Murdock K., Stiglitz J. (2000), “Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirement Enough?”, American Economic Review, 90, 147–165. Hildebrand P. (2008), “Is Basel II Enough? The Benefits of a Leverage Ratio”, Financial Markets Group Lecture London School of Economics, http://www.bis.org/review/ r081216d.pdf.

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7 CRISIS MANAGEMENT AND RESOLUTION OF FINANCIAL INSTITUTIONS

Beyond the supervision of financial institutions in “ordinary” or “normal” times, the continuity of the provision of financial services in crisis times should also be ensured. To avoid contagion to other financial institutions or the wider economy, when some banks are likely to fail, decisions need to be made regarding the preservation of banks’ critical functions for the continuing provision of financial services, and the possible unwinding of the failing financial institutions. In this perspective, the episode of Lehman Brothers’ bankruptcy in 2008, as well as public interventions in 2007–2008, has highlighted the need to better manage the situation of banks, the failure of which may have a systemic impact. This was the motivation for reforming resolution regimes. There are several arguments in favour of setting up mechanisms to restructure troubled financial institutions. Their complexity, both economic and legal, makes it difficult to carry out an orderly rescue or a rapid liquidation. Financial institutions establish a wide range of links in the functioning of financial markets or partnerships. They have deposits with each other, they exchange, lend or repo securities, provide their counterparties with collateral, enter into more or less long-term contracts that may, under certain conditions, give rise to margin calls, etc. The strategic behaviour of stakeholders seeking to extract the highest possible level of rent at the expense of taxpayers also increases the cost of bankruptcy. The accounting of successive loans of securities or futures contracts with specific conditions is often imprecise. The balance sheets of credit institutions, investment funds, and large insurance companies are therefore particularly opaque. In addition, the reciprocal commitments between these companies and their subsidiaries are often cross-borders. They are governed by different accounting and financial law systems. If an institution encounters difficulties, the law of the country whose authorities supervise the restructuring of the institution in trouble is not necessarily the law applicable to the institution’s possessions or debts, making it more difficult to recover or resolve them.

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Bailing out banks when their failure could trigger a crisis is not a satisfactory solution. Indeed, the existence of explicit or implicit safety nets for financial institutions in difficulty creates moral hazard (Chapter 1). This situation can be analysed as the provision of insurance to financial institutions, the cost of which is assumed by default by other stakeholders, notably taxpayers. The existence of such insurance is likely to encourage banks to take undue risks. To avoid moral hazard, there are two simple solutions: give up a priori any rescue of a financial institution, which constitutes a non- credible announcement (Chapter 1), or create a constructive ambiguity. In the latter case, the public authorities suggest that they will not necessarily help an institution in difficulty. These two positions were strongly criticized in the late 1990s (Mishkin, 1998). Indeed, if the failure of an institution has a greater cost for the financial system and the economy as a whole than its rescue, it is unlikely that public authorities will not intervene (too big to fail; Chapter 1). The GFC severely weakened the argument of constructive ambiguity, at least for systemic institutions (Breton et al., 2012). The US authorities have indeed tried to apply this principle by not supporting Lehman Brothers. However, the bankruptcy of the latter institution was immediately followed by the public bailout of several major banks or insurance companies in both the US and other developed economies. Since moral hazard seems impossible to remove, public policies must seek to limit it. Moral hazard can be reduced through two channels: either by making it unlikely to materialize or by limiting its magnitude. In the first case, the objective is to reduce the likelihood that an institution will experience difficulties and that these difficulties will make support necessary. In the second case, the cost of safety nets and bailout measures must be borne by the financial institutions themselves, notably through “bail-in” (i.e. by the banks’ creditors not covered by deposit insurance). However, there are naturally trade-offs implied (Dell’Ariccia et al., 2018). A top priority for regulators after the GFC was to offer better alternatives to bail outs, i.e. the use of taxpayers’ money. These alternatives suppose first an increased crisis preparedness of institutions and regulators, through resolution planning and adapted financial contracts. They are supported by schemes which ensure that the banking system supports the costs of bank failures. They rely on tools enhancing the chances of success of the recovery of financial institutions or of the resolution of a banking crisis.1 In the words of the Squam Lake Report (French et al., 2010), the objective of this legal evolution is to achieve the “restructuring rather than [the] bailing out an institution in difficulty”. It is also to reduce uncertainties and enable faster and more effective action to save or dismantle an institution in trouble. Although the US had some experience with the resolution of small banks (Bolton et al., 2019),2 these procedures were not available to resolve large and complex failing financial institutions before the GFC. In Europe, there was a general lack of well- defined resolution procedures for financial institutions combined with much broader intervention of finance ministries. Bailouts followed by ad hoc restructuration measures were the seemingly easy and natural response to the failure of a large bank.

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In contrast, the last ten years have witnessed major legal changes inspired by the Financial Stability Board (FSB; Chapter 10) key attributes (Table 7.1). In the US, the Dodd Frank Act (DFA) of 2011 (Chapter 8) granted new powers to the Federal Deposit Insurance Corporation (FDIC) with the creation of the Orderly Liquidation Authority (OLA). In Europe, the Bank Recovery and Resolution Directive (BRRD) of April 2014 was followed in the euro area by the Single Resolution Mechanism (SRM) Regulation of July 2014. Then, following the agreement on Total Loss Absorbing Capacity (TLAC) by the G20 in November 2015, the European Minimum Requirement of Eligible Liquidity (MREL) was adapted through CRR2 and CRD5, while additional requirements for GSIBs were included in BRRD2 of May 2019. It is however important to highlight the differences between the US and the EU approach (Philippon and Salord, 2017).3 In the US case, bail-in triggers conversion of contractually bail-in-able debt in order to cover losses and resolution only deals with the liquidation of banks, so that banking subsidiaries of the failing bank can be easily traded. In the EU case, the resolution authority plays a major role for bail-in with a cascade of debt conversion step-by-step with the objective of recapitalizing the bank and not necessarily to close it down. After a description of the tools that can structure financial contracts in a way that enhances the resilience of banks to crisis (7.1), the use of bail-in instruments is discussed (7.2), as well as the new roles granted to resolution authorities (7.3), and the efforts to strengthen banks’ liabilities by increasing their loss-absorbing capacity (7.4).

7.1 Definition of financial contracts Some common financial practices can reduce the risk of destabilization of financial institutions and therefore the likelihood that they will need assistance in crisis times. Regulatory authorities may promote such practices or make them mandatory to institutions. Most of the proposals aim to make it possible for various stakeholders to offset part of the losses and to announce it ex ante. They are then encouraged to exercise more control over institutions (Calomiris and Kahn, 1991). Houston et  al. (2010), based on a sample of 2,400 banks in 69 developed and emerging countries, show that banks are more likely to take risks when the level of creditor protection, including deposit insurance (Chapter 5), particularly in the event of bankruptcy, is high, as stakeholders have less incentive to supervise banks. However, compared to non-financial companies, the risk of contagion, particularly in the financial sector, may lead to consider that certain types of creditors could benefit from a higher degree of protection (in particular depositors and short-term interbank creditors) in order to avoid a run. The speed and credibility of the public intervention process are also important dimensions. In the event of difficulties in a financial institution, it is important to define mechanisms that penalize managers and stakeholders while ensuring business continuity, including short-term financing of the economy (Dewatripont and Freixas, 2012).

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In addition, the literature attempts to take into account the ambiguity of the debt contract. On the one hand, it is a way for shareholders to discipline managers, since it reduces the cash available for unproductive investments (the “free cash flow”; Jensen, 1986) or it is a means of tax optimization, since interest charges are deductible from taxable income (Chapter 9): a high level of debt seems desirable. On the other hand, the debt burden puts pressure on cash management and, in the event of difficulties, it may be desirable to transform claims into contingent securities, in particular in the form of shares, and therefore to reduce debt. Hybrid securities are debt securities which, under certain predefined conditions, can be converted into equity securities. The use of these securities is intended to facilitate the recapitalization of financial institutions in difficulty without recourse to the public authorities (French et al., 2010) or to a buyer. After discussing the different instruments for bailout (7.1.1), several tools that may be triggered by institutions are reviewed: voluntary exchange (7.1.2) and contingent capital (7.1.3)

7.1.1 Bailout Different tools are available for bailout. At the height of the banking crisis in 2008, governments generally intervened by entering into bank capital (as in the US and the UK), subscribing to supersubordinated securities (as in France) or guaranteeing certain assets, or even outright nationalization of banks at least temporarily, as in the UK with Northern Rock and Royal Bank of Scotland and the US for Fannie Mae and Freddie Mac as well as the partial takeover of AIG (see Richardson, 2009, for the pros and cons of banks’ nationalization). When a sectoral plan was proposed, they sought not only to ensure that the banks most in difficulty subscribed to it, but also to limit the stigma for the institutions participating in it. However, this approach has several disadvantages: creating moral hazard on the part of likely-to-be-rescued banks; possibly creating a misallocation of capital in the economy; making the strongest banks indirectly pay for the weakest; and creating suspicion over a larger part of the banking sector. In addition, the example of the US capital injection programme into US banks adopted in 2008, the Troubled Asset Relief Program (TARP), shows that the conditions under which aid was provided, with limits on the remuneration of bank managers (Chapter 4), led the strongest institutions to reject the offer or to repay the aid provided as quickly as possible, which could have involved risk-taking (Bayazitova and Shivdasani, 2012). Moreover, it is not possible to show that the banks that had been rescued were becoming more prudent and reduced their risk-taking in new loans to a greater extent than those that were not assisted (Brei and Gadanecz, 2012). All in all, the sums required to urgently bailout a financial institution can be considerable (USD 29 billion for Bear Stearns and GBP 25.5 billion for the Royal Bank of Scotland in 2008, according to Liikanen et al., 2012). With regard to the European crises, Philippon and Salord (2017) measured that taxpayers financed two-thirds of

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recapitalizations. At the same time, while the US intervened in the early stages of the crisis, the final cost of TARP was less than expected for US taxpayers.4

7.1.2 Voluntary exchange The long-term liabilities of financial institutions are composed of capital and debt. In times of crisis, a large- scale capital increase is generally too costly to carry out, hence the importance of making it possible to convert debt securities into shares. However, some obstacles must be overcome to achieve this. A first obstacle arises from the need to complete the exchange within a short period of time. Indeed, if the conversion is not contractually planned and must be negotiated, it is impossible to complete it quickly enough to protect the institution from the threat of a deposit run. A second obstacle is of a financial nature. Without outside assistance, the financial institution in difficulty can only improve its situation at the expense of that of its shareholders. Indeed, it is well known that a conversion of debt securities worsens the situation of former shareholders in favour of that of creditors due to a standard dilution effect (Landier and Udea, 2009). These first two obstacles show that it is desirable that at least part of the bank debt be contracted under conditions providing for its possible conversion into shares as is the case for contingent capital (7.1.3). The effects of asymmetric market information create a third obstacle to the success of a bailout based on a voluntary exchange, even in the case of public support. When the quality of a financial institution’s assets is even partially unknown to the market but known to its management, organizing a bailout or triggering a restructuring plan sends a negative signal to the market about the financial health of the institution that makes its rescue even more difficult (Landier and Udea, 2009). Institutions participating to a bailout plan can also be perceived as sending a negative signal on their own risk exposure. Suspending rules on market transparency would not solve these signalling issues since it would increase the moral hazard generated by the behaviour of the management.

7.1.3 Contingent capital Hybrid securities are designed to be able to transform debt into equity on a contractual basis. These complex financial instruments were first developed to meet the needs of some investors who wanted to have products that combined the characteristics of a bond and a share. The need of an enhanced resilience of financial institutions to crisis has fostered an increase in their issuance. The first of these were subordinated securities, which started being issued before the subprime crisis (Pop, 2005). This is bank debt not covered by the deposit insurance scheme (Chapter 5), not guaranteed by a bank asset, not at sight and with a subordinated status in relation to any other form of debt contracted by the bank. This subordination clause means that in the event of the bank’s bankruptcy, the

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holders of subordinated debt securities are junior to all other debtholders and have priority only over shareholders. These securities receive higher interest rates in compensation for the higher risk, and when they are listed and quoted on financial markets, their price is more sensitive to the risk exposure of the bank. Therefore, bank managers have an incentive to closely monitor risk-taking. In addition, Tirole (2006) points out that the option of converting bond securities into shares represents a credible threat to shareholders from creditors, which may encourage shareholders to reduce their risk-taking.5 Some authors have proposed that banks should be required to issue this type of debt in order to strengthen market discipline (Pop, 2005; Calomiris, 2009). However, the GFC has shown that these incentives are still insufficient for systemic institutions that receive implicit support from governments as TBTFs (Chapter 1) and are therefore reluctant to activate conversions when the decision is theirs (Pazarbasioglu et al., 2011). As a consequence, as noted by Avgouleas and Goodhart (2015), subordinated creditors were in the past bailed out alongside senior creditors by taxpayers. This led to creditor inertia. Nevertheless, hybrid securities, because they can be converted into shares, have been accepted as regulatory capital under certain conditions, with the Basel III agreements reinforcing the requirements for this (Chapter 6). For hybrid securities to play a role in financial stability, conversion to equity should take place at a time when institutions need it most. To this end, most authors suggest that mechanisms should be provided to automatically trigger the conversion of debt into equity when certain conditions are met. The securities are then referred to as contingent capital (Pennacchi et al., 2010). They include in particular “contingent convertible bonds” or “CoCos”, i.e. bonds convertible into capital.6 Among the first banks that issued such securities, it is possible to mention Lloyds Bank in November 2009 and Rabobank in March 2010.7 Contingent capital does not only allow ex post capital to be increased at a time when it is difficult to issue it. It also makes it possible ex ante to raise funds even at a time when it would be impossible to issue capital as such or when capital dilution seems difficult for shareholders to accept. However, a limitation lies in the ex ante signal provided to the market. Indeed, compared to “hard” equity, i.e. traditional equities, the issuance of contingent debt can be interpreted by investors as a sign that the bank is not in a position to issue real shares, thereby corroborating market doubts. Finally, these securities have a tax interest: issuers also benefit, for the calculation of taxable income, from the deductibility of interest on debt as long as they have not been converted (Pennacchi et al., 2010). Several types of products have been proposed. Two criteria can be used to classify them (Pazarbasioglu et al., 2011): the trigger threshold (7.1.3.1) and the conversion rate (7.1.3.2).

7.1.3.1 Threshold When the institution’s solvency deteriorates and reaches the trigger threshold, all or part of the contingent capital is converted into capital pursuant to a contractual

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clause associated with the debt security. This threshold could in principle be set on the basis of either asset valuation, deposit levels (Hilscher and Raviv, 2012), share price (Flannery, 2009), or regulatory solvency ratios. This last kind of threshold is the market standard. A high threshold, which applies when the bank is still far from insolvency, reduces systemic risk. However, it could encourage a bank to manipulate its share price and induce sales of assets at discounted prices to avoid crossing the threshold, for fear of damaging its reputation. There is therefore a risk of multiple equilibria (Prescott, 2011), which could reinforce systemic risk by creating new vectors of contagion between institutions. A low trigger threshold makes contingent debt a resolution instrument (7.3). Thus, in 2010, the Swiss National Bank announced a programme to increase the solvency ratio of Swiss banks to 19% from 2012 to 2019: ten percentage points of hard equity and nine percentage points of CoCos, including three points with a high trigger threshold (a common equity tier 1 (CET1) ratio of 7%) and six points with a low trigger threshold (a CET1 ratio of 5%). Chan and van Wijnbergen (2015) show that while the CoCo conversion of the issuing bank might bring the bank back into compliance with capital requirements, it will nevertheless increase the probability of a bank run happening, because conversion is a negative signal to depositors about asset quality. Avdjiev et al. (2017) revisit some of these issues in the light of the post- GFC experience, on the basis of data on all CoCo issues by banks between 2009 and 2015, which amount to USD 521 billion. They show that the propensity to issue a CoCo is higher for larger and better- capitalized banks. CoCo issues result in statistically significant decline in issuers’ CDS spreads, indicating that they generate risk reduction benefits and lower costs of debt. This is especially true for CoCos that convert into equity, have mechanical triggers and are classified as Additional Tier 1 instruments. On the other hand, CoCos with only discretionary triggers do not have a significant impact on CDS spreads. Regarding the aforementioned debate on the endogeneity of share price, CoCo issues have no statistically significant impact on stock prices, except for principal write-down CoCos with a high trigger level, which have a positive effect. Dewatripont (2015) also suggests, in order to appropriately discipline bank management, different triggers for CoCos, distinguishing between idiosyncratic and macroeconomic events, as the latter may be taken care of by public policy, notably monetary policy. However, such instruments may not be easy to design. He argues that it is better to introduce capital insurance, probably State-provided, or automatic stabilizers (e.g. through deposit insurance premia indexed on the business cycle), based on the idea that the State should act as insurer of last resort.

7.1.3.2 Conversion rate With regard to the conversion rate, a high rate results in a concentration of losses on the former shareholders in the event of activation of the conversion clause. The threat of dilution of their share in the capital encourages shareholders ex

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ante to be cautious and to take less risk in order to avoid losses that could even temporarily impair the bank’s solvency (Hilscher and Raviv, 2012). Conversely, if the conversion rate is low, creditors lose the most during the conversion and are the most vigilant ex ante. All in all, apart from capital requirements (Chapter 6), contingent capital may appear as the only way to make it possible, without public intervention, to increase capital and reduce debt during a future crisis period. Nevertheless, the issuance of eligible securities such as core capital (e.g. equities) remains the best way to strengthen the soundness of institutions and the financial system.

7.2  Internal bail-in ­ Other instruments are only available to authorities. This is the case of bail-in, where more generally private creditors contribute to the restructuring of a bank in difficulty. Bail-in is a major component of resolution, which is studied in detail in the following section, together with the other instruments available to resolution authorities. Bail-in constitutes a significant step with respect to the tools mentioned in the previous section, which – although complex – do not infringe on property rights. Relying on bail-in may indeed challenge existing property rights under the control of courts. It is therefore expected to be exceptional, both in the EU and the US. After a review of the objectives of bail-in (7.2.1), its implementation (7.2.2), impact on banks’ financing costs (7.2.3), and limitations are discussed (7.2.4).

7.2.1 Objectives of bail-in The objective of such a procedure is to generate resources to absorb losses, once existing shareholders have already been written off, and recapitalize a bank without using public finances by involving the bank’s internal creditors (bail-in) rather than relying on financial assistance from the government (bailout). These objectives include reducing moral hazard (Chapter 1), preserving competitive conditions (Chapter 9), reducing implicit government support for private creditors, particularly TBTF creditors (Chapter 1), and reducing the risk that support for banks will undermine the sustainability of public finances (Chapter 9). As indicated by Avgouleas and Goodhart (2015), the bail-in approach is based on the penalty principle, namely that the costs of bank failures are shifted to where they best belong: bank shareholders and creditors. It replaces the public subsidy with private penalty or with private insurance, forcing banks to internalize the cost of risks, which they assume. While the conversion of contingent debt is based on the activation of contractual clauses, the administrative resolution authority in charge of restructuring banks in difficulty (7.3) may want to use some of the securities issued by an institution to absorb its losses (Zhou et al., 2012). Since such a conversion is an infringement of property rights, an authority needs specific statutory powers and

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must abide to procedures protecting stakeholders’ rights to perform bail-in. This procedure relies on automatic clauses to limit the authorities’ temptation to be tolerant. Such powers allow the resolution authority, for example, to treat unsecured debt securities and non-activated contingent debt as hybrid securities whose conversion it can trigger. It can also modify the characteristics of the shares. In order to abide by the No Creditor Worse Off (NCWO) principle (7.2.2.1), the conversion of debt follows the hierarchy of creditors. Convertible debt, considered as junior, is usually converted. But ordinary debt is not converted unless necessary. If the debt buffer available to the resolution authority is large enough, long-term creditors permanently provide a guarantee to the bank to prevent the flight of deposits or securities sold under repurchase agreements (Zhou et al., 2012).

7.2.2 Implementation of bail-in In an internal bail-in procedure, the legal effects of other contracts are maintained, but the order in which the different types of debt are mobilized must be defined by the law, or based on a few principles enforced by courts. The precise terms of the bail-in differ in terms of scope (7.2.2.1) and triggering mechanism (7.2.2.2).

7.2.2.1 Scope The scope of liabilities possibly subject to bail-in may be more or less broad. Since resolution is an alternative to the winding up of a company infringing the creditors’ and shareholders’ rights, every tool used in resolution, including the bail-in, should not deteriorate their situation compared to a normal insolvency proceeding (NCWO principle). As a result, the hierarchy of creditors in the event of liquidation (pecking order) is the basis for determining the order in which liabilities should be converted. In addition, the law or technical features may forbid the conversion of some liabilities. The advantage of a broadly based bail-in is the existence of a significant buffer to facilitate the absorption of losses by a larger number of creditors. But the question arises of the protection of depositors, who are themselves covered by deposit insurance below a certain threshold (Chapter 5). Such deposits are in principle excluded from bail-in. However, in a very limited number of cases, the resources of the deposit insurance fund (DIF) may be used to avoid the failure of the bank, so that the DIF might contribute to a bail-in. An identical treatment towards exclusion can be considered for SME deposits above the deposit insurance coverage. In that case, there is a trade-off between, on the one hand, the impact on the real economy and, on the other hand, the lack of incentive provided to SME depositors to monitor the bank. Similarly to household and SME deposits, transactions causing potential runs such as short-term interbank deposits, derivatives cleared in CCPs, and liabilities to payment systems can also be excluded. With regard to deposits, the US introduced a depositor preference system in 1993 that strengthens the relative position of all depositors, whether or not they are

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covered by deposit insurance and others, compared to other unsecured creditors. The objective was to protect the insurance fund over deposits, the argument being that giving priority to deposits in bankruptcy settlement increases the likelihood that it will not be necessary to use the insurance fund for deposits. However, such an objective is difficult to achieve if the change in regulation leads to a change in the structure of liabilities (7.3) or if the extension of the guarantee granted to banks generates moral hazard (Chapter 1) and leads them to take more risks on their assets. In Europe, the case of Cyprus in March 2013 showed that, in certain circumstances, it was necessary to limit moral hazard and reduce the levy on taxpayers to make holders of large deposits contribute; this need seems to have been understood by the public since, contrary to fears sometimes expressed, this measure did not trigger runs on bank deposits in other European countries.

7.2.2.2 Trigger The second important modality is the process of activation of the bail-in. In this respect, a “statutory” bail-in is based on a legal text, such as the BRRD in the European case (7.3), defining the debt securities that may be the subject of such a procedure, with more or less flexibility to protect certain types of creditors from the effects of the bail-in, depending on whether there are “principle” or “discretionary” exceptions. This flexibility, which may conflict with the principle of equal treatment between banks, makes it possible to respond more effectively to unexpected systemic events. However, as it is very costly to implement, such a flexibility is likely not to be actually used. Contractual clauses setting a minimum level of usable debt for the bail-in may be added. As already mentioned, in order to operate without infringing the property rights, it is important that the bail-in arrangement abide by the NCWO principle (7.2.2.1), which would have been inevitable in the absence of resolution mechanism. Thus, the resolution authority (7.3) serves the general interest by maximizing the sums received by creditors. For Dewatripont and Tirole (1994), it therefore acts as if it were their “representative”. This objective is realistic: the FDIC considered that it would have been possible to put in place a Lehman Brothers resolution plan that could have guaranteed creditors the recovery of 97% of their receivables, i.e. much more than they received in the Chapter 11 bankruptcy procedure that was eventually implemented (FDIC, 2011).

7.2.3 Impact of bail-in on financing costs The introduction of bail-in arrangements into financial law has many consequences for banking institutions. Two effects may be distinguished: a static effect, whereby investors request a compensation for the higher risk from the possible activation of bail-in; a dynamic effect where issuers have an incentive to make their balance sheet bail-in proof, either coming from the market or from authorities (which require, as in the case of TLAC or BRRD, a buffer of subordinated

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debt). In addition, to the extent that TBTF institutions would no longer benefit from an implicit guarantee from the government, their long-term debt credit rating would have to be lowered. The cost of debt financing is thus expected to increase, which would strengthen market discipline and reduce the debt burden, although the weight of short-term debt is expected to increase (increase in secured debt or deposits in the case of “deposit preference”). Nevertheless, few systematic studies are available on the effect on financing costs associated with institutional changes in bail-in or deposit preference. In the case of the US or Switzerland, the effects on financing costs are apparently small (Lenihan, 2012). In the first case, however, it is necessary to consider the creditors’ expectations regarding the likelihood of a bailout. Flannery and Sorescu (1996) show that returns on subordinated debt securities only react to risk factors after 1989 because of the reduction in the safety net from that date with the modification of the deposit insurance scheme (FDICIA law; Chapter 4). In fact, economic literature shows the existence of a volume effect as well as a price effect. Goldberg and Hudgins (2010) study savings banks in the US during the 1980s and 1990s and show that non-covered deposits react significantly to indicators of impending bankruptcy. Savings banks in difficult circumstances have lower deposit levels and difficulties attracting additional deposits; market discipline increased in the early 1990s with the reduction of protection on unsecured deposits. Avgouleas and Goodhart (2015) argue that regarding how much funding costs of (large) banks have to rise if they have to hold specific types of debt, either for contractual conversion or administrative bail-in, there is a range of views about the possibility of a rise in bank funding costs. As in the case of equity, if we compare one otherwise identical equilibrium with another, when the sole difference is that some categories of bank debt become bail-in-able, it is doubtful whether the overall cost of bank funding would rise by much, say 10–30 basis points. However, the authors fail to distinguish between the benefits from contractual subordination of debt leading to conversion when needed (7.2), and additional contractual provisions that may help the implementation of the administrative decision of bail-in, hence increase its effectiveness and reduce the ex ante insurance premium required by investors.

7.2.4 Limitations Beyond the issues of liquidity and cross-border exposures that are reviewed below (7.3), several limitations of bail-in should be mentioned: the risk of contagion and the need to exclude retail deposits (7.2.4.1), possibly higher legal costs (7.2.4.2), and the risk of spillovers (7.2.4.3).

7.2.4.1 Contagion risk from bail-in and the need to exclude retail deposits By concentrating action on liabilities, bail-in helps avoid the sale of assets at discounted prices, one of the vectors of contagion in banking crises and bank runs

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(Chapter 1). However, some financial market participants may seek to “test” the failing bank (Dewatripont and Freixas, 2012), hence creating additional sources of financial instability. Indeed, it is often difficult to avoid a run on other institutions, in particular due to contagion effects. According to Schoenmaker (2017), the major direct contagion effect of bail-in is the spread of losses to the holders of bail-in-able debt (see also Avgouleas and Goodhart, 2015). In practice, this bail-in-able debt is primarily held within the financial sector, in particular the banking sector, with a strong home bias, so that risks remain within the domestic banking system.8 On the basis of ECB data, he shows that euro area banks (i.e. credit institutions) hold the largest share of bail-in-able bonds issued by other euro area banks, while the next category is households, followed by insurance companies and pension funds. Several recent cases provide evidence that bail-in applied to deposits remains a touchy issue. First, bail-in was applied in Cyprus in March 2013, imposing a haircut on most of non-covered deposits. As described by Philippon and Salord (2017), it was the first time that depositors were forced to contribute. Since then, the BRRD disallowed discrimination between creditors on the basis of their nationality or domicile, eradicating this advantage of bail-ins over bailouts. In addition, its implementation for the restructuring of the Spanish banking sector (Bankia) was much criticized. Indeed, from a political economy point of view, bail-in can be costly when households hold a large part of bail-in-able debt. This was particularly relevant in Italy, where most of the bail-in-able bonds of Italian banks are held by Italian households, which can be a way for banks to escape market discipline. In November 2015, before the BRRD’s bail-in rule went into effect in January 2016, Italy conducted a partial bail-in of four small institutions. It was then widely reported in the press that, as a result of the bail-in of one of these banks, Banca Etruria, a pensioner lost a large part of his savings and committed suicide. In May 2016, a law was passed to partially refund the retail investors of the four banks. Later, Italian regulators acted to avoid another bail-in. As argued by Bolton et al. (2019), despite the BRRD, authorities resisted to the bail-in of Banca Monte dei Paschi di Siena (MPS), Veneto Banca, and Banca Popolare di Vicenza. In June 2017, the European Commission rejected the “public interest” for resolution,9 but approved a “precautionary recapitalization” of MPS as an exception to the BRRD’s bail-in requirements, with the Italian government once again compensating retail investors in MPS subordinated debt. Veneto Banca and Banca Popolare di Vicenza were liquidated and their deposits were transferred to Intesa Sanpaolo. The operation was not costless for Italian public finance. The economic rationale for avoiding bail-ins of bank deposits is consistent with Diamond and Dybvig’s (1983) model, which is a model without moral hazard in terms of public intervention. If bank deposits are fully protected against any haircuts, depositors no longer have any incentive to run, also because haircuts send a destabilizing signal that more haircuts may be coming. However, by solving a short-term issue, this may cause high costs in the form of capital misallocation and financial crises (Chapter 2) in the longer run.

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From a more global perspective, the final holding of bail-in-able securities by other financial institutions can generate a channel of contagion, which should be closely scrutinized by supervisors (Chapter 6). As with the treatment of equity, the Basel Committee decided to deduct the amount of securities held under the TLAC from Tier 2 liabilities.

7.2.4.2 Higher legal costs Avgouleas and Goodhart (2015) argue that legal costs are likely to be higher with bail-in since the burden is concentrated on a relatively small number of investors. Shifting the burden of meeting the costs of recapitalization from a small charge (on average) imposed on the generality of taxpayers to a major one imposed on a smaller group of creditors, easily capable of acting in unison, would almost be bound to multiply the legal costs of such an exercise.

7.2.4.3 Spillover risk Spillover risk and amplification of shocks through bail-in should not be ignored. Bernard et al. (2017) show that the existence of a credible bail-in procedure is related to the amplification of the shock through the financial system, which occurs through liquidation losses, bankruptcy costs, and negative feedback effects between highly interconnected banks in distress. Credible bail-in strategies exist if, and only if, this amplification lies below a certain threshold. If it exceeds this threshold, the losses to the real economy are too large and induce the government to have recourse to bailouts. As a consequence, the government cannot credibly commit not to bail out the distressed banks. According to the authors’ analysis, bail-in is more feasible in less dense banking networks. They also argue that banks may anticipate which bail-in consortia are credible for which network structures, and hence choose their counterparties so that the resulting interbank network minimizes their ex ante expected contributions to the equilibrium bail-in plan. This adds an important layer to the moral hazard literature: in addition to maximizing the value of their bailout option through excessive risk-taking, banks can affect the likelihood of a government bailout in bad states of the world through their interbank lending decisions. In general, therefore, bail-in is only one element of the restructuring of distressed banks, and the use of “real” capital is the solution that guarantees a minimum social cost and maximum social benefit (Admati et al., 2013). However, it is too early to conclude how the reforms implemented have changed the holding of banks’ debt by financial institutions and in particular institutional investors. All this does not preclude ex ante provision of precise conditions for the resolution of institutions in difficulty (Freixas, 2010) that are now discussed in greater detail.

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7.3 Resolution of financial institutions The introduction of comprehensive resolution procedures, together with authorities in charge of these procedures, is one of the most significant changes in the post-GFC reform agenda. The new objectives of financial resolution (7.3.1), the differences between the EU and US frameworks (7.3.2), the economic impact of financial resolution (7.3.3) and the issue of cross-border resolution (7.3.4) are successively reviewed.

7.3.1 New objectives Against the background of the arguments in favour of setting up mechanisms to restructure troubled financial institutions (see above), the economic analysis underlines the fact that the success of a recovery or resolution operation requires a very clear definition of: −

− − − − − − −

The authorities responsible for the recovery and resolution of financial institutions and their links with the authorities already responsible for the supervision of financial institutions or markets. The initiation of recovery and resolution measures when an institution is experiencing significant difficulties. The sufficient level of ex ante funding of the resolution authorities. From the legal side, but with economic consequences, it is also important to: Define the conditions of a timely intervention. Respect the conditions of NCWO (7.2.2.1). Ensure that the guarantees may be activated (independent evaluation of assets; legal actions). These conditions were endorsed in 2011 by the FSB key attributes of effective resolution (Box and Table 7.1).

There are two main objectives of resolution: respond to crisis situations by giving real powers to a resolution authority (7.3.1.1), and make financial resources available, while protecting public finances by involving private creditors (7.3.1.2).

7.3.1.1 Respond to crisis situations by giving powers to a resolution authority This implies creating a resolution authority, as well as defining early detection instruments and intervention powers. 7.3.1.1.1 The resolution authority In times of crisis, the rescue or, on the contrary, the liquidation of financial institutions by the courts alone is often too long compared to the short maturity of most

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financial liabilities of a bank. Consequently, reforms have granted specific powers to an administrative authority to resolve banking crises. This was already true for the FDIC, with a long experience in dealing with the failures of small banks. Its resolution powers were increased with Title II of the DFA of July 2010 and the creation of the OLA, a resolution procedure administered by the FDIC, which can be triggered by the Financial Stability Oversight Council (FSOC),10 in order to resolve any systemically important financial institution. The novelty of OLA is that it can be used for large banks and also for large non-bank financial institutions that have been designated as systemically important by FSOC. Similarly, in the EU, the Banking Recovery and Resolution Directive, enacted in May 2014, led to the creation of the Single Resolution Board (SRB) and National Resolution Authorities (Chapter 10). 7.3.1.1.2 Early detection Recovery and resolution procedures require the timely identification of fragile institutions. To encourage supervisory authorities to be more responsive, some jurisdictions have introduced early warning systems that automatically launch an enhanced supervisory procedure when an institution’s solvency deteriorates. In the US, a 1991 law created the “prompt corrective action” (PCA). Banks are classified into five categories according to their solvency ratio. Insufficiently capitalized banks are subject to stricter control and must submit a recovery plan (FSOC, 2011). While the procedure is adapted to small and medium-sized institutions, the crisis has shown the limits of such arrangements for systemic institutions: in the US, the five largest financial institutions that failed or were restructured had capital ratios, at the time of their demise ranging from 12.3% to 16.1%, well above the levels required by Basel regulations (Kuritzkes and Scott, 2009). Institutions in difficulty may suffer from liquidity problems rather than solvency problems, and the solvency situation may deteriorate in a few months without giving the supervisor and the company time to apply a recovery plan. An ex ante and general mechanism is therefore necessary. To function satisfactorily, a recovery and resolution mechanism must be able to rely on a detailed knowledge of financial institutions that exist only within these institutions themselves. This is why the economic literature has argued in favour of the preparation by financial groups of crisis management plans and recovery plans sometimes referred to as living wills (Goodhart, 2010). In the US, the DFA (Chapter 8) requires financial institutions recognized as systemic by the federal government to prepare such documents. Living wills describe how, in the event of serious difficulties, the institution can quickly improve its liquidity situation and strengthen its equity, including by selling non-core assets. In addition, in connection between banks and authorities in the US, or directly designed by the authorities in the EU, resolution plans are drafted for the actions that the institution must implement, in the event of failure of the recovery plan, in order to facilitate the dismantling of the company. These plans are therefore intended to describe precisely the legal and economic structures of financial institutions. Thus, the opacity of the latter is reduced, if not vis-à-vis the market, then at least vis-à-vis the regulator. In fact,

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the existence of a living will makes risk-taking less attractive and imposes containment and hedging measures, which are essential to an orderly resolution that reduces the benefit of risk-taking. In addition, living wills must explicitly plan the financial contribution of the various stakeholders (creditors, shareholders, resolution funds) to the bailout of the institution (burden sharing). Living wills are therefore an irreplaceable instrument to facilitate the action of the authorities responsible for the recovery and resolution mechanism. There is evidence that US banks took them seriously, in particular since inadequate plans could lead to the failure of stress tests, hence triggering higher capital requirement (Philippon and Salord, 2017; Bolton et al., 2019). 7.3.1.1.3 Intervention powers A resolution authority may transfer the assets to a bridge bank without the consent of the creditors. Its powers may include the possibility of a bailout by creditors (bail-in), the ability to exclude or not certain types of debts from the bail-in. It may provide for a more or less broad scope of application of bail-in, which spreads the cost of liquidation on a broader or, on the contrary, narrower basis.11 The protection of depositors, including depositors not covered by a guarantee mechanism, is one of the objectives of the resolution framework set by the BRRD. Nevertheless, its powers are regulated: it exercises them under the supervision of the judge who assesses whether the rights of creditors are preserved along the “NCWO” principle (7.2.3.4).

7.3.1.2 Generate financial resources while protecting public finance by involving the private sector This objective of protecting public finances became all the more important because, during the crisis, they were heavily mobilized. Interventions were all the more costly because there was no effective procedure for managing systemic institutions and involving private creditors. Reforms introduced provisions limiting banks’ bailout. An important provision of the BRRD designed to protect against bailouts is the 8% bail-in (7.2) requirement before any public funds (bailout) from the Single Resolution Fund (SRF; Chapter 10) can be tapped. Under this requirement, not only must shareholders be wiped out, but also unsecured debtholders up to 8% of total liabilities in any resolution that involves injection of public funds by the SRF. The public authorities’ contributions in terms of financing are limited by the BRRD. They are subject to the State aid regime, and are therefore controlled by the European Commission. In the US, government intervention excludes equity investments; only loans and guarantees are allowed. On the other hand, resolution authorities may be funded, for example, through a specific tax and the cost of any action may be charged in advance to its potential beneficiaries, provided that an institutionalized form is given to any public intervention. In this way, moral hazard is reduced.

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Box 7.1 Key attributes of effective resolution regimes for financial institutions In order to avoid negative externalities from the failure of cross-border groups, the G20 endorsed a document prepared by the FSB (FSB, 2011). This text describes the main features of the recovery and resolution mechanisms that States must put in place to effectively organize the rescue or liquidation of financial enterprises. Table 7.1 presents its main features.

TABLE 7.1 FSB’s key attributes of effective resolution regimes for financial institutions

FSB recommendation

Banking recovery and resolution directive (EU, April 2014)



Any institution whose failure would have systemic or critical consequences.



The resolution regime must be administered by a resolution authority with a mandate to ensure financial stability and continuity of critical business activities. The regime should include the possibility of: Transferring critical activities Converting debt into capital Introducing a debt moratorium Phasing out activities in an orderly and gradual manner.

The principle should be a general application to credit institutions and investment firms because it is difficult to understand in advance the importance of the consequences of a bank failure (recital 6, 25). Member States must designate an authority and have a fairly wide discretion in their choice (Article 3).





It must be possible to isolate customers’ assets.



The plan must guarantee that any creditor will receive at least what he or she would have received in the event of liquidation of the institution.

The regime should include the possibility of (Article 17; Chapter IV): Transfering shares or assets, rights or commitments Depreciating or cancelling shares Converting or writing down debt Replacing management Introducing a debt moratorium Organizing the continuity of essential services. The protection of customers’ funds and assets is one of the objectives of the resolution procedure (Article 26). If shareholders and creditors receive less for their claims than they would have received in the event of liquidation, Member States shall ensure that they are entitled to payment of the difference from the resolution authority (Article 73).

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FSB recommendation

The regime must provide for temporary funding mechanisms to allow critical activities to continue. The regime must promote international cooperation between the authorities concerned.

Banking recovery and resolution directive (EU, April 2014) States must set up a European system of funding mechanisms to cover the costs of the resolution (Articles 99, 100). The management of international groups is one of the objectives of the Directive. It is carried out under conditions similar to those of prudential supervision of credit institutions in Europe. Cooperation with third countries is also provided for (Article 97). These groups are mentioned (Article 88, 97).

8 Crisis Crisis management groups (CMG) management involving the authorities of groups the headquarters countries and the main countries of activity of the establishment must be set up to prepare and facilitate the possible resolution of G- SIFIS. These agreements are mentioned Cooperation agreements must be (Article 7). concluded in order to prepare and facilitate the possible ­ resolution of G- SIFIS (cooperation agreements, COAG). They must be implemented for This task should be entrusted to the ­ all G-SIFIS. national resolution authority, and concerns a priori all institutions and groups. Recovery and resolution plans must States must establish them for be drawn up according to precise all institutions whose failure criteria, the technical details of would have systemic or which will be drawn up by the EBA critical consequences. (Articles 8–15). The issue is addressed throughout All obstacles to the proper the Directive, in particular for the flow of information treatment of groups (Articles 84) necessary for the planning or and in the context of relations with implementation of remedial third countries (Article 44, 67). and resolving measures must be removed within and between States.

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7.3.2 Differences between EU and the US The essential principles of the FSB key attributes (Box 7.1) are currently fulfilled by the EU through the BRRD and by the US in the context of the DFA, even if the US administration considered possible amendments to this law.12 However, there are specificities on both sides of the Atlantic.13 In particular, it should be noted that: − −

− −

−

−

The decision-making process differs across countries, with a more significant role of supervision in the EU (see Box 7.2). The European resolution mechanism is more flexible, since it allows resolution at the level of a single point of entry (SPOE) or multiple point of entry (MPOE), which offers a greater degree of freedom for the resolution of cross-border groups (7.3.4), while the DFA focuses on the banking holding company (BHC). European resolution authorities establish both resolution and recovery plans, while American banks only provide recovery plans, also called living wills (7.3.1.2). Another important difference is that the DFA is limited to an orderly winding- down procedure, (i.e. a closed bank process). The BRRD resolution tools may be used to restructure or to liquidate the financial institution as a going concern or as a gone concern. By contrast to the SRF, in the EU, the US Orderly Liquidation Fund (OLF) has never been funded. Indeed, as mentioned before, the FDIC would first rely on the bankruptcy code (Title I), and second, on a resolution temporarily funded (if necessary) by government resources (Title II). The second piece, the OLA was expected to be funded by the OLF. However, the fund never received financial support (Cecchetti and Schoenholtz, 2017). This creates uncertainty and prevents the emergence of a credible resolution scheme, which, in turn, creates moral hazard, since banks may anticipate that bailout will be implemented in case of crisis. On the other hand, it also raises the stakes for the financial institutions, which are faced with the alternative of living on their own resources or going bankrupt. In parallel, the latest reforms in the US would lead to an increased role of courts. Indeed some observers (Cecchetti and Schoenholtz, 2017) note that DFA permits the FDIC to favour one creditor over another (subject to the proviso that NCWO constraint is observed), creating uncertainty for the process and diminishing effective counterparty discipline in normal conditions. This is evidence that the issue of the relative merits of having a dedicated administrative body or courts in charge of resolution is not settled.

7.3.3 Assessment of resolution reforms It is too early to assess fully the first experiences in resolving and mobilizing bail-in tools. However, there is preliminary evidence regarding the effectiveness of the new procedure (7.3.3.1) and its impact (7.3.3.2).

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Box 7.2 Decision-making for resolution In the US, under DFA, the Treasury Secretary must determine whether a systemic financial company is in default or in danger of default. In the EU, three conditions must be met: (a) the institution is declared “failing or likely to fail” by the supervisory or the resolution authority, (b) there is no reasonable expectation that any alternative private sector measure or supervisory action could prevent failure in reasonable time, and (c) resolution is necessary in the “public interest”. The main difference between the two frameworks is that the prudential supervision authority in charge of the day-to- day monitoring of the banks decides upon the opening of the resolution procedure in the euro area, whereas this decision belongs to the FDIC under the DFA. This puts heavy pressure on the supervisor who is unlikely to trigger a mechanism that may signal it has not done its work properly (see Chapter 10 on the “captive regulator”). More precisely, the decision tree for resolution in the euro area is the following: The first step is the decision by the Board of the Single Supervision Mechanism (SSM) of the ECB whether the bank is “failing or likely to fail”. - If the SSM decision is positive, the SRB determines whether the resolution is in the “public interest”. If it is the case, the SRB uses its administrative power for selling the bank, creating a bridge bank, and/or separating assets and/or for bailing in. Otherwise, the bank enters national insolvency procedures (potentially including state aid, conditional on EU approval under the state aid regime). - If the SSM decision is negative, either the bank may request precautionary recapitalization from its national government, conditional on EU approval under the state aid regime, or the SSM may appoint administrators to manage the bank or the bank continues its operations.

7.3.3.1 Effectiveness As indicated by Bolton et al. (2019), so far the SRM resolution procedure has been applied only once – to resolve Banco Popular Español in June 2017 under a purchase-and-assumption deal with Santander akin to those routinely executed by the FDIC. The SRM resolution of Banco Popular took place after the ECB, as single euro area supervisor, declared that the bank was likely to fail and after the SRB decided that it was approaching the point of non-viability (PONV). The SRB intervention resulted in the elimination of all of Banco Popular’s equity claims and the conversion of its CoCos into equity, which was subsequently also wiped out. This bail-in was deemed sufficient for Santander to acquire Banco Popular for the price of one euro and assume all its remaining liabilities. It can

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be concluded that the Banco Popular resolution worked as intended: there was no bailout apart from the CoCos conversion, there was no market disruption and the CoCo instruments issued by Banco Popular served their intended purpose of facilitating a quick write- down of debt in resolution. However, while bail-in represents the major innovation, in practice transfers of activities were originally favoured above bail-in and the creation of bridge banks, as the last two tools still raise implementation issues (Visnovsky, 2019).

7.3.3.2 Impact A recovery and resolution system represents a direct cost for the companies subject to it. They must develop new internal procedures, collect and analyse quantitative data (e.g. on their exposures) and qualitative information (e.g. on their internal organization), which are required by the supervision and resolution authorities. Information on the nature of exposures is an important dimension of the resolution because managers and shareholders often have an interest in minimizing actual losses in order to avoid expropriation by pushing for partial and repeated restructurings, which are generally more costly than global and early restructuring (Dewatripont and Freixas, 2012). Furthermore, this information is useful for the day-to- day risk management of the company. Banks may also be subject to contributions aimed at constituting or replenishing a possible resolution fund through ex ante contributions. Finally, if the BRRD recommends or imposes structural reforms on groups, institutions may be forced to bear transition costs and sometimes also higher operating costs, even if Bolton and Oehmke (2019) consider that the outcome has been positive. It should be noted that there is a risk of a conflict of objectives between the authorities in charge of banking regulation which, by refusing systematic public bailouts, make debt riskier and some governments that would seek to make their financial centres more attractive (Dewatripont and Freixas, 2012). The definition of supranational resolution frameworks should reduce this conflict of objectives. For the Bank for International Settlements (2015), the introduction of resolution framework may have the effect of reducing: (i) the probability of a crisis due to lower risk-taking (the economic literature suggests a one-third reduction in the probability of a crisis14), and (ii) the cost of crises due to more effective crisis resolution as a result of new resolution mechanisms. Beck et al. (2017) exploit the unexpected failure of a major Portuguese bank and subsequent resolution, using a matched firm-bank dataset on credit exposures and interest rates to show that while banks more exposed to the bail-in significantly reduced credit supply at the intensive margin, affected firms compensated the tightening of overall credit with other sources of funding. Nevertheless, SMEs were subject to a binding contraction of funds available through credit lines and reduced investment and employment. These dampening effects are explained by the pre- shock internal liquidity position of smaller firms.

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Taking into account post- GFC reforms, Schäfer et al. (2017) find an impact of the new resolution framework on funding costs. They provide evidence of increased CDS spreads and falling stock prices most notably after the bail-in in Cyprus. However, bail-in expectations appear to depend on the sovereign’s fiscal strength, i.e. reactions are stronger for banks in countries with limited fiscal space for bailout. Overall, the evidence suggests that bailout expectations have been reduced but have not disappeared. Beck et  al. (2019) analyse the relationship between bank resolution frameworks and systemic risk (measured by the CoVar), using a database of bank resolution regimes in 22 member countries. Analysing a number of system-wide and bank-specific events, they find that systemic risk increases more in countries with more comprehensive bank resolution frameworks after negative systemwide events, such as Lehman Brothers’ default, while it decreases more after positive system-wide events, such as Draghi’s “Whatever it takes” speech. In the case of bank-specific negative events, however, such as Deutsche Bank’s loss announcement in 2016, they find that systemic risk increases less in countries with more comprehensive bank resolution regimes. These results suggest that bank resolution rules are effective in dealing with bank- specific events, while they appear procyclical in case of system-wide events. However, the authors carefully note that the paper does not study the ex ante effects of resolution regimes, and their impact on incentives, so that it cannot provide a full evaluation of bank resolution regimes. It rather warns against too high expectations of the power of resolution regimes in system-wide crises. Indeed, in those circumstances, macroeconomic policies are called for (Chapter 9).

7.3.4  Cross-border ­ resolution As evidenced by the difficulties surrounding Lehman’s failure, cross-border resolution is certainly a very difficult issue, compounding different legal frameworks regarding securities characteristics as well as bankruptcy rules and expressions of political interests. Avgouleas and Goodhart (2015) stress that for the resolution system to be credible and stable, the incentives of national authorities before and during a crisis must be assessed and aligned. Otherwise, national authorities may decide to ring fence capital and liquidity ex ante or refuse to abide by an agreement when it turns out to be unfavourable ex post. In addition, cooperation is less likely to take place in crisis times. As noted by Avgouleas and Goodhart (2015), “it is doubtful if any form of non-binding bilateral arrangements, including MOUs (Memorandum of Understanding), would hold in the event of a cross-border banking crisis, involving a transfer of funds from one jurisdiction to another”. The implementation of the resolution requires an alignment of interests between the country of the head of the group (home) and the country where subsidiaries of international banks (host) are located. In this respect, large subsidiaries must also meet the requirements of the TLAC and as part of BRRD 2, group heads may have to subscribe to subordinated debt

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issued by the subsidiaries. The alternative is to have a European and/or an international institution in charge (Chapter 10). One major distinction is between SPOE and MPOE. According to Bolton et al. (2019), the basic idea of SPOE is that resolution would be executed only through the parent holding company – that is the SPOE. Any losses incurred by operating affiliates in any jurisdiction would be pushed up and be absorbed by the parent holding company. Under SPOE no resolution of any affiliate would in principle be needed, solving in one stroke all the potential complexities associated with the resolution of multiple entities in multiple jurisdictions. But it is not clear that institutions have the right incentives or always benefit from an appropriate legal context to make SPOE the most efficient approach. In contrast, under MPOE, a financially distressed banking group could potentially be resolved in several different jurisdictions, depending on where losses materialize. With the agreement of national regulators, a banking group would then have multiple resolvable entities (e.g. a parent holding company in the home country and intermediate holding companies in other countries). Any of these holding companies could then be involved in a resolution procedure. In this approach, the problem is of course that each regulator will be biased towards defending the interests of its jurisdiction against global social welfare. Generally, US and French G-SIBs rely on the SPOE model, while MPOE is preferred by some non-US G- SIBs, especially those with significant activities in emerging countries: −

−

If the goal is to maximize the scope of cross-border banking and global financial integration and maximize social welfare at the global level, then SPOE is the most efficient resolution model because it allows a G-SIB to use all its assets to the full extent to back its liabilities. As Bolton and Oehmke (2019) show, SPOE is the resolution model that requires the smallest amount of TLAC, and therefore the model that minimizes the cost of capital to G-SIBs. In very general terms, financial incentives are stronger under SPOE, but MPOE gives rise to a more resilient organizational structure with respect to affiliates’ incentives and decision by local authorities caused by the crisis (as capital controls). More precisely, Bolton and Oehmke (2019) uncover the following trade- off under SPOE in providing financial incentives to operating affiliates: any given affiliate’s incentives are undermined by the greater sharing of risks across affiliates, but each affiliate also retains a larger share of profits, so that financial incentives may be strongest under SPOE. In contrast, under MPOE, the G- SIB by construction relies less on intragroup transfers, so that it is also better able to absorb a break down in incentives at a given affiliate.

According to Schoenmaker (2017), a joint fiscal backstop, or a full backstop by the home country, for the entire bank facilitates SPOE resolution. By contrast,

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when the involved countries only stand behind the respective domestic parts of an international bank, MPOE resolution is unavoidable.

7.4 Calibration of TLAC In order to make bail-in possible, the FSB requested a broadening of the set of liabilities with loss absorbing capacity. As a consequence, the liabilities that should be restructured and the liabilities that should remain outside resolution are now carefully defined in advance. We review the objectives of TLAC (7.4.1), its requirements (7.4.2) and impact (7.4.3), as well as its application specifically to the EU (7.4.4).

7.4.1 Objectives of TLAC The TLAC was initiated by the FSB in consultation with the Basel Committee, in response to the call by the G20 to provide standard of adequacy for GSIBs. It follows proposals to limit the “Too Big to Fail” privilege of some of these GSIBs (Chapters 1 and 8). Initially developed for GSIB, it was generalized to all significant institutions in the EU with the MREL. The main objective of TLAC is to make bail-in possible by ensuring that the liability structure of the GSIB allows it to effectively absorb losses, should they occur, hence making bail-in a realistic option in a going concern approach. It also ensures that resolution is possible from a gone concern point of view. The additional objective is to limit the implicit public subsidy to G- SIBs as a result of being TBTF (Chapter 1). On top of Basel III capital requirements (Figure 7.1), banks have therefore to issue a minimum level of capital and subordinated debt.

FIGURE 7.1

Link between TLAC and Basel III requirements.

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7.4.2 Requirements In the initial TLAC requirements, i.e. the November 2015 “TLAC term sheet” (FSB, 2015a), all GSIBs were targeted, but those from emerging economies were allowed to start the process after 2012. The minimum requirements for external TLAC are the following: by January 2019, Loss Absorption Capacity (LAC) had to reach at least 16% of RWA and 6% of the Basel III leverage ratio denominator; by January 2022, LAC must reach at least 18% of RWA and 6.75% of the Basel III leverage ratio denominator. In addition, there is a requirement for “Internal TLAC”, where “material” subgroup will be required to meet internal TLAC requirements (75–90% of the TLAC requirements on a stand-alone basis) (FSB, 2017). The TLAC ratio is derived from the following calculation: TLAC(%) =

Loss Absorption Capacity × 100 Risk Weighted Assets or Leverage Exposure

Where LAC is the sum of instruments that contain a contractual or a statutory trigger or be subordinated that can be written down or converted into equity. It includes CET1 capital, but also CoCos and subordinated, unsecured long-term debt (with a maturity in excess of one year). The debt portion (T1 and T2 debt liabilities, as well as other TLAC- eligible liabilities) is expected to be at least equal to 33% of the total LAC, in order to ensure a homogeneous treatment of debt securities and avoid concentration on a small number of issuers. It should also be noted that TLAC holdings of non- capital TLAC instruments are restricted as well as the holding of banks’ capital by other banks (6.3). In the end, what matters is the issuance of TLAC net of holdings of TLAC liabilities by other banks (which are deducted from the gross TLAC amount). This is designed to reduce contagion across institutions. According to the regulatory standard issued in October 2016, TLAC holdings will be deducted from Tier 2 liabilities. This ensures a consistent application between G-SIB and non- G-SIB as well as avoiding incentives to invest in such liabilities. However, this measure is applied only above a minimum threshold.15

7.4.3 Impact It is too early to assess the economic impact of TLAC, which will be closely connected to the other resolution reforms. FSB (2015b) assesses its likely impact, but only from a forward-looking perspective. If cross-border arrangements are viewed important (Chapters 7 and 10), by designating resolution entities in different jurisdictions in advance, and prepositioning TLAC to these entities, regulators can limit the need for ex post cross-jurisdictional transfers that might be contradicted by national ring-fencing. From this point of view, the regulation goes in the right direction. Taking a broader perspective, Bolton et al. (2019) note that adding Basel III capital and TLAC requirement imply a buffer of roughly 10% of total exposure,

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which is at a level consistent with the low end of the levels suggested by current research (Chapter 6). However, they do not argue in favour of shifting the proportions between debt and equity by increasing equity and reducing debt. Indeed, even if the social cost of further equity finance is low, and private costs of bank capital generally exceed the social costs, it is private costs which drive behaviour.

7.4.4 Transposition in EU: MREL At the international level, the additional requirements for TLAC are primarily aimed at GSIBs. However, the EU has decided to transpose this measure to all banks in the form of a MREL requirement, which has similar objectives to the TLAC. In all cases, it is a question of defining an additional set of debt securities to cover losses if the capital is not sufficient. At the European level, the basic requirements of GSIBs are defined in Pillar 1, while those for other banks are defined in Pillar 2. In fact, the BRRD was introduced before the TLAC term sheet; so there was a need to adjust BRRD to TLAC. This was the main object of BRRD 2 of May 2019. Its main characteristics are presented in Box 7.3.

Box 7.3 Main characteristics of Minimum Requirement of Eligible Liquidity (MREL) • • • •

•

MREL is applied to all credit institutions and investment firms, and not only GSIBs. The overall amount is determined by the resolution authority. The set of eligible liabilities is broader than for TLAC: equity, junior, and senior debt. Link with bail-in and resolution: As discussed by Bolton et al. (2019), following significant losses, CoCos can allow for bank recapitalization without entering resolution. By contrast, bonds that are a part of a bank’s TLAC may only be available once a bank becomes insolvent. Similarly, MREL aims at ensuring a private “bail-in” rather than a public “bailout”. Deductions for MREL holdings (equivalent of TLAC holdings) are only applied to securities issued by GSIBs and held by GSIBs.

To conclude, with regard to resolution regimes, international harmonization has been very significant. However, resolution regimes remain yet untested for the largest banks, the very ones for which they have been developed. Furthermore, there is room for progress: bankruptcy proceedings and the hierarchy of creditors remain heterogeneous within the EU and their harmonization would ease the resolution of banking crises and enhance the efficiency of the SPOE approach in Europe. Finally, as discussed by Dell’Ariccia et al. (2018), it is still necessary to improve the trade- offs

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between the spillover effects from bail-ins and the moral hazard consequences of bailouts. In the insurance sector, while the FSB deplored delays in the management of the resolution, it should be noted that in France, a decree-law creating an insurance resolution regime was adopted on 27 November 2017.

Notes 1 The tools associated with recovery are exceptional management or supervisory measures for entities experiencing difficulties but not yet “Failing or Likely to Fail” (FOLTF). Entities that are FOLTF may be subject to a resolution framework, which is a set of exceptional legal provisions. In case of return to normal business, one generally refers to “restructuring”, which is however a rather loose concept. 2 As discussed by Bolton et al. (2019), the orderly resolution procedures available in the US before the GFC were FDIC receivership and Chapter 11 of the US Bankruptcy Code for non-financial companies. FDIC receivership procedure was used for the Savings and Loans (S&L) crisis of the early 1980s. The receivership model is built around the idea of “purchase and assumption”. The failed bank is purchased by a solvent bank, which agrees to purchase the failed bank’s assets and also to assume most of its debts. If some debt reduction is needed to make the failed bank solvent, the FDIC may take on some of the debt obligations so that the acquirer does not have to assume debts in excess of the value of the failed bank’s assets. In contrast, before the GFC, only a small number of countries had a special legal provisions dealing with the failure of financial institutions. Beyond the US, it was only the case of the UK, Canada, Italy, and Norway (Dewatripont and Freixas, 2012). 3 See Section 7.3.2 for details. 4 According to US Congress Budget Office, the net final cost of TARP is expected to be around USD 32 billion, much less than the USD 444 billion initially disbursed. 5 The argument is general in scope and goes beyond financial institutions. 6 CoCo bonds are subordinated bonds that pay a coupon and can either be converted into CET1 capital or written down when contractually specified trigger events occur. CoCos differ from traditional convertible securities in that conversion cannot be triggered by the bondholders. 7 In the case of Rabobank, however, it is not exactly a conversion. Indeed, if the solvency ratio falls below 7%, the bonds would be repaid at 25% of par. The bank could therefore record an accounting gain of 75%, which would strengthen its shareholders’ equity. 8 In the EU, all banking debt with a maturity above seven days, with the exception of covered deposits, is de jure bail-in-able. Banks are logically very active in this market. 9 See Figure 7.1 for the procedures involved for resolution in the euro zone. The EU Commission and the SRB expressed so far a restrictive view on public interest, which is defined as the need to preserve critical functions of the bank and avoid negative effects on financial stability (Visnovsky, 2019). 10 The FSOC was created by Title I of the DFA. 11 Short-term deposits, cleared derivatives transactions in CCPs and liabilities to payment systems are generally excluded from the bail-in. Deposits not covered by deposit insurance are bail-inable in the EU (as was the case during the Cyprus crisis in March 2013, but before the entry into force of the BRRD). 12 The Choice Act in the US, supported by Republican representative in the wake of D. Trump’s election, suggested a more significant role of courts. 13 The reader is referred to Philippon and Salord (2017) for a detailed analysis of resolution mechanisms in the US and in Europe.

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14 Alfonso et al. (2014) show that the higher probability of public support leads to risktaking and a deterioration in the quality of loan portfolios. 15 The deductions for holdings of non- CET1 TLAC eligible liabilities are implemented only when holdings are above 5% of CET1 of the investing bank (this extends the 10% threshold for capital). For GSIBs, all holdings are deducted; the deduction of holdings above 5% only applies for trading book held less than 30 days, in order to allow market-making activities.

Bibliography Admati A.R., De Marzo P.M., Hellwig M.F., Pfeiderer P. (2013), “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive”, Standford Graduate School of Business, Working Paper, 22 October, No. 2065. Alfonso G., Santos J., Trana J. (2014), “Do ‘Too-Big-to-Fail’ Banks Take on More Risk?”, Federal Reserve Bank of New York, Economic Policy Review, 41–58, https:// www.newyorkfed.org/medialibrary/media/research/epr/2014/1412afon.pdf. Avdjiev S., Bogdanova B., Bolton P., Jiang W., Kartasheva A. (2017), “CoCo Issuance and Bank Fragility”, BIS Working Papers, November, No. 678. Avgouleas E., Goodhart C. (2015), “Critical Reflections on Bank Bail-Ins”, Journal of Financial Regulation, 1(1), 3–29. Bank for International Settlements. (2015), Assessing the Economic Costs and Benefits of TLAC Implementation, Report submitted to the FSB, November. Bayazitova D., Shivdasani A. (2012), “Assessing TARP”, Review of Financial Studies, 25(2), 377–407. Beck T., Da-Rocha-Lopes S., Silva, A. (2017), “Sharing the Pain? Credit Supply and Real Effects of Bank Bail-ins”, CEPR Discussion Paper 12058. Beck T., Radev D., Schnabel I. (2019), “Can Bank Resolution Regimes Increase Systemic Risk?”, mimeo. Bernard B., Capponi A., Stiglitz J. (2017), “Bail-ins and Bailouts: Incentives, Connectivity, and Systemic Stability”, Vox EU, 18 October. Bolton P., Cecchetti S., Danthine J.-P., Vives, X. (2019), Sound at Last: Assessing a Decade of Financial Regulation, Centre for Economic Policy Research, IESE Banking Initiative. CEPR Press, London. Bolton P., Oehmke M. (2019), “Bank Resolution and the Structure of Global Banks”, Review of Financial Studies, 32(6), June 2019, 2384–2421. Brei M., Gadanecz B. (2012), “Have Public Bailouts Made Banks’ Loan Books Safer?”, BIS Quarterly Review, September, 61–72. Breton R., Pinto C., Weber P.-F. (2012), “Banks, Moral Hazard and Public Debt”, Banque de France, Financial Stability Review, 16, April. Calomiris C.W. (2009), “Financial Innovation, Regulation, and Reform”, Cato Journal, 29(1), 65–91. Calomiris C.W., Kahn C.M. (1991), “The Role of Demandable Debt in Structuring Optimal Banking Arrangements”, American Economic Review, 81(3), 497–513. Cecchetti S., Schoenholtz K. (2017), “Bank Resolution: The Importance of a Public Backstop”, Vox EU, May 28. Chan S., van Wijnbergen S. (2015), “Cocos, Contagion and Systemic Risk”, CEPR Discussion Paper, No. 10960. Dell’Ariccia G., Martinez Peria M.S., Igan D., Addo Awadzi E., Dobler M., Sandri M. (2018), “Trade-offs in Bank Resolution”, IMF Staff Discussion Note, February 18.

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Dewatripont M. (2015), “Which Protection for Bank Liabilities?”, Sciences Po / Banque de France Seminar, Paris, March 25 https://slideplayer.com/slide/4546290/. Dewatripont M., Freixas X. (2012), “Bank Resolution: Lessons from the Crisis”, in The Crisis Aftermath: New Regulatory Paradigms, London: CEPR, 105–143. Dewatripont M., Tirole J. (1994), The Prudential Regulation of Banks, Cambridge, MA: MIT Press. Diamond D.W., Dybvig P.H. (1983), ‘‘Bank Runs, Deposit Insurance, and Liquidity”, Journal of Political Economy, 91(3), 401–419. Federal Deposit Insurance Corporation (2011), “The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act”, FDIC Quarterly, 2(5). Financial Oversight Council. (2011), Report to the Congress on Prompt Corrective Action, www.treasury.gov/initiatives/fsoc/studies-reports/Documents/FSOC%20PCA%20 ­ Report%20FINAL.pdf. Financial Stability Board. (2011), Key Attributes of Effective Resolution Regimes for Financial Institutions, https://www.fsb.org/work-of-the-fsb/policy-development/ ­ ­ ­ ­ effective-resolution-regimes-and-policies/key-attributes-of-effective-resolution­ ­ ­ ­ ­ ­ ­ ­ ­ regimes-for-financial-institutions/ ­ ­ ­ Financial Stability Board. (2015a), Principles on Loss-Absorbing and Recapitalisation Capacity of G-SIBs in Resolution: Total Loss-Absorbing Capacity (TLAC) Term Sheet, 9 November 2015, https://www.fsb.org/wp-content/uploads/TLAC-Principles-and-Term-Sheet­ ­ ­ ­ ­ ­ for-publication-final.pdf. ­ ­ Financial Stability Board. (2015b), TLAC Quantitative Impact Study, 9 November 2015, ­ ­ ­ ­ ­ https://www.fsb.org/2015/11/bcbs-tlac-quantitative-impact-study-report/ Financial Stability Board. (2017), “Guiding Principles on the Internal Total LossAbsorbing Capacity of G- SIBs (‘Internal TLAC’)”, 6 July 2017, https://www.fsb. org/2017/07/guiding-principles-on-the-internal-total-loss-absorbing-capacity-of-g­ ­ ­ ­ ­ ­ ­ ­ ­ ­ sibs-internal-tlac-2/. ­ ­ Flannery M.J. (2009), “Stabilizing Large Financial Institutions with Contingent Capital Certificates”, ssrn.com/abstract=1485689. Flannery M.J., Sorescu S.J. (1996), “Evidence of Bank Market Discipline in Subordinated Debenture Yields: 1983–1991”, Journal of Finance, 51(4), 1347–1378. Freixas X. (2010), “Post- Crisis Challenges to Bank Regulation”, Economic Policy, April, 375–399. French K.R., Baily M.N., Campbell J.Y., Cochrane J.H., Diamond D.W., Duffie D., Kashyap A.H., Mishkin F.S., Rajan R.G., Scharfstein D.S., Shiller R.J., Shin H.S., Slaughter M.J., Stein J.C., Stulz R.M. (2010), The Squam Lake Report – Fixing the Financial System, Princeton and Oxford: Princeton University Press. Goldberg L., Hudgins L. (2010), “Depositor Discipline and Changing Strategies for Regulating Thrift Institutions”, Journal of Financial Economics, 63, 263–274. Goodhart C. (2010), “How Should We Regulate Bank Capital and Financial Products? What Role for ‘Living Wills’?”, in The Future of Finance: The LSE Report, London School of Economics and Political Science, London, 165–186. Hilscher J., Raviv A. (2012), “Bank Stability and Market Discipline: The Effect of Contingent Capital on Risk Taking and Default Probability”, Working Papers, 53, Brandeis University, Department of Economics and International Business School. Houston J.F., Chen L., Lin P., Ma Y. (2010), “Creditor Rights, Information Sharing, and Bank Risk Taking”, Journal of Financial Economics, 96, 485–512. Jensen M.C. (1986) “The Agency Costs of Free Cash Flow: Corporate Finance and Takeovers”, American Economic Review, 76(2), 323–329.

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Kuritzkes A., Scott H. (2009), “Markets Are the Best Judge of Bank Capital”, Financial Times, September 23. Landier A., Udea K. (2009), “The Economics of Bank Restructuring: Understanding the Options”, IMF, Staff Policy Note, 09/12, June 5. Lenihan N. (2012), “Claims of Depositors, Subordinated Creditors, Senior Creditors and Central Banks in Bank Resolutions”, AEDBF Conference, Athens, 5–6 October, ­ http://www.aedbf.eu/fr/wp-content/uploads/sites/3/2012/10/LENIHAN.pdf. Liikanen E. et  al. (2012), Final Report of the High-Level Expert Group on Reforming the ­ Structure of the EU Banking Sector, https://www.pruefungsverband-banken.de/en/ infobereich/downloads/Documents/Liikanen_report_en.pdf Mishkin F. (1998), “Financial Consolidation: Dangers and Opportunity”, NBER Working Paper, No. 6655. Pazarbasioglu C., Zhou J., Le Leslé V., Moore M. (2011), “Contingent Capital: Economic Rationale and Design Features”, IMF Staff Discussion Note, SDN/11/01, 25 January 2011. Pennacchi G., Vermaelen T., Wolff C.P. (2010), “Contingent Capital: The Case for COERCs”, Insead Faculty & Research Working Paper, 2010/55/FIN. Philippon T., Salord A. (2017), Bail-ins and Bank Resolution in Europe: A Progress Report, Geneva Special Report on the World Economy 4, ICMB and CEPR Press. Pop A. (2005), “Is the Subordinated Debt Policy as an Alternative to the Third Pillar of Basel II Feasible?”, Recherches Economiques de Louvain, 71(2), 193–221. Prescott E.S. (2011), “Contingent Capital: The Trigger Problem”, Working Paper Series, Federal Reserve Bank of Richmond, WP 11–07. Richardson M. (2009), “The Case for and against Bank Nationalization”, Vox EU, 26 February. Schäfer A., Schnabel I., Weder di Mauro B. (2017), “Expecting Bail-in? Evidence from European Banks”, Vox EU, May 15. Schoenmaker D. (2017), “A Macro Approach to International Bank Resolution”, Bruegel, Policy Contribution Issue n˚20, July. Tirole J. (2006), The Theory of Corporate Finance, Princeton, NJ, and Oxford: Princeton University Press. Visnovsky, F. (2019), “Résolution bancaire, pourquoi? qui? comment? quelles lecons de l’experience”, séminaire de recherche Banque de France- Sciences Po, November 13, https://acpr.banque-france.fr/sites/default/files/medias/documents/20191113_scpo_ ­ resolution.pdf. Zhou J., Rutledge V., Bossu W., Dobler M., Jassaud N., Moore M. (2012), “From BailOut to Bail-in: Mandatory Debt Restructuring of Systemic Financial Institutions”, IMF Staff Discussion Note, SDN/12/03.

8 MACROPRUDENTIAL POLICY

On top of management standards imposed on institutions from an individual perspective, taking their economic environment as given (Chapter 6), the GFC highlighted the need for a macroprudential approach (Farhi and Tirole, 2011). The latter takes into account institutions’ interactions with the financial system as a whole and their impact on the real economy, particularly in situations where there is systemic risk (Chapter 1). Even though this concern is not new and, in practice, microprudential policies already incorporate a wider perspective than the situation of individual institutions, the notion of macroprudential policy (MaP) has only recently acquired an operational content. Documents and research that refer to it come largely from the community of central banks, supervisory authorities, and international institutions, mainly from the early 2000s. Galati and Moessner (2011) mention some public statements using this term in the mid-1980s and in a 2000 speech by Andrew Crockett, then director general of the Bank for International Settlements (BIS; Chapter 10). From 2009 on, several speeches by senior officials of the ECB, the Fed and the BIS refer to it. However, just as the notion of financial stability is still unclear (Chapter 1), the contours of MaPs remained for a long time uncertain. If the theme appears very frequently, pure MaPs have only recently been implemented, hence the difficulty to establish a systematic review. The objectives of MaPs (8.1), the indicators likely to trigger them (8.2), the main instruments used and their limits (8.3) and the questions related to their implementation (8.4) are presented successively.

8.1 Objectives MaPs respond to new concerns (8.1.1); their ultimate goal deserves clarification (8.1.2).

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8.1.1 The role of macroprudential policy The economic analysis has highlighted the need for a macroprudential approach (8.1.1.1), which appears to be complementary to the microprudential approach (8.1.1.2).

8.1.1.1 The need for a macroprudential approach Macroprudential analysis seeks to identify vulnerabilities in the financial system as a whole. It starts from a cross- cutting approach to the risks to which financial institutions are subject and seeks to overcome it by taking into account the existence of externalities that create systemic risk. Three factors led to the implementation of this new approach: (8.1.1.1.1) the endogenous nature of financial risk-taking, (8.1.1.1.2) the need for a global analysis of the financial system and (iii) the flaws in regulation. 8.1.1.1.1 Endogeneity of financial risks For more than 15 years, economic literature has highlighted the endogenous nature of financial risks (Table 8.1), notably because of their interaction with macroeconomic dynamics (Holmström and Tirole, 1997; Chapter 1). Economists have recognized that credit risk is endogenous (Hellwig, 1995) and not exogenous as implied by the microprudential approach. In addition, the probability of realization and the impact of certain risks have received more prominence. In this regard, the literature stresses the liquidity risk that affects the entire financial system (Greenlaw et al., 2012). 8.1.1.1.2 Need for a comprehensive approach In addition, during the GFC, many a priori independent financial risks turned out to be in fact correlated with each other, due to the accumulation by financial institutions of positions in the same direction, leading to chain reactions in the event of the liquidation of these positions upon the occurrence of a crisis. A general overexposure of banks to the same risks is generally observed in the ascending phase of the financial cycle, with an underestimation of collateral damage in the event of a crisis (Saporta, 2009). Institutions are interconnected and develop common exposures, and the proper way to assess these two sources of systemic risk is to consider them at the level of all institutions. In addition, MaP instruments are collective measures that avoid stigmatizing any particular institution. For example, it may appear important at a given time to favour the issue of shares by banks. This can in particular avoid biases associated with an isolated issuance of shares by one bank in terms of signalling (Myers-Majluf, 1984).

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In addition, the increasing size of the shadow banking system (Chapter 2, 5) increases the vulnerability of the whole financial system. Indeed, particularly in the US, non-banks became an increasingly important source of credit for the real economy in the years preceding the crisis: between 2001 and 2007, non-bank financials accounted for over 70% of the total growth in home mortgage credit (according to the Financial Accounts of the US, cited by Aikman et al., 2019b). This growth was accompanied by an increased reliance on debt financing of the non-bank system. Short-term borrowing became more important, with the belief that it could be rolled over continuously. These observations suggest that the arsenal of macroprudential regulators must include tools to affect the overall propensity to rely on debt financing and its maturity, and macroprudential regulators must have the ability to apply these tools both to banks and to non-banks. This is all the more important, given their macroeconomic impact. According to Aikman et al. (2019b), household overindebtedness and deleveraging accounted for around three-quarters of the contraction in output that occurred during the GFC in the US. 8.1.1.1.3 Failure of regulation Microprudential regulation may be procyclical (Hellwig, 1995, Chapter 6). With regulation in terms of minimum capital ratio, and if the banks are unable to anticipate that they could make losses or if they anticipate that in this case they will be bailed out by the authorities, capital can only adjust when it is above the minimum. It may thus be appropriate to introduce capital buffers (Greenlaw et al., 2012). Capital requirements must then increase in the upward phase of the financial cycle and can be reduced after the outbreak of the financial crisis. Finally, it is important to protect the authorities from the risk of being held hostage by the financial system in the event of difficulties. Indeed, financial institutions may have an interest in adopting correlated strategies in order to maximize the likelihood of joint defaults, which increases the likelihood of rescue by the authorities (Farhi and Tirole 2011; Tirole 2011).

8.1.1.2 The complementary role between micro and macroprudential policy Microprudential and MaPs have different objectives (Table 8.1), notably in the sense that one is in partial equilibrium and the other in general equilibrium; one sets short- term objectives, the other medium- term objectives (Saporta, 2009). Nevertheless, it would be wrong to consider that they are in opposition. In addition to the fact that MaPs mainly use microprudential tools (Chapter 6), their objectives appear to be more complementary than substitutable. In particular, when the financial sector is concentrated, the distinction between micro and macro levels is not clear- cut (IMF, 2011). MaP depends on the environment created by microprudential policies: the higher  the

Macroprudential policy  221 TABLE 8.1 Difference between micro and macro-prudential approach

Microprudential approach Goal

Field of supervision Understanding of risks

Operational approach

Macroprudential approach

To limit the risk of default To limit the probability of systemic tensions involving a significant (and the consequences part of the financial system and the of a possible default) of macroeconomic impact of these individual institutions, tensions. protect savers and the deposit insurance system. Individual financial Financial system as a whole. institutions. Risks independent of the Endogenous risks (resulting from the actions of other actors; collective action of the actors and bottom-up. ­ their interactions, correlated risks); ­ top-down. Financial stability is appreciated at the The robustness of global level (including the shadow institutions at the banking system). individual level is Macroprudential supervision supposed to guarantee exploits the complementarity that of the financial of information, expertise and system. perspectives. Microprudential supervision requires a strong specialization of supervisors.

level of the minimum solvency ratio required of banks, the lower the systemic risk and the less active MaP must be (Saporta, 2009). That the two approaches share the same objective can be illustrated by the recommendation of the European Banking Authority (EBA) of 8 December 2011 (EBA, 2011) to create a capital buffer to deal with the sovereign crisis (Chapter 9). The measure was based on both microprudential (individual risk management, Basel III preparation) and macroprudential reasons (restoring investor confidence in banks, emphasis on strengthening the level of equity and not on increasing the capital ratio that could have led to deleveraging). Similarly, the aim of capital buffers on Global Systemically Important Banks (G-SIBs; see below) is to safeguard the solvency of large institutions, for which supervisors are not well equipped (6.4), but also to reduce the systemic risk created by more favourable funding conditions inducing institutions to increase risk-taking, hence jeopardizing the stability of the whole financial system. In times of recession, a dilemma may appear. On the one hand, the desire to spur the supply of credit may justify lowering regulatory requirements from a macroprudential perspective. On the other hand, the microprudential supervisor may be reluctant to encourage additional risk-taking. However, the dilemma should not be exaggerated because MaP aims to safeguard financial stability

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(Gambacorta and Shin, 2018), not the smoothing of the cycle, which is the objective of monetary policy (Chapter 9).

8.1.2 The definition of the final objective While the ultimate objective of MaPs is to preserve financial stability, this objective needs to be clarified in view of its rather vague nature (Chapter 1). First, the goal of preventing financial stability involves excluding crisis management from the MaP area (Chapter 7; IMF, 2011). The same is true of macroeconomic imbalances if they have no financial effects. On the other hand, MaPs address all the risks that emerge in the financial sector or that are amplified by it. This excludes the management of an individual bankruptcy if there is no risk of contagion. Galati and Moessner (2011) distinguish between (i) ensuring the robustness of the financial system in the face of external shocks and (ii) building resilience to endogenous shocks to the financial system. They also oppose measures to prevent the emergence of financial cycles (boom /bust) to policies that seek to prevent crises from having a macroeconomic impact. The Committee on the Global Financial System (CGFS) (2010) distinguishes between policies that aim at strengthening the resilience of the system and those that seek to mitigate the financial cycle. It is also possible to oppose the search for financial stability at a given point in time, i.e. the fight against contagion phenomena and the pursuit of financial stability over time by limiting the procyclicality of the financial system (CGFS 2010). Borio (2011) nevertheless considers that a final objective of resilience of the financial system is more realistic than seeking to control the financial cycle.

8.2 Indicators Identifying the need for MaP interventions requires spotting emerging risks that are likely to become systemic and accumulating vulnerabilities prior to a crisis. Such a vulnerability analysis requires indicators to trigger the implementation of MaPs at the right time. Three types of indicators are available: individual or combined indicators of the financial cycle (8.2.1), quantitative measures of systemic risk (8.2.2), and information derived from stress tests (8.2.3).

8.2.1 Indicators of the financial cycle The first major family of indicators used to implement macroprudential measures is individual or combined indicators of the financial cycle. They serve to trigger countercyclical measures (countercyclical buffers or measures to avoid a bubble in the real estate market; 8.3). These indicators are briefly reviewed (8.2.1.1) and their information content is examined (8.2.1.2).

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8.2.1.1 Types of indicators Numerous indicators have been proposed in the literature (Saporta, 2009; Galati and Moessner, 2011; de Haan et al., 2015). In addition, there are specific indicators for Counter Cyclical Capital Buffer (CCyCB), notably the “Basel gap”, as discussed in 8.2.1.2. These are generally leverage ratios, i.e. loan to value ratios (amount of credit granted/value of the financed property) or loan to income ratios (amount of credit/income) at the individual or sector level, including interest and repayment expenses related to disposable income. Macroeconomic indicators, such as the unemployment rate, which can precipitate certain imbalances, particularly in the real estate market because of the risk of insolvency, also fall into this category. To be relevant, these indicators must meet a number of criteria (IMF, 2011). They must provide information on the risks taken in their various dimensions (cyclical/cross-section), constitute advanced signals and be available quickly. It is possible to distinguish between indicators that measure the probability of occurrence of an event and those that evaluate the impact of the financial cycle on macroeconomic developments, the latter dimension being more complex to evaluate (IMF, 2011). One can also oppose stock indicators that measure the rise of vulnerabilities and those of flows that are more reactive (Saporta, 2009).

8.2.1.2 Relevance of indicators There is an abundant literature on the monitoring of debt build-up using the “credit-to- GDP” ratio, or more precisely on the predictive capacity of the “credit/GDP” indicator measured as a deviation from its long-term trend. Many empirical studies have shown that during periods of very abundant credit, financial bubbles tend to develop. They retrospectively highlight the influence of credit developments on the economy, the probability of financial crises, the depth of recessions and the speed of recovery (International Monetary Fund, 2009; Claessens et al., 2011; Schularick et al., 2012; Schularick et al., 2013). The Basel Committee (BCBS, 2010) proposed such an indicator, the so- called “Basel gap”, as a trigger signal for activating the countercyclical buffer (6.3). Drehmann et al. (2011) highlight, empirically, the interest of using the difference between the ratio “credit/GDP” and its long-term trend, itself measured by filtering. This indicator measures the development of vulnerabilities in the bottom-up phase of the financial cycle. According to their analysis, it performs better than other variables such as GDP or credit growth, money supply, asset prices. They also consider that after the burst of a credit bubble, it is necessary to resort to other indicators such as credit spreads. Drehmann et al. (2011) also highlight the robustness of their results if one includes a broad definition of credit – including international financial flows to take into account risks of arbitrage between countries (8.4).

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However, Repullo and Saurina (2011) highlight the sometimes erroneous signals provided by the “credit-to- GDP” ratio. They note that the correlation between the credit-to- GDP ratio gap and GDP growth is very unstable over time and may even be negative, which may seem counter-intuitive and especially undesirable for an indicator of the financial cycle. Two factors may explain this negative relationship. On the one hand, it comes from the very definition of the ratio: when the economy enters into recession, the decline in GDP in the denominator leads to a mechanical increase in the ratio. On the other hand, even in a downturn in activity, credit growth can remain positive, with firms and households drawing on credit lines previously granted. In a sample of large OECD countries, Repullo and Saurina (2011) show that the correlation between credit growth and GDP is positive, although Drehmann et al. (2011) point to the poorer performance of the credit growth indicator than the credit-to- GDP ratio gap in anticipating bank crises. Two limitations of this type of work stem from (i) their essentially empirical nature, and (ii) the fact that, to obtain robust results, it is necessary to have a representative and sufficiently wide sample of periods of crises. In this respect, the identification of crisis periods and the statistical methods for measuring cycles open the door to further research. Jordà (2011) suggests, using the method of Harding and Pagan (2002), which is an improved version of the Bry and Boschan (1971) filter, rather than the Hodrick and Prescott (1997) filter for calculating cycles. In addition, Edge and Meisenzahl (2011) point out that statistical revisions have a significant impact on measuring the difference between the credit/GDP ratio and its trend. Van Norden (2011), however, considers that the argument is not decisive and does not question the conclusions of Drehmann et al. (2011). Nevertheless, the interest of using credit as an indicator for the dating of financial cycles remains controversial. Gadea Rivas and Perez- Quiros (2012) compare, for 39 OECD countries over the period 1950–2011, the forecast performance, with uncertainty on the dating of the cycle, of models including or not credit to the economy. They conclude that the addition of credit only marginally improves the forecast of turning points. The importance of credit in identifying the business cycle and its characteristics would be very limited. Several contributions also evaluate the information content of other indicators, like asset prices and in particular real estate prices ( Jordà et al., 2015): −

−

−

Alessi and Detken (2011) propose different indicators of financial cycles in the equity and real estate markets. One of the conclusions, as for the creditto- GDP ratio, is that the identification of crisis periods is also dependent on the statistical filters used. In addition, these indicators provide a coincidental and unanticipated measure of the cycle. Foos et al. (2010) show, based on a sample of 16,000 banks in 16 countries, that excessive bank credit growth (measured by faster than average growth in the country) results in non-performing loans in the next three years. Büyükkarabacak and Valev (2010) conclude that strong household credit growth on a panel of developed and developing countries is a robust

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−

indicator of future financial crises. However, the effect is weaker and less robust for business loans. Barell et al. (2010) show in a sample of banks in OECD countries that countries in which financial institutions have a high solvency ratio one year before the crisis or which hold a high level of liquidity and securities experience significantly fewer crises. In contrast, a sharp rise in real estate prices significantly increases the risk of crisis three years later.

All in all, as indicated by Aikman et al. (2019a), although there are clear signals of imbalances in the run-up to the crisis, one needs to remain cautious about the ability of macroprudential regulators to understand the nature of systemic financial risks as they emerge in real time. However, the analysis of “GDP-at-risk”, which assesses the impact of financial variables on the distribution (and not only the point estimate) of future output is a promising avenue here; see, for example, Adrian et al. (2019) and Prasad et al. (2019).

8.2.2 Measurement of systemic risk Beyond the measurement and forecasting of the financial cycle, the triggering of macroprudential tools of a structural nature – in particular systemic capital buffers or surcharges on institutions that create systemic risk (8.3) – requires an explicit measurement and quantification of systemic risk as a whole. This is also a step in understanding the mechanisms underlying systemic risk (Chapter 1). As noted by Hansen (2012), a systemic risk indicator is intended to help in the definition of MaPs and therefore needs to be consistent with a systemic risk model for proposing alternative remedies. Quantification therefore appears as a necessary condition of a scientific approach, i.e. of confronting economic facts. However, in the absence of consensus on a common model of systemic risk, purely descriptive models should not be rejected outright. The GFC has led to a proliferation of indicators of systemic risk. The situation thus changed radically from the beginning of the 2000s, when academic articles highlighting the existence of systemic risk could be the subject of an almost exhaustive survey (de Bandt and Hartmann, 2000). Today, it is no longer possible to present in detail the many indicators that provide a quantitative measure of systemic risk, and the reader can consult the various syntheses available (de Bandt and Hartmann, 2000, 2019; Billio et  al., 2010; Bisias et al., 2012; ECB, 2012) for additional references. After an overview of the available models for measuring systemic risk (8.2.2.1), a review is presented (8.2.2.2).

8.2.2.1 Measures available It is convenient to distinguish between indicators that focus on institutions  – banks or insurance – (8.2.2.1.1), those related to market infrastructures (8.2.2.1.2), those that measure interconnections within networks (8.2.2.1.3), and synthetic indicators (8.2.2.1.4).

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8.2.2.1.1 Institutions A number of indicators measure the contribution of individual institutions to overall systemic risk. There is a fundamental difference between indicators based on market data available in real time and those derived from detailed accounting data, often of regulatory origin and sometimes subject to confidentiality constraints. On the basis of market data, economic literature proposes extreme value indicators since the work of Hartmann et al. (2005). More recently, statistics based on conditional value-at-risk (VaR) have emerged, with a distinction between “systemic fragility” indicators that measure the impact of a systemic shock on a given institution and “systemic significance” indicators, which assess the impact of an institution on the rest of the financial system. It is this last notion that Adrian and Brunnermeier (2016) seek to measure by proposing a value- at-risk (CoVaR) contagion indicator that measures the maximum decline that bank stocks can experience in 5% of cases when the share price of a given bank experiences a decline that can only occur with a probability of 5%. The ΔCoVaR then measures the difference between this conditional VaR in a situation of market stress and VaR in a normal situation. CoRisk is an indicator proposed by the IMF; its mode of construction is identical to that of CoVaR but the indicator is not on the equity market but on the debt market, via the credit default swap (CDS) spreads. Measuring “systemic frailty”, Acharya et al. (2012) extend the notion of expected shortfall and calculate a Marginal Expected Shorfall (MES), which is the expected return on an institution’s assets when the market as a whole reaches its lower outcomes (5% of occurrences). Taking into account the leverage of the institution, it is possible to infer recapitalization needs. It is also the intuition of the Systemic Expected Shortfall (SES) of an institution that measures the propensity to be undercapitalized when the system itself is undercapitalized as a whole. The original idea of the MES was combined with techniques proposed by Brownlees and Engle (2011) to lead to the indicator SRISK. It measures the amount of capital an institution should raise in the event of a crisis. All these indicators are available on the New York University website (V-LAB, 2012). Jobst and Gray (2013) develop an analysis in terms of contingent claims, based on the work of Merton (1973). They use stock market prices and the Black-Scholes option pricing techniques to measure the price of a theoretical put option for bank assets, which they compare to CDS premiums. The difference between the two is the implicit guarantee of the government, since the latter is only included in the listing of the CDS. The sum of the guarantees provides a measure of systemic risk. Regarding accounting data, the systemic risk identification work was produced on the initiative of the Financial Stability Board (FSB; Chapter 10) in order to identify the major financial institutions generating systemic risk (Systemically Important Financial Institutions or SIFIs; Box 8.1), for both G-SIBs and Global Systemically Important Insurers (G-SIIs). There is not only an issue of measuring the overall systemic risk, but also the contribution of the different institutions. While it

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may be convenient to have additive measures, whereas each institution contributes a fraction of the overall risk, the underlying assumption of linearity is objectionable. Moreover, it should be emphasized that such a measure is necessarily relative, since an institution is systemic only in a given financial system. One consequence is that it is not possible, with these types of indicators, to assess the impact of macroprudential measures that would change the structure of the international financial system. However, at this stage, there is some consensus regarding G-SIBs, while the measurement is more controversial on the insurance side (Box 8.1). Greenwood et al. (2015) model the effects of sell- offs (Chapter 1) of sovereign securities using data published by the EBA (Chapter 10). They distinguish between banks’ contribution to systemic risk and exposure to it. Brunnermeier et al. (2011) propose a “topography of risk” indicator based on banks’ liquidity needs, where balance sheet items are weighted according to their liquidity level. In addition to the accounting data, the calculation of the indicator requires data to be collected by supervised institutions through surveys. 8.2.2.1.2 Market infrastructures For market infrastructures, the measure of systemic risk refers to the structural rather than the temporal dimension, i.e. the assessment of resilience to shocks. On the one hand, there is the question of the management of margin calls, which may themselves have a procyclical aspect (Chapter 6). Usual practices in that area depend on the rules specific to each infrastructure. On the other hand, there is the question of the optimal organization of clearing houses, given the existence of an arbitrage between counterparty risk and concentration risk in the event of default by the clearing house. From this point of view, Galbiati and Soramaki (2012) describe the topology of the settlement systems. They show that the best topology depends on the objective pursued: the most concentrated systems (i.e. which have a larger market share), with the lowest number of central counterparties (CCPs) having the highest netting ability. But there is an arbitrage between netting capacity in normal times and resilience to extreme shocks. 8.2.2.1.3 Indicators for measuring interconnections in banking networks In general, in interbank networks, the measurement of systemic risk is based either on descriptive indicators of the topology of the network or on the measurement of the degree of contagion. Many studies use descriptive methods adapted from sociology (study of social networks) and graph theory to derive a measure of systemic risk (van den Brink and Gilles 2010; De Castro Miranda et al., 2012; Battiston et al., 2012). Other indicators are based on the modelling of actors’ behaviour and contagion mechanisms. Gouriéroux et al. (2012) propose a methodology for distinguishing between the direct effects of solvency shocks and contagion. They show that some networks are very resilient to some types of shocks, but not others.

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Other works focus on contagion based on liquidity and refinancing institutions, such as Cifuentes et al. (2005) and Arinaminpathy et al. (2012). Alves et al. (2013) analyse solvency and refinancing shocks on the network of the 53 major European banking groups, and Fourel et al. (2013) study the French interbank market. Other works focus more on calibrating shocks to derive contagion indicators. For example, Cont et al. (2013) define a default impact and contagion index that measures the capital loss for an institution following a shock. 8.2.2.1.4 Synthetic indicators The last category of indicators considers several dimensions at once, including imbalances in the financial markets: −

−

−

Hollo et al. (2012) develop a composite indicator of systemic stress (CISS), which measures stressed situations in a contemporaneous way. The indicator is essentially based on data from five sub-markets: financial institutions, bond markets, money markets, equities, and currencies. It gives more weight to situations, characteristic of systemic events, where stress is simultaneous in several markets. Billio et  al. (2010) measure systemic risk through contagion between the banking, insurance, and hedge fund sectors, evaluated on the basis of Granger causality between returns. Kritzman et al. (2010) construct an absorption ratio representing the portion of the variance of returns that is “absorbed” by a fixed number of eigenvalues in a principal component analysis. They measure the extent to which markets are correlated.

Also of note is the extensive literature on Early Warning Systems, which measure in a coherent and systematic statistical framework the properties, in terms of leading indicators of future crises, of macroeconomic variables, taken individually or simultaneously. This research builds on the work of Kaminsky and Reinhart (1999). An overview of recent contributions is provided by the ECB (2012). An illustration is provided by Detken et al. (2018). Among interesting approaches, one can note that: − −

−

−

Schwaab et al. (2011) use credit risk mismatch versus fundamentals as a leading indicator of systemic risk. To do this, they use a latent-variable model of credit risk. Jahn and Kick (2012) construct a financial stability indicator for German banks from 1995 to 2010, and provide evidence of the interest of monetary and asset price variables and indicators of the business cycle. Babecky et al. (2012) build a leading indicator for developed countries. They show that credit growth, capital inflows and rising short-term interest rates are leading indicators of banking crises over the period 1970–2010. Barone-Adesi et al. (2011) argue that systemic risk originates from a change in “sentiment,” which they measure as a component of asset prices. They suggest following this “sentiment” indicator, which is correlated with changes in economic fundamentals.

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Box 8.1 Identification of systemic risk for major financial institutions Under the leadership of the FSB, the Banking Supervision Committee (BCBS) and the International Association of Insurance Supervisors (IAIS) have put in place common methodologies for the identification of large financial institutions generating systemic risk (SIFIs). Four indicators are common (size, interconnection, non-substitutability, crossborder activities). To take into account the specificities of insurance, the FSB and the IAIS have increased the weight of so- called “non-traditional” activities, a criterion that replaces the complexity criterion chosen for banks. These are essentially complex activities exposing insurers to specific financial risks.

TABLE 8.2 Systemicity indicator for banks and insurance groups

Indicators

I Cross-border ­ activities



Systemic banking groups (2018 Systemic insurance groups (2016 methodologya) methodologyb) Sub-indicators ­

Weighting Sub-indicators ­

Cross-border ­ claims

20%

Weighting

Revenues derived 5% outside the country of origin

Cross-border ­ liabilities

Number of countries where the company is located

Total exposures 20% (Basel III leverage ratio)

Total assets

5%

Total revenues III Interconnection Intra-financial ­ system assets

20%

49.3% A. Counterparty exposure (26.8%) A1. Intra-financial ­ assets

Intra-financial ­ system liabilities

A2. Intra-financial ­ liabilities

Securities outstanding

A3. Gross or net technical provisions in accepted reinsurance (indicator in level) A4. Derivatives

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Indicators

Systemic banking groups (2018 Systemic insurance groups (2016 methodologya) methodologyb) Sub-­indicators

Weighting Sub-­indicators

III Interconnection (continued)

I V Non-­ substitutability

Weighting

B. Macroeconomic exposure (22.5%) B1. Derivative trading B2: Financial guarantees (indicator in level) B3: Minimum guarantees on variable products Additional indicators: large exposures; intragroup commitments, derivative trading (excluding hedging and replication) Assets under custody

Transactions through payment and settlement systems Underwritten transactions in debt and equity markets (50%)/trading volume (50%)

20%

Gross premiums written on specific business catastrophe, credit, aviation and marine risks

5%

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Indicators



Systemic banking groups (2018 Systemic insurance groups (2016 methodologya) methodologyb) Sub-­indicators

Weighting Sub-­indicators

Weighting

Notional value of OTC derivatives

20%

35.9%

1. Non-policy ­ holder liabilities and noninsurance funding (7.5%)

Tier 3 assets (unlisted shares, etc.)

2. Short-term ­ funding (7.5%)

Value of trading portfolio and available-for­ ­ sale assets

3. Level 3 Assets (6.7%) 4. Turnover (6.7%) 5. Liability liquidityb (7.5%)

a https://www.bis.org/bcbs/publ/d445.pdf; https://www.iaisweb.org/file/61179/updated-g-sii­ ­assessment-methodology-16-june-2016. ­ b To measure policy holders’ propensity to surrender.

For banks, the methodology adopted and published in November 2011 by the Basel Committee consists in calculating for each bank a systemicity indicator as a weighted average of the criteria in Table 8.2, then classifying the institutions according to their level of systemic importance. G- SIBs are those institutions that exceed a certain threshold of systemicity. Most indicators are defined as a ratio, i.e. the ratio between the value of the indicator for this bank and the total value of this indicator for all banks in the systemic universe. The ratio is therefore interpreted as a measure of individual bank’s contribution to overall systemic risk. Banks have been publishing the value of their own ratios since 2014. The list of some 30 banks initially identified as G- SIBs on the basis of the Basel Committee’s methodology was first published in November 2011 by the FSB. This list is updated and published annually. There are other more sophisticated methods developed in the academic world that seem less operational. Brownlees and Engle on the basis of the indicator SRISK (V-LAB, 2012) establish such a ranking, but using market variables as basic indicators. They get fairly close results to the one published by the Basel Committee, but their indicators are very volatile over time. In addition, Huang et al. (2011) show that the contribution of banks to systemic risk is linearly related to their default probability, but in a non-linear way to their size and the

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correlation of their assets. Benoit et al. (2019) suggest aggregating “standardised” sub-indicators (i.e. once they have been divided by their standard deviation). For insurance, a similar list was published annually between 2013 and 2016, but given the lack of consensus among jurisdictions, the IAIS has not issued any list since then. In addition, the methodology has evolved, first with an emphasis on the “Activity Based Approach”, focusing on the systemic nature of some “non-traditional” activities like banking products (as opposed to the “Entity Based Approach”, described above and based on indicators). The current approach is more “holistic” with a view to assessing the systemic consequences of the default of one entity.

8.2.2.2 Assessment What about these indicators and to what extent are they useful for triggering macroprudential instruments? First of all, it is possible to note that most of these indicators are measured in partial equilibrium and not in general equilibrium, as would be required by a truly macroprudential approach or, more generally, any approach aimed at evaluating public intervention. Second, they are based on a number of assumptions that have been challenged by macroprudential analysis and often also by modern finance. This is the case of the hypothesis of normality in the distribution of shocks and asset returns, the non-inclusion of regime changes and excessive reliance on the patterns of the past. In addition, these different indicators sometimes provide divergent signals. Rodriguez-Moreno and Pena (2013) show that the simplest indicators, such as those taken from the CDS market, are the best performers. Benoit et al. (2014) compare the information content of ΔCoVaR, SRISK, and MES. They show that the MES does not discriminate between institutions, ΔCoVaR providing little information in relation to VaR. As a result, they suggest using SRISK. Castro and Ferrari (2012) also show that ΔCoVaR does not establish a hierarchy between systemic banks. Indeed, the indicators are calculated in relation to a benchmark that varies (i.e. the market for bank shares to the exclusion of the bank in question) and inconsistencies may appear: by comparing banks two by two. As a result, a higher level of the indicator is not necessarily associated with higher systemic risk, which does not allow using it in an operational way. Overall, it is possible to summarize the advantages and disadvantages of balance sheet data in relation to market data (8.2.2.2.1), and of the usefulness of indicators according to whether they are advanced or coincident (8.2.2.2.2) or still capable to trace contagion (Chapter 1) rather than standard transmission of shocks (8.2.2.2.3). 8.2.2.2.1 Benefits and drawbacks of balance sheet data with respect to market data Many systemic risk indicators are calculated with market data due to the inability to use confidential information collected by supervisors. Both types of data have advantages and disadvantages. Market data are available quickly, but they may be very volatile, hence resulting in potential volatility in the systemic risk

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assessment (Cerutti et al., 2012). Accounting data provides detailed information, but is available with a lag. The contribution of market data for supervision has been studied by Gropp et  al. (2004) as well as Curry et  al. (2008), which show that they constitute useful information. In contrast, Furlong and Williams (2006) conclude that information derived from market data is not very significant. Berger et al. (1998) compare the valuation of large US banks by supervisory authorities and by the market. They conclude that the two types of information are complementary, but that supervisors’ assessments are more accurate when they are associated with onsite inspections (Chapter 6). 8.2.2.2.2 Leading or coincident indicators? For systemic risk indicators to be useful, it is important that they provide an advanced signal. However, many systemic risk indicators only confirm the existence of tensions as they occur. Idier et al. (2012) study the properties of the MES indicator for a panel of 65 banking holding companies over 15 years. By regressing the MES on bank balance sheet indicators, they show that the MES is fairly well explained by these variables, which suggests that the MES itself does not provide much additional information. They also show that a cross- sectional analysis of the MES before the crisis would not have made it possible to determine which ones would suffer the most. They conclude that traditional bank balance sheet indicators are better able than the MES to predict future bank losses. 8.2.2.2.3 Contagion versus shock transmission The notion of systemic risk goes beyond the mere transmission of shocks. However, several indicators are limited to observing correlations between variables, which are not enough to prove the existence of a systemic risk. Indeed, a return correlation can result from an integration of asset markets. On the contrary, systemic risk is associated with the notion of “regime change”. For example, in the context of a time-varying coefficient autoregressive vector model (VAR), the response functions must show a more marked and unfavourable effect in a period of crisis than in the “normal” period. This is the case for the CISS indicator as indicated by Hollo et al. (2012), and for the real estate market. Indeed, de Bandt and Malik (2010) use a Markovian regime shift FAVAR model and show that the sensitivity of local real estate prices to international property prices are stronger in times of crisis, beyond the fact that shocks to international prices have also been more pronounced during these periods.

8.2.3 Role of stress tests Stress tests are a third type of indicator useful for triggering macroprudential measures. They aim at highlighting vulnerabilities by measuring the reaction of

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the financial system, and more specifically financial institutions (banks and insurance companies), to large- scale but realistic shocks (i.e. severe or extreme yet plausible scenarios). The GFC has led to a significant strengthening of their role (BCBS, 2009). Published annually in the US since the Dodd-Frank Act (DFA) (Box 8.2), they are often carried out by supervisors in a micro- or macroprudential perspective, even if they are not necessarily published. After a review of the main principles of stress tests (8.2.3.1), the strengths and weaknesses of these tools are presented (8.2.3.2).

8.2.3.1 Main principles of stress tests Haldane et al. (2007), Borio et al. (2012), the IMF (2012b), and Hirtle (2018) provide a synthesis of the challenges of stress tests in terms of purpose (8.2.3.1.1) and implementation (8.2.3.1.2). 8.2.3.1.1 Purpose of stress tests Stress tests provide a rich and varied information on financial institutions, but behind this name, there are different types of exercises, which should be distinguished because this has consequences on the information they provide. As indicated by Hirtle (2018), stress tests are designed to ask “what if ” questions in a forward-looking way. They are not a prediction of future events, but rather hypothetical exercises intended to assess the robustness of a bank’s resources against various potential future bad outcomes. Initially, the stress tests were purely microprudential for the supervisor or internal risk management for the institution, seeking to measure the impact on solvency of shocks on assets that may arise from an adverse macroeconomic context. However, a new type of stress tests was introduced by the Supervisory Capital Assessment Program (SCAP) in 2009 in the US. At the European level, there were exercises launched by the Committee of European Banking Supervisors (CEBS), the predecessor of the EBA (Chapter 10) in 2010 and the EBA in the summer of 2011 (EBA, 2011). These were “crisis management” stress tests aimed at restoring investor confidence in individual banks (see IMF, 2012a, for a description of these exercises). Admittedly, crisis management in the strict sense is not part of the macroprudential approach, but these exercises in fact had a broader, macroprudential purpose, since, taking into account common exposures to sovereign risk, their aim was to absorb the consequences of the euro area sovereign debt crisis. Greenlaw et al. (2012) underscore that stress tests must be above all macroprudential, which implies that they must be severe, with the aim of preventing banks from being an additional channel of financial instability. The IMF (2012a) envisages four different objectives – microprudential/internal management/macroprudential/crisis management but also resolution. The comprehensive capital analysis and review (CCAR) exercises conducted annually in the US since 2011 have a micro

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and a macroprudential purpose. In addition, the Dodd-Frank Act required annual stress tests (DFAST) on bank holding companies, in order to assess the capital strength of these individual companies and the banking system based on consistent scenarios. Both CCAR and DFAST are based on scenarios defined by the Federal Reserve. However, CCAR assesses internal capital planning and allows the Federal Reserve to restrict capital distributions by these companies (Hirtle and Lehnert, 2014). Another related issue is the perimeter of the stress tests and whether they concentrate on the banking sector or whether they extend to non-banks, insurance companies but also shadow banking (see Aikman et  al., 2019b, for a system-wide approach, including key sectors of the UK financial system beyond banking). 8.2.3.1.2 Implementation of stress tests Faced with these multiple objectives, several approaches are used: −

−

−

−

“Top-down” or “bottom-up” stress test: The most important distinction is between stress tests implemented by the supervisor (top- down) and those performed by financial institutions (bottom-up). They each have advantages and disadvantages (IMF, 2012). The tests carried out by the institutions are more detailed but more heterogeneous; they reveal specific risks, but the reliability of the results depends on the institutions’ cooperation with the supervisor; they can prove costly if onsite supervisory missions are launched on this occasion. The stress tests implemented by the supervisor are more homogeneous, but they lack precision. Their quality depends on the performance of the models available to the supervisor and the capacity of the supervisor to truly leverage the cross- sectional information available to calibrate the stress tests. Macroeconomic or sensitivity stress tests: The former measure the sensitivity of balance sheets and income statements to coherent macroeconomic scenarios at a horizon of one or two years; the latter measure the effects of mono-factor shocks, more precise and in the shorter term (a few days or a few months), in line with the internal management of the institutions. Solvency or liquidity stress tests: Solvency continues to play a central role (Schmieder et  al., 2011), particularly with regard to corporate credit (de Bandt et  al., 2019). But liquidity is an area of increasing importance (de Bandt et al., 2020) and the ECB conducted a sensitivity analysis of interest rate risk in the banking book in 2017 and a sensitivity analysis of liquidity risk in 2019.1 Market- or balance sheet-based tests: The use of market data, especially because it reflects the investor’s point of view, is advocated by Acharya et al. (2017) and the IMF (2012b). The fair value model can lead, in situations of strong information asymmetries not taken into account by investors, to exacerbating the perception of the crisis (Chapter 4).

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−

−

−

Static or dynamic tests: The usual convention of stress tests is to study whether the current situation of banks can create vulnerabilities, which excludes any strategy of reaction of banks to shocks; however, this assumption is sometimes considered as unrealistic in macroeconomic stress tests for one or two years. “Crash tests”, “reverse” stress tests or long-term tests on the “business model”: More and more stress tests are trying to assess the long-term resilience of the institutions, especially on the viability of their business model; reference is also made to “reverse” crash tests or stress tests as measures of the maximum shock that a given bank can sustain without failing. This may also include climate change stress tests (Chapter 11) which may look at scenarios over a longer horizon. Point or distributional stress tests: Rather than considering a few ad hoc selected scenarios, it may be interesting to consider all the risk configurations, i.e. the entire distribution of shocks (Breuer and Csiszár, 2013).

Hirtle (2018) describes the choices made by US authorities in the context of SCAP/CCAR and DFAST: stress tests are based on regulatory capital ratios in order to be consistent with the broader regulatory regime. The guiding assumption is that a bank’s balance sheet and the nature of its exposures do not change over the stress test horizon. The supervisory estimates do not embed behavioural responses to the stress scenario, including additional risk mitigation or changes in business strategy. In addition, banks are assumed to maintain credit supply even as economic conditions deteriorate.

8.2.3.2 Strengths and weaknesses of stress tests Stress tests appear as an essential element of the prudential landscape and therefore of the information available for triggering macroprudential measures. Philippon et al. (2017) provide evidence that EBA stress tests are informative and unbiased predictors of realized bank losses as well as equity returns around announcements of macroeconomic news. Hirtle et al. (2016) demonstrate that a top-down stress test based on a macroeconomic scenario, like the one that played out in 2007–2008, would have predicted a significant capital shortfall in the US banking system as early as 2004. However, stress tests would have had to cover the entire financial system: broker- dealers; commercial paper, repo, and derivative markets; specialized investment vehicles (SIVs); and other conduits (Chapter 2). However, many criticisms were addressed to stress tests, and several proposals were made for evolution. With regard to the role of the communication of stress tests for macroprudential purposes, the May 2009 SCAP exercise in the US has, in the view of most observers, effectively reduced tensions and facilitated the recapitalization of banks (IMF, 2012). The publication of individual information during the stress tests was an innovation of the CEBS/EBA and SCAP/CCAR exercises (Acharya

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et al., 2013). Petrella and Resti (2013), based on a study of events, conclude that the EBA stress tests in 2011 provided useful information on banks. On the other hand, many criticisms have been expressed regarding stress tests. First, the publication of stress tests triggered controversy because it did not prevent subsequent bankruptcies (Borio et al., 2012; IMF, 2012; Acharya et al., 2013). This was the case, for example, of Icelandic banks that went bankrupt just after successfully passing stress tests conducted by the local supervisor (Borio et al., 2012). The same is true for the Irish banks in 2011 and the Dexia bailout in October 2011, whereas the stress test concluded that these institutions were not unfunded in July 2011. Similarly, all US banks that went bankrupt in 2008 also had capital ratios largely in excess of prudential ratios. Then, some basic criticisms were made about the models used and the practice. Alfaro and Drehmann (2009) show that stress tests were unable to anticipate past crises and to take the bad risks into consideration. There was also an inability to identify all channels of transmission (IMF, 2012). A number of structural causes explain the weak performance of stress tests. Borio et al. (2012) show that recent crises have not been preceded by a deterioration of fundamental economic factors. There is also the problem of regime change with the crisis, which makes the use of models estimated on the pre- crisis period difficult. There are also doubts about the ability of stress tests to integrate all risks or to measure them accurately. Acharya et al. (2013), based on their SRISK model (8.2.2.1), show that losses calculated by SRISK are consistent with stress tests. On the other hand, the recapitalization needs of the 2011 EBA financial year would have been underestimated, in terms of solvency ratios even more than of leverage ratios. Using the method of Acharya et al. (2012), the required capital risk weights from stress tests appear to be too low, which the authors interpret as a behaviour of optimization of prudential ratios by banks. However, the empirical evidence for this conclusion, like the previous one, is based on the reliability of the SRISK model. This model uses market data that incorporates the most recent information, including bankruptcy episodes. However, it remains to be demonstrated that the SRISK model provides better information than stress tests and therefore is a good measure of recapitalization needs. In addition, as noted above, the SRISK indicator is highly volatile over time, making it impractical to calibrate MaPs. More generally, there is the issue of comparability in time and space of stress testing exercises. Indeed, the severity of the shock depends on the context (the same shock is more severe in an economy in recession). All in all, it appears necessary to complement the stress tests in order to make these exercises more relevant. A crucial feature for supervisors is to build the necessary infrastructure in terms of models in order to be independent from the institutions that are supervised (Camara et al. 2015; Dees et al., 2017; Hirtle, 2018). One of the most promising avenues, beyond the need to better take into account “second round” effects (Bruneau et al., 2012; Dees et al., 2017), in particular in connection with fire sales (Cont and Schaaning, 2017), and to deepen liquidity

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stress analysis, is to better integrate stress tests into the internal management of financial institutions.

8.3 Intermediate objectives and instruments A large number of intermediate objectives and instruments have been proposed to implement MaPs (8.3.1), but it is still too early to make a full assessment of their effectiveness (8.3.2).

8.3.1 A plurality of intermediate objectives and instruments In view of the broad objective of MaPs, it is useful to define intermediate objectives (8.3.1.1) and associated instruments (8.3.1.2).

8.3.1.1 Intermediate objectives There are many intermediate objectives of MaPs in the literature. Houben et al. (2012) establish a parallel between different intermediate objectives of the European Systemic Risk Board (ESRB), the CGFS and the Bank of England. Houben et al. (2012) get the following taxonomy, distinguishing between: − − −

Limit leverage and excessive credit growth (including transformation risk); Avoid imbalances in liquidity, in order to avoid public bailout; Increase the resilience of market infrastructures; limit interconnections, concentration of risks and fight TBTF.

The ESRB (2018) develops more fully these objectives in a comprehensive framework, introducing the prevention of maturity mismatch, the limitation of exposure concentration as well as misaligned incentives, creating moral hazard. Regarding a possible hierarchy between these objectives, several policymakers focus on the objective of resilience of institutions as opposed to “leaning against the wind” policies (Chapter 9), given uncertainties in achieving the latter intermediary objective. These intermediary objectives are quantified on the basis of the statistical indicators reviewed above (8.2). As indicated by Buch et al. (2018), the challenge for research is to identify the most relevant subset of indicators, or intermediary objectives.

8.3.1.2 Macroprudential instruments From the outset, it is important to highlight two features of macroprudential instruments. On the one hand, most of them are microprudential instruments used to achieve macroprudential objectives (IMF, 2011; ESRB 2018). This is particularly the case for capital buffers, which play a major role among macroprudential

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instruments (De Nicolo et al., 2012). On the other hand, there is no preferred instrument but a taxonomy of instruments (Galati and Moessner, 2011; Hanson et al., 2011; Lim et al., 2011), which also includes non-prudential instruments such as monetary as well as fiscal policy (Chapter 9). Within this “toolbox”, a distinction can be made between instruments that act on prices or on quantities, those that are reactive or preventive by signalling the concerns of supervisors (CGFS, 2010), aggregated or sectoral, countercyclical, or structural. Aikman et al. (2019) distinguishes between tools to reduce leverage, tools to reduce funding mismatches, notably the liquidity ratios (Chapter 6), and tools to reduce the build-up in household debt. The following analysis is based on the distinction between (8.3.1.2.1) countercyclical instruments, and (8.3.1.2.2) structural and cross- sectoral instruments. 8.3.1.2.1 Countercyclical instruments 8.3.1.2.1.1 Provisioning modes The instruments in this area are based on the experience of the Bank of Spain, which has implemented dynamic provisioning rules since the mid-2000s. Taking into account the dynamics of losses in the past enables the making of provisions in the higher phase of the cycle, when the institutions accumulate risks, so that the institutions constitute a level of provisions which is roughly constant over the cycle. It is possible to link this tool to International Financial Reporting Standard (IFRS) 9, implemented in 2018, with a view to moving to a model of provisions based on expected losses rather than actual losses. 8.3.1.2.1.2 Restrictions on the distribution of dividends When a bank has a solvency ratio greater than the minimum but below the target ratio, restrictions on its ability to distribute dividends can be put in place. The purpose of the “conservation buffer” introduced in Basel III is to set up a capital target ratio higher than the minimum requirement, the difference between the two having been set at 2.5% in terms of the solvency ratio. 8.3.1.2.1.3 Countercyclical capital buffer In an explicitly macroprudential manner, the CCyCB is a capital requirement that increases in the upper phase of the financial cycle and can be reduced after the outbreak of the financial crisis. It applies at the same time to all banks in a given jurisdiction. This countercyclical buffer is activated and deactivated according to a set of relevant indicators, as defined by the national macroprudential authority,2 which can vary according to the countries and over time. The measure may cover all the capital or certain components. Hanson et al. (2011) point out, however, the limit of this instrument, namely that in times of crisis, investors want banks to increase not to decrease their capital. As it is difficult to issue good quality capital at that time, the intuition is to set the constraint at the top of the cycle very clearly above what investors require at the bottom of the cycle.

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In addition, there is an issue of international leakages or inter-country arbitrage if the measure is uncoordinated at the international level (8.4). In 2018, 12 EU countries had activated the CCyCB, with a non-zero buffer (ESRB, 2018). Two-third of EU countries had implemented the CCyCB by 2020, including UK, France, and Germany. 8.3.1.2.1.4 Instruments specific to real estate market and credit distribution Given the importance of the real estate market, which accounts for a significant portion of household investment and banks’ financing of the economy, while there are large fluctuations in real estate prices, many macroprudential instruments aim either at strengthening risk management by financial institutions in this area or at weighing on the supply of mortgage loans. In the first case, the risk weights for real estate risk or any other sectoral risk can be modified cyclically in order to constrain credit supply. In the second case, constraints can be imposed on the distribution of credit at the individual level of customers: upper limits on loan-to-value (LTV) or loan-to-income (LTI; Crowe et  al., 2011). Aikman et al. (2019a) focus on the latter types rather than on minimum down payment (LTV) restrictions. They do so because the impact of the latter may have been limited by the twin nature of the household debt and house price booms (i.e. flat LTV ratios may miss the underlying increase in indebtedness when house prices increase too, a situation observed in many countries before the GFC, 3 and even after the GFC in some countries). The authors’ conclusion is that the impact LTI increases in a housing boom may be small, so that a macroprudential regulator determined to reduce a rapid build-up in household debt might wish to take additional actions. Indeed, as a complement to LTI limits, some macroprudential authorities, aiming to enhance the resilience of household sector balance sheets, implement also affordability tests, which require lenders to assess borrowers’ capacity to service debt in different circumstances, in particular under different interest rate and employment scenarios (as discussed in Bank of England, 2017, Box 5, p. 13). In addition, countries like Switzerland have implemented a CCyCB targeted at the real estate sector ( Ferrara et al., 2018). Increasing the capital cost on specific types of exposures, like real estate, is also possible in the EU under the new framework for the Systemic Risk Buffer in CRD5 (see below). 8.3.1.2.1.5 Concentration limits from a macroprudential standpoint Large exposures restrictions are usually tools of a microprudential nature.4 These restrictions can be tightened for a macroprudential purpose. Restrictions on intra-financial exposures can be imposed using Article 458 of the CRR (see above footnote in 8.3.1.1). They may target both direct exposures and excessive (indirect) interconnectedness among financial institutions, thereby reducing contagion risk. The French Financial Stability Council (HCSF) activated such an instrument in December 2017 to reduce bank’s individual exposures to large corporate entities to 5% of bank’s capital instead of 25%.

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8.3.1.2.1.6 Macroprudential instruments in the field of insurance In the insurance sector, the European regulation Solvency 2 (Chapter 6) provides a mechanism whose logic is of the same type as the “capital buffer” for banks, even if the details differ. In the case of Solvency 2, the “minimum capital requirement” (MCR) establishes a level of capital requirement that institutions must meet at all times and the “solvency capital requirement” (SCR) a capital requirement that institutions must generally meet but which may temporarily not be met. If the solvency ratio of an institution is temporarily below the SCR, the institution must take corrective measures to comply with the SCR again within a few months in normal situations, and a little longer in periods of particular tensions in the financial markets. Beyond the long-term measures (Chapter 6), the EIOPA and the ESRB discussed for the EU different macroprudential measures, distinguishing between (i) instruments already available in Solvency II with a macroprudential impact (EIOPA, 2018a) and (ii) new instruments that could be defined and which are adaptations to the insurance sector of similar instruments used in the banking sector, in terms of capital, liquidity, or exposure-based tools (EIOPA, 2018b). In addition, in some countries, macroprudential authorities may introduce a temporary suspension of convertibility on life insurance contracts. While supervision authorities usually have the power to suspend the convertibility of individual contracts, the Sapin law of 2016 for France granted such a power to suspend convertibility market-wide to deter waves of surrenders of insurance contracts. 8.3.1.2.2 Structural instruments The best-known structural measures concern large financial institutions generating systemic risk and risk management in market infrastructures. But other structural instruments are also used. 8.3.1.2.2.1 Capital buffer on systemic financial institutions As a result of the work of the FSB (Chapter 10) to identify major financial institutions that generate systemic risk, additional capital requirements are required from these institutions. For banks, systemic capital buffers, consisting of common equity Tier 1 (CET1), are required for G- SIBs (BCBS, 2011). Depending on the ranking in the G- SIB list, this surcharge varies between 1% and 2.5% of risk-weighted assets (RWA). Banks that reach a level of systemic importance higher than those observed today would even be subject to a surcharge of 3.5%. In addition to heightened supervision, these measures are expected to be complemented by resolution procedures in the event of bankruptcy. Other measures might include stricter control of major exposures or risk concentrations of G-SIBs. The BCBS and FSB also distinguish systemic institutions on the basis of their global or domestic reach. In the first case, they are G- SIBs, while in the second case, systemicity is only assessed at the domestic or national level (they are called “domestic- SIBs” or D- SIBs).

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These measures have been transposed in CRD4/5. Requirements for specific capital buffers are mandatory at the global level for G- SIBs (they are called SIIs, for Systemically Important Institutions in EU texts), but they are optional for D-SIBs (OSIIs for “Other Systemically Important Institutions” in EU texts). The latter buffer on OSIIs is capped at 3% in CRD5 (or even higher, if approved by the EU Commission), as compared to a general ceiling at 2% in CRD4. The systemic risk buffer, a non- cyclical instrument (see next section), and the buffers applicable to SIIs are generally not cumulative: only the most important of the three buffers applies. Similar measures can be applied to systemic insurance companies, particularly for non-traditional or non-insurance activities (Box 8.1). In addition, one could in theory consider additional requirements in terms of liquidity. Regarding liquidity requirements, Ferrara et al. (2018) suggest to require “significant banks” (8.2.2.1) to hold more liquid assets than the other banks. 8.3.1.2.2.2 Systemic risk buffer Under CRD 4, Member States have the possibility of introducing an additional Tier 1 capital buffer to cover non-cyclical systemic risk. Member States have the capacity, without prior authorization from the European Commission, to apply systemic risk buffers ranging from 1% to 3% for all exposures and up to 5% for national and country exposures. For activities performed outside the EU for which the macroprudential authorities consider that there is a risk for the whole group, they may even impose larger buffers with the prior authorization of the European Commission. If a Member State decides to impose a buffer of up to 3% for all exposures, this buffer must be the same for all exposures located in the EU. With CRD5, the SRB may be implemented on a subset of exposures, like residential or commercial real estate in a specific country, or non-financial exposures outside real estate. 8.3.1.2.2.2 Instruments to increase the resilience of market infrastructures and oversight of OTC derivative contracts In many countries, central clearing is mandatory for most standardized derivatives (Ingves, 2013; Chapter 5). 8.3.1.2.2.3 Regulation of the shadow banking sector Several instruments are available to limit the risks posed by the shadow banking system (Chapter 2). Among them is the possibility of imposing haircuts on collateral, which vary in the event of a crisis for securitized products.

Box 8.2 The Dodd-Frank Act Following the outbreak of the financial crisis, the US adopted a broad financial reform with the Congressional vote of the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA), promulgated on 26 July 2010. The DFA places stricter regulations on lenders and banks in order to protect consumers.

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The implementation of a 2,319-page document required the adoption of 236 enforcement measures, each of which is several hundred pages long, by the regulators concerned. In addition, as with other laws, these implementing measures can only be adopted after a complex validation process involving the conduct of assessment work by the regulator leading to a proposal, the submission of this proposal to public discussion for a period of 30–60 days, the response to these comments and enactment of an amended rule. That rule may be invalidated by the courts if it does not sufficiently take into account the relevant comments, while of course remaining in accordance with the intentions of the legislator. They are published with a date for entering into force. Eight years after its enactment, only about 70% of the measures planned by the DFA had been adopted (Mason et al., 2018).

At the institutional level (Chapter 10), the DFA has created the Financial Stability Oversight Council (FSOC). The FSOC is chaired by the Secretary of the Treasury. Its other members represent the various regulators (Federal Reserve, Federal Deposit Insurance Company (FDIC) in charge of deposit insurance, Securities and Exchange Commission (SEC) in charge of financial markets, etc.). The FSOC has three missions: to identify financial institutions that generate systemic risk (SIFIs – see Box 8.1), a mission challenged by the Trump administration; protect taxpayers against the losses investors would incur in securities issued by these institutions; and respond to emerging threats to the stability of the US financial system. FSOC guidelines are implemented by regulators, but the FSOC can also make decisions. In particular, the FSOC may, by a two-thirds majority, decide to close a SIFI (8.2.2.1) in an orderly manner if it considers that this decision is likely to preserve financial stability (in the case of Lehman Brothers, this decision was implicitly taken by the Fed in consultation with the Treasury). Moreover, the qualification as SIFI carries obligations such as increased requirements in terms of incentives (disclosure of information, issuance of contingent capital, drafting of resolution plans; Chapters 4 and 7) and management standards (capital, liquidity and leverage; Chapter 6). It was noted, however, that the FSOC approach to systemic risk focused excessively on individual companies and not enough on their exposures to common risks or interconnectedness (Krainer, 2012). Another important institutional provision of the DFA was to entrust the Fed with a new financial stability mandate, with a vice president in charge of supervision who is required to report twice a year to the Congress. In charge of regulating and supervising the main banking and nonbanking institutions, the Fed is at the centre of the US financial stability system. The Fed is in charge of implementing and publishing stress tests every year (the so- called “DFA stress tests”). On the other hand, for the purpose of transparency and clearer assignment of fiscal and financial stability responsibilities, the Fed has imposed new obligations. Among them

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is the obligation to lend only to general categories of borrowers capable of providing guarantees of good quality and no more to individual banking or non-banking firms that present a substantial risk of bankruptcy, as it did in 2008 in favour of the insurer AIG. Another obligation is to make public after two years the list of all the beneficiaries of its loans as well as the amounts and conditions attached. Finally, the Consumer Financial Protection Bureau  –  hosted by the Fed, the Office of National Insurance and the Office of Credit Rating Agencies – was established. Only the Office of Thrift Supervision (OTS), previously responsible for the supervision of savings banks, disappeared. One of the best-known provisions of the DFA is the introduction of the “Volcker rule”, which limits the ability of banks to engage in transactions considered as risky (Chapter 5). Proposals by the Trump administration challenged the compliance rules: instead of assuming that positions held less than 60 days count as proprietary trading unless proven otherwise, specific tests were suggested; in addition, the range of activities banks are allowed for liquidity management would be expanded (Financial Times, 20 August 2019). Among the other measures, the DFA provides in particular: −

−

−

In order to limit the moral risk associated with TBTF (Chapter 1), the prohibition to merge for two financial institutions whose total liabilities would exceed 10% of those of their sector. Increased incentives (Chapter 4) in the area of market discipline: Requiring securitization institutions to retain 5% of risk; creation of an Office of Credit Agencies in the SEC; increased disclosure requirements for information by rating agencies to the SEC and the public; removal of references to rating requirements in public regulations whenever possible; submission to the shareholder advisory vote of the executive compensation plan and the possibility of clawback of bonus up to three years after payment in case of an accounting error. Constraints (Chapter 5) such as the obligation for investment fund managers and private equity managers managing more than 150 million of assets to register with the SEC, which may require them to provide information or even to reduce their leverage; or the obligation to clear derivatives through a CCP; possibility for market regulators to set limits on positions.

In addition to its contribution to creating a more complex financial architecture, the DFA was criticized because of the relative narrowness of its field (Krainer, 2012). In particular, the government-sponsored enterprises (GSEs) were not concerned while they played an active role in the subprime crisis (Chapters 2 and 9). Moreover, the shadow banking system (Chapter 2) is imperfectly covered and accounting standards are not mentioned. Nonetheless, the DFA is an important reform that seeks to reduce moral hazard,

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improve incentives and strengthen management standards, especially for SIFIs, thereby contributing to financial stability. However, the Trump Administration attempted to overturn some of its measures. The US president issued an executive order instructing regulators to review the DFA. In May 2018, he signed, with bipartisan support, a bill easing regulation on small and medium-sized banks (minimum assets of USD 250 billion, instead of USD 50 billion), for implementing mandatory stress tests (no longer required), and reducing loan data mortgage reporting requirements.

8.3.2 Effectiveness and limits It is not possible to make an exhaustive assessment of the effectiveness of macroprudential instruments, given the still partial and relatively recent nature of their use. However, instrument evaluation principles can be suggested (8.3.2.1) and a few examples of MaP evaluations can be reviewed (8.3.2.2).

8.3.2.1 Principles of evaluation of instruments One of the difficulties in evaluating macroprudential instruments is Lucas’ critique, which emphasizes that the behaviour of economic agents is not invariant to economic policies, and which is also, of course, relevant to prudential policies (Lucas, 1976). From a normative point of view (Chapter 4), it appears necessary to evaluate the medium-term impact of MaPs, which has not yet been done systematically, apart from a few exceptions (Lim et al., 2011; Buch et al., 2018). This requires evaluating the costs and distortions caused by these policies (additional obstacles to competition, obstacles to the free movement of capital in the EU, among others), as opposed to the benefits they provide, in terms of Cost-Benefit Analysis, as advocated by Buch et al. (2018). The coordination of instruments is also an issue, given the wide range of instruments available. If the specialization of instruments has advantages (i.e. being able to use one instrument per intermediate objective, according to de Haan et al., 2015), having a large number of instruments makes it possible to take into account specific or local situations (IMF, 2011). However, a balance must be struck between extension of the field and regulatory arbitrage; furthermore, some instruments may interfere with others, with unintended side effects. A final limitation is the need to better understand the transmission channels. In the current state of limited knowledge of these channels, it is the robustness of the instruments that should be privileged (Borio, 2011).

8.3.2.2 Applications Galati (2011) emphasized that much remains to be done to measure the effectiveness of macroprudential instruments. Several years later, not much has been made in terms of assessment. However, a number of experiments can be

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mentioned regarding usage, impact, effectiveness, costs, unintended effects and lack of instruments in some areas. Regarding usage: −

−

The IMF (2012a), based on Lim et al. (2011), provides some guidance on the use of macroprudential instruments and shows that they have a significant impact on credit dynamics. However, the analysis concentrates on the beginning of the 2000s, which was rather marked by a tightening of MaPs, while the relaxation of these policies over the period after 2008 coincided with a crisis period. Overall, it is therefore not certain that the trends uncovered by the authors can be attributed to MaPs and not just to the financial crisis. Cerutti et al. (2017) provide slightly more updated information on the usage of MaPs. The authors document the use of MaPs for 119 countries over the 2000–2013 period. Emerging economies use MaPs, especially foreign exchange related ones, more frequently than developed economies. Developed economies use borrower-based policies more than lender-based ones. Usage of MaPs is generally associated with lower growth in credit, especially household credit. Effects are less in developed economies (perhaps because circumventing MaPs is easier) and in busts.

Regarding impact: −

−

Saurina (2009) and Jiménez et al. (2017) show that the dynamic provisioning policy put in place in Spain may have contributed to the stabilization of the Spanish financial system. They demonstrate how a countercyclical dynamic provisioning smooths cycles in the supply of credit and in bad times upholds firm financing and performance. Nevertheless, it is clear that during the GFC, dynamic provisioning has made only a marginal contribution to alleviate the vulnerabilities of the Spanish banking system, due to the extent of the real estate crisis and problems of incentives in savings banks (Cajas). Darracq Pariès et al. (2011), followed by several others (Ferrara et al., 2018, among others), integrate MaP into a DSGE model. They show that an active management policy of capital requirements improves cyclical stabilization.

Regarding the effectiveness of macroprudential tools: −

For instruments targeted at the real estate market, there is overall evidence that measures directly controlling credit demand have the expected impact and that macroprudential instruments have a clearer impact on volumes (credit) than on prices. Consequently, these instruments are probably not the best ones to fight bubbles. More specifically, Alam et al. (2019) use data from 134 countries from 1990 to 2016 and find that loan-targeted instruments (especially supply-side measures such as restrictions on credit growth) have a significant dampening effect on household credit. However, Poghosyan

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−

(2019) focuses on lending standard restrictions (LTV, DSTI) implemented in 28 EU countries over 1990–2018 and finds that they are generally effective in curbing house credit and prices, albeit with a delay (the peak effect takes place after three years) and an asymmetric impact (tightening is less effective than loosening). Violon et al. (2018) provide the most comprehensive review to date regarding the effectiveness of the buffer on G- SIBs implemented at the international level. On the basis of a study of a population consisting of international banks likely to qualify as G- SIBs, they show that the implementation of the G-SIB device led, at the aggregate level, to a decline in total assets managed by systemic banks. At the individual level, the effect of the new regulatory regime was to slow the expansion of the G- SIBs’ balance sheets, without leading to a reduction in their share of lending to the economy. Nevertheless, the authors observe that, compared to other banks, G- SIBs still have access to lower-cost financing, which suggests that the implicit public support enjoyed by these banks has not been removed by this regulation.

Little is known on the costs of MaPs. However, Richter et al. (2018) find that (only) in emerging market economies, the impact of a ten percentage point LTV tightening can be viewed as roughly comparable to that of a 25 basis point increase in the monetary policy rate. In addition, there are side effects as well as unintended effects: −

−

Acharya et al. (2018) provide evidence that the introduction of LTI and LTV limits on residential mortgages in Ireland led to the reallocation of mortgage credit from low- to high-income borrowers and from high to low house price appreciation areas, cooling down house prices in these markets. At the same time, banks more affected by the limits increased their risk-taking in their securities holdings and corporate credit, two asset classes not targeted by the policy. From the theoretical side, Allen et al. (2019) highlight possibly unintended consequences of LTV limits. They develop an overlapping generation model with risk-shifting and asymmetric information. In their model, there are two assets: real estate and a productive asset. Projects are run by entrepreneurs who differ in terms of their ability to successfully run projects. Lenders cannot observe borrowers’ ability as well as whether they invest in real estate or in the productive asset. As a consequence, low ability borrowers will not run projects, but borrow and invest (speculate) in the real estate asset. Hence, less borrowing is available for productive investment by entrepreneurs. LTV restrictions imply that entrepreneurs with high ability but low initial wealth can no longer borrow; hence, more saving is directed to the real estate sector, bidding up its price. In that case, LTV restrictions have the opposite effect of the intended one.

From a general point of view, there may be a lack of instruments to control the rise of the shadow banking system, for instance, the increase of market debt

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issued by large corporates in international financial markets. In the event of a default of a large corporate, financial investors, notably asset management companies but also insurance companies, would rapidly propagate the shock to the whole international financial system. Markets authorities generally have very limited power to restrict securities and OTC issuances. The only exception is the measure on concentration limits towards overleveraged large non-financial corporates introduced by the HCSF in December 2017 (8.3.1). Although the measure was implemented by the banking supervision authority and only applies to banks, hence excludes asset management companies, which are only indirectly affected, such a measure provides evidence of the flexibility of macroprudential instruments, which also act through signalling effects, hence may also have an impact on the rest of the financial sector.

8.4 Questions related to the implementation of macroprudential policies In addition to coordination with other economic policies (Chapter 9), the implementation of MaPs poses questions in terms of communication (8.4.1), international coordination (8.4.2), and statistical information needs (8.4.3).

8.4.1 Communication and responsibility Communication on MaP is a sensitive subject, given the partly endogenous nature of financial risks. In addition, the risks are asymmetric since prudential policy errors are subject to high media coverage, while supervisory successes tend to go unrecognized (Born et al., 2010). It is important to distinguish between the decision-making process of MaP and the communication on financial stability per se. With regard to the decision rule on the implementation of MaPs, the usual debate in monetary policy on the benefit of rules over discretionary policies is echoed in the field of MaPs. Strict rules for triggering countercyclical MaPs ensure transparency and time consistency for the authorities (Goodhart, 2004).5 This remark applies not only to the definition of capital buffers, but also to the resolution of institutions. For de Haan et al. (2015), strict rules would bring not only ex ante transparency on the chosen strategy but also ex post on the way the strategy has been implemented. This requirement is all the more useful because the real cycle and the financial cycle do not necessarily coincide. This creates risks of conflict, for example, if a financial boom occurs while the real economy is in crisis (CGFS, 2012). Clear rules are easier to explain and justify (CGFS, 2010). However, a policy of “constrained” or “guided” discretion (ESRB, 2018) may also be useful because of uncertainty about the measurement of systemic risk, unlike monetary policy where the objective (price stability) is measurable (IMF, 2011; Chapter 1). The literature also highlights, in the opposite direction, an inaction bias (Houben et al., 2012; ESRB, 2018). Indeed, the gains from macroprudential

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measures, especially structural measures, are only visible in the long term and are not always quantifiable even though their costs (notably implementation and compliance costs) are immediately perceived; it is a common feature of all structural policies. In addition, these measures target distribution tails (rare events). This configuration can lead to perverse effects, such as a certain tolerance on the part of the regulator (forbearance). In this case, the use of rulebased policies should be preferred (Saporta, 2009). This may be implemented through quasi- automatic procedures to trigger an instrument on the basis of indicators (ESRB, 2018). As regards more specifically the communication from the authorities responsible for financial stability, the question of transparency arises. While it is important to highlight imbalances in the financial sector, communication should not create self-fulfilling prophecies (Libertucci and Quagliariello, 2010). Born et al. (2010) show that the publication of financial stability reviews has a lasting impact on the price of bank stocks and reduces their volatility. In the opposite direction, Cihak et al. (2012) point out that the publication of financial stability reviews has no significant impact on financial stability. Contrasting multi-agency financial stability committees with formal powers and those that rely on voluntary cooperation of other regulators to achieve their policy goals, Aikman et al. (2019a) also argue that the institutional frameworks do matter for mitigating biases towards inaction in the implementation of MaPs. The US FSOC (Box 8.1) and the UK FPC stand at the two opposite sides of the spectrum, as the former holds directly very few powers, while the FPC may rely on a wide range of tools. The FSOC is designed to facilitate information sharing between relevant regulatory agencies. Its only binding tool is the power to designate systemically important non-bank (notably insurance) financial institutions.

8.4.2 International coordination Like other open economy policies, MaPs raise the question of their coordination at the international level. Spillover effects on foreign financial systems are a consequence of the free movement of capital and the internationalization of the activities of banking groups. However, not all macroprudential measures require coordination. Indeed, real estate markets remain largely local, justifying mainly national MaPs. In the opposite direction, systemic risk created by systemic financial institutions at the global level justifies a high level of international coordination. More generally, international coordination is needed to avoid a “race to the bottom” (Chapter 10). The absence of coordination leads to several perverse effects: −

It may create “leakage” effects which reduce the effectiveness of national measures if customers rely on foreign competitors when macroprudential measures limit domestic credit supply, hence restrain banks in the home jurisdictions only. Aiyar et  al. (2014) show that for the UK, over the 1998–2007 period, UK-regulated banks reduced lending in response to a

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−

−

time-varying, bank- specific capital requirements, but non-UK regulated banks (resident foreign branches) increased lending. It favours the inaction bias, if the negative effects of national MaPs are felt only on foreign countries. In this case, the macroprudential supervisor will have no incentive to intervene to correct an unsatisfactory situation in terms of welfare at the global level. This might occur if financial institutions would face stronger pressures from the political authorities, without the macroprudential authorities opposing them in order, for instance, to maintain a high credit flow in the context of a recession in the home country. In such a case, banks might reduce the activity of their foreign subsidiaries to cope with the financing constraints they face. It leads to conflicts between home and host supervisors, which hamper good risk management within the groups, for example, if the host country requires locating the group’s capital in the subsidiary to the detriment of the rest of the group (de Haan et al., 2015).

Cooperation reduces regulatory arbitrage (IMF, 2011), for example, for the countercyclical capital buffer. A purely national measure can be circumvented by loans by subsidiaries or branches of unhedged foreign banks or by intragroup loans. At a minimum, there is a need for coordination of announcements and communication (Saporta, 2009). Due to the progress of European financial integration, the European banking union made significant progress in that direction (Chapter 10), granting macroprudential powers to the ECB in the form of “topping-up” power, whereby national measures may be strengthened by the ECB. For some macroprudential measures, there are provisions for reciprocity at the world level (Basel Committee; Chapter 10) as well as at the regional level (notably EU, for which the ESRB, Chapter 10, is in charge). Reciprocity in the macroprudential context is defined as the implementation of the same measure on the same scope by foreign authorities. It is therefore more an “acknowledgement”/ recognition of a national measure by foreign authorities. For example, following jurisdiction A’s decision to request a CCyCB on exposures to assets located in A, a decision which applies to banking groups or subsidiaries headquartered in jurisdiction A, a foreign authority in country B may decide that banks in country B also apply the same buffer to exposures in country A. In a limited number of cases, reciprocity is built into the macroprudential instrument and automatic, as for the CCyCB when the buffer is below 2.5%.6 In other cases, there may be a request for reciprocity. The ESRB is in charge of organizing reciprocity among EU jurisdictions.

8.4.3 Statistical information needs The GFC highlighted the need to improve the statistical information available on the financial system, although, as noted by Borio (2011), the lack of statistical data was not the cause of the GFC. Moreover, it is doubtful whether new data

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can better predict crises, as illustrated by the “paradox of financial stability”, namely the observation that the system never looks as robust as before a financial crisis (Hannoun, 2010). Nevertheless, the bankruptcy of Lehman Brothers showed that supervisors did not have sufficient information to understand the cross-border exposures of banks, nor to have a global view of the financial system, as confidentiality constraints prevent them from getting information about banks that they do not supervise directly. Based on the observation that supervisors did not have sufficiently detailed and high-frequency information on financial institutions, including their international exposures, the BIS and the IMF launched a large- scale project under the G20 umbrella in order to further develop available statistical data on finance, known as the “G 20 data gaps initiative”, which includes (Cerutti et al., 2012): − − −

The collection of data on international exposures. The collection of consolidated data on financial groups (balance sheet and profit and loss accounts) at the individual level. The development of a harmonized data collection framework on systemic institutions at the global level.

More than ten years after the start of the GFC, much progress has been made to release data on stress tests and on individual systemic scores, although the evaluation of MaP still requires additional granular data (Buch et al., 2018).

Notes 1 See notably https://www.bankingsupervision.europa.eu/press/pr/date/2017/html/ssm. pr171009.en/ssm.pr171009_slides.en.pdf and https://www.bankingsupervision.europa. eu/press/pr/date/2019/html/ssm.pr190206_presentation.en.pdf ?b230e12494bfaf 3740d14cce8e246d52 2 Including the ECB in the Euro area (Chapter 10). 3 Adelino, Schoar, and Severino (2017) also document the relatively stable distribution of combined LTV ratios at origination between 2001 and 2007. 4 The large exposure limit is defined at the ratio of a bank’s exposure on an individual entity (or a group) to the bank’s own funds. CRD4 sets a maximum of 25%. The exposure amount is computed as net of any collateral value. 5 Time consistency requires that whenever public authorities pre- commit, private agents believe that authorities are likely to stick to their commitment (Kydland and Prescott, 1977; Barro and Gordon, 1983). 6 CRD4 transposed in the EU law the agreement reached at the international level for Basel III. Above 2.5%, reciprocity is only voluntary.

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9 ECONOMIC POLICIES AND FINANCIAL STABILITY

To what extent may economic policies limit the cost of crises (Chapters 1 and 2)? In crisis situations, monetary policy can play a role but can also be constrained; however, in normal times, there are also interactions between monetary policy and financial stability, some of which have to be taken into account (9.1). Fiscal policy (9.2) and structural policies (9.3) may also influence financial stability.

9.1 Monetary policy The levers of monetary policy in crisis situations as well as the constraints that can bear on it are first reviewed (9.1.1). The interactions between monetary policy and financial stability are then discussed (9.1.2).

9.1.1 Levers and constraints in crisis situations The central bank has a powerful tool at its disposal in periods of liquidity crisis: it can act as lender of last resort (9.1.1.1). However, if the crisis lasts, the conduct of monetary policy can be constrained, and even possibly dominated, by fiscal policy (9.1.1.2).

9.1.1.1 Lender of last resort In periods of liquidity crisis (Chapters 1 and 2), the central bank can reduce systemic risk by acting as lender of last resort: it supplies short-term liquidity to sound financial institutions whose liquidity stress could force them to proceed to potentially destabilizing asset fire sales in order to fulfil repayments of their creditors, or to drastically restrain their credit supply. Large central banks have acted as lenders of last resort at the beginning of the GFC (Bernanke, 2008; Trichet, 2010).

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The classical lender of last resort doctrine was formulated by Thornton (1802) and Bagehot (1873). The central bank’s intervention, be it in favour of a specific institution (Goodhart and Huang, 2005) or in favour of the market as a whole (Goodfriend and King, 1988), should comply with three requirements: − − − − −

−

Liquidity should be supplied only to solvent institutions holding collateral of good quality. Loans should be granted at an interest rate, which is higher than the one prevailing before the crisis, so as to incentivize the payee to repay at the earliest. The central bank should announce its willingness to lend “freely”, i.e. without ex ante limits, to solvent institutions holding collateral of good quality. This classical approach rests on a solid microeconomic grounding: Announcing the supply of a potentially unlimited amount of liquidity is likely to stem the liquidity crisis resulting from the panic of investors or a contagion following the default of a credit institution (Diamond and Rajan, 2005). The recommendation to lend to solvent institutions at a higher interest rate than before the crisis should contain the element of moral hazard that is inherent in any public intervention (Chapter 1).

However, the classical approach has been criticized or qualified on four main grounds (Freixas et al., 2004; Cecchetti and Disyatat, 2010): −

−

−

−

The frontier between illiquidity and insolvency is blurred. Indeed, banks asking for a loan of last resort are usually deemed to be insolvent by their potential counterparties in the interbank market, since they find it necessary to apply to the central bank (Goodhart, 1987). Furthermore, Bagehot emphasized the need to provide collateral of good quality, which makes the distinction between illiquidity and insolvency less material (Goodhart, 1999). As a matter of fact, lending by the central bank only against collateral of good quality tends to exclude any lending of last resort, since a bank which is unable to get financing in the money market is unlikely to hold such collateral. Consequently, the supply of emergency liquidity would either have to take place against collateral of lower quality or not occur at all. An interest rate which is higher than the one that prevailed before the crisis should not be understood as a penalty rate, such as those observed during episodes of panic. Indeed, a genuine penalty rate would make the difficulties encountered by the ailing bank considerably worse. As a consequence, the emergency liquidity would have to be supplied at relatively benign conditions (Giannini, 1999), which would be consistent with the objective of countering the effects of panic. The theory was devised at a time when financial markets were less developed. Nowadays, the central bank could provide the appropriate amount of liquidity at an aggregate level through its refinancing operations and let the

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interbank market, which is much more sophisticated than in the times of Bagehot, reallocate it. This would stimulate market discipline (Goodfriend and King, 1988). In other words, when the markets function well, solvent financial institutions cannot be illiquid. However, Freixas et al. (2004) and Rochet and Vives (2004) point out that information asymmetries are the justification for the existence of banks, which makes Goodfriend and King’s argument less pertinent. Furthermore, if states of illiquidity and insolvency are hard to distinguish in the midst of a crisis, this means that the interbank market does not then function perfectly. As a matter of fact, as underlined by Bernanke (2008), Madigan (2009), Cecchetti and Disyatat (2010), and Trichet (2010), Bagehot’s dictum should be interpreted and adapted to the modern period. In particular: −

−

−

−

To counter a panic and a systemic risk, the central bank should stand ready to lend to a possibly wider range of counterparties than it usually does. For instance, in a situation of panic, non-banking institutions, such as money market funds (MMFs) or special investment vehicles (SIV), or else investment banks, can be victims of runs. In periods of crisis, uncertainties surrounding banks’ solvency can be heightened by their dependence on the central bank’s course of action. This makes an ex ante commitment to act as lender of last resort all the more important. The value of collateral can be lessened, up to a degree which is difficult to assess, by tensions in the financial markets rather than by an intrinsic deterioration in their quality. The interest rate at which the central bank grants liquidity can vary upon circumstances and the institutions considered.

In the same vein, Pfister and Valla (2018) propose that a new framework for the central bank acting as lender of last resort could incorporate the following three features: − −

−

First, central banks could offer liquidity support on a standing basis. Second, the interest rate on the lending of last resort facility (or facilities) could be set significantly above the policy rate or above the one on the marginal lending facility for those central banks that, as the ECB, operate a corridor. Third, to avoid that banks in need of liquidity assistance rely on standard monetary policy instruments, instead of the lending of last resort instrument(s), the list of eligible instruments accepted in the former ones could be narrowed to the highest quality instruments with the overall list remaining unchanged, thereby not reducing the potential overall provision of liquidity in comparison with the present situation.

Pfister and Valla (2018) also recommend that central banks be provided with the appropriate institutional environment (Chapter 10). In particular, putting a

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binding limit on how long the central bank can lend to any specific institution through its lending of last resort window (for instance, six months in crisis periods) could be useful. Once this limit is reached, the central bank would either appropriate the collateral posted by the institution, the management of which would be taken over by the resolution board (Chapter 7), or be reimbursed by the resolution fund of the loan of last resort previously granted.

9.1.1.2 Relationship with fiscal policy Sims (2013) points out that the consequences of the GFC – increases in debt levels in the main developed economies, sovereign debt crisis in the euro area – have highlighted the interrelations between monetary and fiscal policies. In particular, Hannoun (2012) emphasizes the risk of fiscal dominance, that is to say the risk that the sharp increase in public debt may submit monetary policy to the needs of fiscal policy, in order to alleviate the debt burden by weighing on the level of long-term interest rates, or possibly by creating more inflation than is in line with central banks’ statutes. Indeed, history offers numerous examples of episodes during which central banks have pursued ultra-accommodating monetary policies, the only effect of which was to delay an inevitable fiscal adjustment. Be it as it may, the purchases of public bonds by central banks, in the framework of unconventional monetary policy measures (UMPs; Pfister and Sahuc, 2019), reinforce the interdependence between the central bank’s and the general government’s balance sheets. Furthermore, they fuel moral hazard, since governments are encouraged to issue more debt when long-term interest rates are kept at very low levels. Finally, “exit policies”, via the reduction of central banks’ public securities portfolios, are made particularly difficult in a context of low natural interest rates and weak growth (Laubach and Williams, 2016). Indeed, such policies may put pressure on long-term interest rates, to the extent that a rebuilding of term premiums would not be offset by a fall in expected policy rates, and thus on the broader economy. Historically, the forced reduction of the debt burden can be implemented via (Reinhart and Sbrancia, 2011): −

−

A default or a debt restructuring. However, insofar as the public debt securities are largely held by financial institutions, a default could destabilize the financial system (Shirakawa, 2012 and 9.2.1). Furthermore, a default is usually followed by a period of exclusion from financial markets, forcing the issuer to self-finance or to depend on international financial institutions (Chapter 10). Or so-called “financial repression” measures, i.e. a wide array of policies that aim, inter alia, to allow a government to place its debt at relatively low interest rates. These measures can take the form of ceilings on sight and term deposit rates and on loan rates, notably for central government loans, the mandatory holding of public debt securities by domestic institutional investors, exchange rate controls, etc. They are presented by their promoters

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as supporting financial stability by protecting investors, financial institutions and markets against themselves and have characterized the period from the 1930s to the 1970s. When the central bank is under fiscal dominance, these measures are accompanied by an acceleration of inflation. The latter one offsets the decrease in the repayment capacity of the central government through the monetization of public deficits by the central bank. Insofar as inflation expectations are affected, inflation then alleviates the real debt burden. Public defaults, the financial repression and the inflation that often come with them, are major factors of financial instability (Reinhart and Rogoff, 2009). Financial repression generates a bad allocation of resources and a biased pricing of assets. Default destroys wealth and creates uncertainty on asset prices (it becomes more difficult to find a riskless interest rate when public securities get very risky). Inflation makes relative price comparison and investment planning more difficult; it also biases asset allocation in favour of real assets at the expense of financial assets and supports recourse to debt. However, the expansion of central banks’ balance sheets as a result of large scale asset purchases – LSAPs, also frequently referred to as “quantitative easing” or QE – has not so far led to a resumption of inflation. Indeed, the mechanism through which fiscal dominance has an impact on the price level deserves an explanation. A formalization of this mechanism is described by Sargent and Wallace (1981) under the label of “unpleasant monetarist arithmetic”. If the budget is permanently in deficit, independently of inflation and debt level developments, then monetary policy cannot control inflation anymore. When the maximum debt/ GDP ratio is reached, as a result of a limit in the capacity of the private sector to absorb public securities, the central bank has no other choice than to “print money” to generate the seigniorage revenues that will allow it to pay the interests on the public debt. The money stock increases and, in line with the monetarist approach of the authors, the price level adjusts through a rise in inflation. In the approach of Sargent and Wallace (1981), fiscal policy affects inflation only if the central bank accepts to monetize the public deficit. However, in the fiscal theory of the price level, fiscal policy can act independently from monetary policy on the price level (Leeper and Walker, 2011). The sequences of the theory, which is grounded on the fact that governments usually issue nominal debt instead of inflation-indexed debt, are more easily described in the framework of extreme configurations (Sims, 2013). For example, in economies where inflation and the nominal debt are high, such as Latin American countries in the 1990s, interest rates are high, which weighs heavily on the debt service. If inflation accelerates from its already high level, the central bank should increase its policy rate by even more, in order to raise the real interest rate and influence inflation expectations, according to the so-called “Taylor principle” (Drumetz et al., 2015). However, if there are disagreements in Parliament (for instance, if the adjustment burden is not considered as homogenous within the population), fiscal policy does not react by increasing the primary balance and the increase in

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the policy rate results in an acceleration of public nominal debt issuance. If the holders of the nominal debt understand the situation, the increase in the policy rate does not have the expected restrictive effect and inflation accelerates. The main determinant of inflation has become fiscal policy. Leeper and Walker (2011) underline that the “unpleasant monetarist arithmetic” and the fiscal theory of the price level are two different conceptions of the determination of inflation. Inflation and the level of prices depend in both cases on monetary and fiscal policies, but these conceptions refer to different monetary and fiscal regimes or institutions. In that regard, neither the “unpleasant monetarist arithmetic” nor the fiscal theory of the price level have so far been validated in the advanced economies. However, they remind of the need for fiscal rules to constrain government (Chapter 10).

9.1.2 Interactions between monetary policy and financial stability The role of monetary policy in creating financial imbalances has been questioned in the past few years, in relation with the pursuit of very accommodating policies, especially in Europe and in Japan (9.1.2.1). Indeed, even in normal situations, there are interactions between the conduct of monetary and macroprudential policies (9.1.2.2). However, it is not clear that central banks should modify their monetary policies to incorporate financial stability considerations (9.1.2.3).

9.1.2.1 Has monetary policy been a source of financial instability? In accordance with price developments below their objectives and sub-par growth, many central banks, including the ECB and the Bank of Japan, have been pursuing very accommodating monetary policies in the course of the decade following the GFC and, in the case of the ECB, the sovereign debt crisis (Chapter 10). These policies have been criticized, including in the media (see, for instance, Bloomberg, 2019), inter alia for contributing to creating financial imbalances. The main arguments are that persistently low interest rates – and in particular negative nominal interest rates – (i) encourage “search for yield” strategies, with the risk of increasing the number of non-performing loans (NPLs), (ii) erode the profitability of banks as low rates are typically associated with lower net interest margins (NIMs), and (iii) as a result, contribute to reducing banks’ equity and hence weigh on banks’ supply of loans. Following Pfister and Sahuc (2019), these arguments are assessed in turn. −

Do ultra-low interest rates increase NPLs and encourage risk-taking? Figure 9.1, taken from Pfister and Sahuc (2019), plots the dynamics of the NPL ratio (defined as the share of NPLs in total loans) in the countries that implemented negative rates, as well as for the US. There is an upward trend in the NPL ratio from 2008 to 2013 for the euro area and Denmark, while it is constant for Sweden and Switzerland. This ratio started to decline from 2014

Economic policies and financial stability  265 10

A. Non-Performing Loans to Total Loans

8 6 4 2 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 United States 7

Euro area

Denmark

Sweden

Switzerland

B. Central Bank Policy Rates

5

3

1 -1 2008 2008 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 US:Fed Funde Denmark:One-week Certificate of Deposit Switzerland:Overnight eight deposit

FIGURE 9.1

ECB: Overnight Deposit Facility Sweden: One-week debt certificates

Non-Performing Loans Ratios and Policy Rates (%).

Sources: World Bank (WDI) and Thomson Reuters.

with the implementation of negative deposit facility rates combined with asset purchases. The decline of NPLs with lower interest rates is an intended consequence of a very accommodative monetary policy stance: it lowers interest payments and reduces the default risk of borrowers thanks to general equilibrium effects/higher aggregate demand. However, if banks take on too much risk because of low interest rates/search for yield strategies, this short-term reduction of NPLs masks a future increase: loans of bad quality will underperform in a few years’ time, especially when interest rates start to increase. At the end of 2019, there had been no signs of such developments. Also, the NPL ratio has been steadily decreasing since 2008 in the US. Over the seven years during which UMPs were conducted in the US, there was no clear sign of excess risk-taking resulting in an increase in NPLs.

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−

−

−

A related issue is whether a prolonged period of low interest rates might produce overconfidence in economic agents, (i) increasing dramatically their risk tolerance and (ii) contributing to financial imbalances. This mechanism, called the risk-taking channel of monetary policy, can have long-lasting adverse consequences for economic activity if it is neglected (see Borio and Zhu, 2012; Fève et al., 2018; among others). The longer the yield curve remains flat, the higher the risks associated with the level of interest rates for the financial sector. In addition, an excessively long accommodative policy may encourage the build-up of leverage and fuel asset price bubbles. With respect to the US, the evidence reviewed by Kuttner (2018) is reassuring in this regard. As far as the euro area is concerned, Heider et al. (2019) find that banks that rely mainly on deposit funding take on more risk than banks that rely on other funding sources when the policy rate becomes negative. However, they also find that firms that receive loans from those banks appear financially constrained, and do not resemble “zombie” firms. Based on 196 euro area banks (70% of total EA loans), Demiralp et al. (2019) also show that banks in the euro area with an overall heavier negative interest rate burden – associated with holdings of excess liquidity and the collection of funds from the public – reallocate more towards higher-yielding assets (i.e. loans) in an effort to maintain adequate profitability. Do ultra-low interest rates affect bank profitability? The evidence is mixed and, up to the late 2010s, banks’ profitability has overall remained resilient in countries where interest rates have been ultra-low, although keeping policy rates and/or the slope of the yield curve low during a protracted period does seem to have detrimental effects. Using a sample of 3,385 banks from 47 countries from 2005 to 2013, Claessens et al. (2018) find that a 1% interest rate drop leads to an 8-basis-point lower NIM, with this effect greater (20 basis points) at low rates, but the effects on returns on assets (ROAs) are found to be much weaker and not statistically significant. The relationship between ROA and the slope of the yield curve is more often statistically significant and consistently larger in a low interest rate environment and the effects of low rates on ROA increase over time, especially in the fourth year. Regarding the euro area, Altavilla et al. (2018) find that the adverse effects of ultra-low rates on NIMs are largely offset by the positive impact on intermediation activity (increases in fees and in lending) and credit quality (lower loss provisions), both resulting from the improvement in the macroeconomic environment. However, they do not disregard the fact that keeping rates low for a long time might have negative consequences for bank profitability. Finally, are nominal negative interest rates special with regard to bank profitability, to the extent that deposit rates would be bounded at zero? In fact, using data from 5,113 banks from the EU and Japan, with observations for 14 different currencies between 2010 and 2016, Lopez et al. (2018) find that banks’ profitability as a whole has been unaffected by negative nominal interest rates, especially in countries with floating exchange rates. Consistent

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with the results of Altavilla et al. (2018), they also find that banks, especially large ones, have been able to offset losses in interest incomes with increases in other income (fees, capital gains, etc.). Furthermore, recent evidence by Altavilla et al. (2018) suggests in fact that some large non-financial companies actually see negative interest rates on their deposits. Overall, it is not clear that very accommodating monetary policies have contributed to creating financial imbalances.

9.1.2.2 Interactions between monetary policy and macroprudential policies Monetary policy can influence financial stability through three main channels (IMF, 2012): − −

−

Leverage constraints (for instance, a monetary loosening increases the value of collateral in the short run) and default probability. Risk-taking incentives for financial intermediaries (de Bandt and Pfister, 2003). On the one hand, the risk-taking channel is conducive, in periods of low interest rates, to an increased risk-tolerance in the framework of “search-for-yield” strategies (Drumetz et al., 2015). This effect is more pronounced as the low interest rate period lasts longer, and is less strong for relatively less capitalized banks (Dell’Ariccia et al., 2013). As a consequence, the possibility of a tradeoff between monetary stability and financial stability depends on the situation of the economy within the cycle: it is non-existent when the economy is close to the peak, at a time when banks take more risks and inflation accelerates. In such a situation, an increase in the policy rate reduces leverage and inhibits inflationary pressures. However, in periods of low inflation and high risk-taking, as in the years just before the GFC, an increase in the policy rate can reduce incentives to risk-taking but also induce an undesirable economic slowdown or possibly deflation. On the other hand, the expectation that monetary policy could be loosened in period of crisis in order to support the financial system can provide an incentive to increased risk correlation (Farhi and Tirole, 2012). Financial asset prices and exchange rates: A lowering of the policy rate increases financial asset prices, which can lead to an asset price boom through an increase in leverage. Conversely, a higher policy rate lowers the value of collateral and may trigger fire sales. At the same time, it can also lead to capital inflows and an excessive reliance on foreign currency debt.

Macroprudential policies (Chapter 8) can ex ante moderate these undesirable effects on financial stability. For instance, in periods of accommodating monetary policy, stricter debt-to-income or loan-to-value ratios can be adopted, in order to curb the increase in housing loans and prices, or capital and liquidity requirements can be raised, in order to limit banks’ risk-taking.

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In the opposite direction, macroprudential policies can have consequences for monetary policy. These consequences can differ according to the time horizon (IMF, 2012): −

−

Implementing capital buffers and limits to loan-to-value ratios should increase, in the long run, the resilience of the economy to aggregate shocks and smooth the distribution of credit. In turn, this decreases the probability of a financial crisis (ECB, 2013) and the size of the needed monetary accommodation, thus reducing the risk of monetary policy hitting the effective lower bound. However, raising capital requirements or making loan-to-value ratios stricter in the boom part of the cycle can have effects on asset prices and the distribution of credit and, as a consequence, on output. If these effects are of a significant magnitude, a loosening of monetary policy can be called for.

9.1.2.3 Which consequences for the strategy and the conduct of monetary policy? Regarding the possibility of adapting monetary policy strategy, in order to incorporate a financial stability objective on top of the price stability objective, or to “lean against the wind” (LAW), the debate has been going on in policy and academic circles for at least two decades (Pfister and Sahuc, 2019). LAW refers to an interest rate rule of responding systematically to the financial cycle, in addition to reacting to the real cycle. The majority view, until the GFC, was that monetary policy should respond to fluctuations in asset prices only to the extent that they affect forecasts of inflation or the output gap, because (i) the early identification of asset price bubbles was deemed too difficult and (ii) monetary policy is too blunt an instrument to deal with such price misalignments adequately. However, this line of argument was not shared unanimously. Borio and Lowe (2002), Cecchetti et al. (2002), and Stein (2012), among others, called for a more active role for monetary policy in addressing financial stability risks. They notably argue that while low and stable inflation promotes financial stability, it also increases the likelihood that excess demand pressures show up first in credit aggregates and asset prices rather than in goods and services prices. Accordingly, in some situations, a monetary response to credit and asset markets may be appropriate to preserve both financial and monetary stability. Smets (2014) also explains that financial stability must be a concern for central banks because there is a risk of financial dominance, i.e. a situation that arises when the financial sector is unable to absorb all of its losses, with the risk of cascading defaults if the financial sector is not bailed out. Adrian and Liang (2018) emphasize the importance of considering the risktaking channel in cost-benefit analyses, because it is a collateral effect of interest rate policies. When the yield curve lowers, intermediaries are induced to engage

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in risk-taking behaviour. Accordingly, too low interest rates for too long may encourage excessive leverage in risky assets, which puts financial stability at risk. Indeed, when the risk-free rate lowers, short-term liabilities – such as repos or ABS commercial paper – become attractive money-like assets that can be used by intermediaries to finance long-term risky positions. In turn, an increase in demand for long-term risky assets lowers yields and spurs aggregate demand. However, in the event of a crisis, abrupt collective deleveraging by “fire sales” to repay short-term liabilities leads to severe financial losses. In this regard, detractors of LSAPs argue that they generate more risk-taking than other unconventional policies because LSAPs not only lower the yield curve, but also increase reserves, expanding the ability of intermediaries to acquire risky assets by issuing money-like liabilities. Moreover, LSAPs directly decrease risk premiums, leading economic agents to underestimate the risk in the economy. However, Woodford (2016) argues that LSAPs increase financial stability risks less than other interest rate policies. His explanation relies on three main arguments. The first one is that, in contrast to other policies, LSAPs reduce the “money premium” of money-like assets – not the rate of return on safe assets directly. Woodford’s (2016) second argument is that LSAPs are typically implemented when the interest rate has already fallen to the level of the interest paid on reserves, which indicates that reserves are already in excess supply. Finally, Woodford (2016) mentions that the reduction in the return on risky long-term assets, when the risk-free interest rate does not move, makes investing in risky positions less attractive, which eventually contributes to reducing financial instability risks. Levieuge (2019) provides a survey of the evaluations of LAW (especially with DSGE models) from 2008 and concludes that the optimality of LAW is sensitive to the model used. As expected, the nature of financial frictions, the loss function of the authorities, the financial variable included in an augmented Taylor rule, the uncertainty about the effects of financial frictions and the effects of monetary policy on these frictions are all factors that influence the optimal rule. Based on existing representative empirical estimates and reasonable assumptions, the finding is that the costs of LAW exceed the benefits by a substantial margin. The reason is that the empirical policy rate effects on the probability and magnitude of a crisis are far too small to make the benefits of LAW match the costs. In addition, a LAW strategy seems to raise at least two sources of uncertainty whose consequences are debated. The first uncertainty concerns the equilibrium value of asset prices. An asset price target (or another financial variable) incorporated into a monetary policy rule must be defined by the difference of a financial variable with its equilibrium value. However, there is no clear method for determining this fundamental value in relation to which a valuation or quantity observed would be considered excessive or insufficient. In this context, LAW is costly because it exposes the central bank to a first species risk and a second species risk: to respond to a bubble when there is none, or not to respond when there is one. A second uncertainty relates to the effects of a monetary policy action on the financial cycle. Theoretically, a fall in interest rates should support stock prices,

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partly due to an increase in anticipated dividends. Nevertheless, what about other asset prices and credit flows? Empirical estimates are rare and can only rely on a small number of observations. They also face a problem of endogeneity as well as a problem of identifying the specific effects, which are attributable to monetary policy. Another branch of the literature focuses on measuring and comparing the costs and benefits associated with LAW. Lars Svensson has produced a series of in-depth studies on this issue, which are overall unfavourable to LAW. In particular, Svensson (2017) shows that, contrary to the desired objective, LAW generates higher losses in the event of a crisis. In particular, the costs of LAW are not only a weaker economy if no crisis occurs, but also, for a given magnitude of crisis, a weaker economy if a crisis occurs. The reason is as follows. Due to the higher interest rates (LAW-imposed requirement), the economy in “normal” (non-crisis) times is at a lower equilibrium, with higher unemployment. Under these conditions, the impact of a financial crisis (which cannot be absolutely prevented, including with LAW) will be all the more severe as the economy has already been weakened by LAW. Kockerols and Kok (2019) evaluate the costs and benefits of LAW using the Svensson (2017) framework for the euro area and find that the costs outweigh the benefits. They also find that macroprudential policy has net marginal benefits in addressing risks to financial stability in the euro area, whereas monetary policy has net marginal costs. This would suggest that an active use of macroprudential policies targeting financial stability risks would alleviate the burden on monetary policy to “LAW”. This reinforces the idea that the dominant view in the post- crisis period still prescribes that monetary policy should not respond to financial stability concerns. The new macroprudential framework seems to represent the most effective tool for ensuring financial stability, because it can directly restrain excessive leverage or risk-taking. The literature is thus now focusing on the optimal coordination between monetary policy and macroprudential policy. Regarding the conduct of monetary policy, and more specifically LSAPs, a point has been made in the wake of the GFC, which can be considered as putting LAW in practice. The point is that, in order to accommodate the possible demand of banks for high-quality liquid assets (HQLA) resulting from the Basel III liquidity regulation, central banks could and perhaps should keep a large amount of reserves on their balance sheets (Duffie and Krishnamurthy, 2016; Greenwood et al., 2016; Logan, 2018). Greenwood et al. (2016) claim that large central bank balance sheets could be a tool for enhancing financial stability because, in times of financial stress, central banks’ provision of safe, liquid securities to market participants in the form of bank reserves should be effective in preventing panic. However, this argument in favour of the central bank playing the role of lender of last resort only implies that the central bank’s balance sheet could be large in times of financial stress, and not permanently. Reserves could also help to make up a shortage of safe assets (Caballero et al., 2017). However, when the central bank purchases safe assets, it does not add to the amount of safe assets or HQLAs, since it withdraws through its purchases the same amount of them as it supplies through the increased

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provision of reserves (conversely, it takes on risk when it purchases assets which are less safe). On the other hand, there can be interplay between monetary policy and liquidity regulation, as the latter might lead to a steepening of the front-end of the yield curve on a permanent basis (BIS, 2015). Liquidity regulation might also lead to more volatile short-term interest rates (BIS, 2015; Bech and Keister, 2017; Keister, 2019), thereby possibly introducing more short-term uncertainty into the transmission mechanism, as experienced in the US dollar money market in September 2019. However, central banks can use standard instruments to deal with this issue, such as increasing remunerated reserve requirements, allowing more reserve averaging and narrowing the interest rate corridor they operate (Drumetz et al. 2015). In full recognition of their role as lender of last resort (9.1.1.1), central banks could also provide liquidity insurance (Goodhart, 2017; Pfister and Valla, 2018), allowing the size of their balance sheets to increase in times of financial stress by providing liquidity to those banks that need it. Last, central banks could tolerate more interest rate volatility or even discontinue the practice of targeting a market interest rate and just signal the monetary policy stance through the setting of their policy rate (in that regard, officially, the ECB does not have an operational target). Regarding banks, they have other HQLAs than reserves at their disposal and can create some supplementary ones through securitization. They can also create “synthetic” short-term assets of high quality through a combination of outright and repurchase transactions in government securities. Overall, the onus of complying with liquidity requirements should fall on the banking sector, that is liable to them, rather than constrain the conduct of monetary policy.

9.2 Fiscal policy In advanced economies, financial stability risks originate primarily in the private sector. According to Reinhart and Rogoff (2011), who employ a long-term database covering two centuries and 70 countries, banking crises are often preceded by rapidly rising private indebtedness. Using over 100 years of data for advanced economies, Jordà et al. (2016) confirm that private credit is a significant predictor of financial crisis and its associated distress. Sovereign debt adds generally little predictive information, a major exception being Greece in 2009–2010 where excess public borrowing appeared as a precursor of banking troubles (Bank for International Settlements, 2016). However, fiscal policy and financial stability interact in a close two-way link, which becomes, in extreme cases, a “doom loop” (9.2.1). How can the loop be loosened? (9.2.2).

9.2.1 A two-way link between fiscal policy and financial stability There is a close two-way link between fiscal policy and financial stability: −

Banking crises (even those of a purely private origin) increase the likelihood of a sovereign default. Reinhart and Rogoff (2011) find a direct effect due to the resulting post-banking crisis recession and an indirect effect due to a

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−

typical post-banking crisis explosion in public debt. Indeed, banking crises are likely to lead to a ballooning of public debt through the cost of bailing out the banking sector, as observed in Ireland during the GFC. In turn, high levels of sovereign debt exacerbate the effects of the deleveraging of the private sector, driving up the output costs of crises (Jordà et al., 2016; Chapter 2). Indeed, high levels of public debt weigh on public and private sector capital accumulation, productivity trends and, consequently, potential growth (Reinhart and Rogoff, 2010), which further slows down the rebalancing of the fiscal position. Conversely, a very unfavourable fiscal position is likely to affect financial stability through a decrease in the government’s ability to bail out or provide guarantees to the banking sector or through losses on banks’ sovereign bond portfolios, weakening their balance sheets. Investors will perceive banks as riskier. Moreover, sovereign rating downgrades normally translate into lower ratings for banks too (Bank for International Settlements, 2016). This loss in creditworthiness can also increase the cost of market finance for all financial and nonfinancial borrowers because sovereign yields typically set a floor under private market funding costs. In addition, a high-level and/ or an unfavourable structure of sovereign debt may act as an incentive for the government to implement financial repression measures to reduce, inter alia, rollover risks and borrowing costs (Reinhart and Sbrancia, 2011).

Indeed, the level and structure of sovereign debt has implications for financial stability (Das et al., 2010): −

−

A high sovereign debt stock can ultimately lead to sustainability problems. Sovereign debt is said to be sustainable (ECB, 2012) if the government is solvent in the medium to long term, i.e. if the net present value of future primary balances is at least as high as the net present value of outstanding government debt. The government must also be “liquid” by reference to its ability to meet its obligations in the short term by maintaining its access to financial markets. Conventional sustainability analysis is based on a number of assumptions and methodological choices, hence uncertainty that may affect its results (ECB, 2012; Tanner, 2013). The structure of public debt can also be a source of vulnerability, inter alia when a significant proportion of outstanding debt is either issued at a floating rate or denominated in foreign currency, when the time to maturity of a significant share of the stock is short or when non-resident holdings of public debt are significant. Indeed, from mid-2010 to the end of 2011, non-euro area investors reportedly reduced their exposure to euro area sovereign debt by $400 billion (Arslanalp and Tsuda, 2012). This withdrawal was partly offset by euro area banks’ purchases, which increased the interaction between banks’ and governments’ balance sheets.

The “doom loop” between the balance sheets of governments and banks is one of the key features of the sovereign debt crisis in Europe in 2010–2012 (Chapters 2

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and 3). Market speculation about the creditworthiness of some governments led to increases in sovereign yields, mark-to-market losses on banks’ portfolios of sovereign bonds, increases in their financing costs and finally to higher interest rates on loans to firms and households (Bank for International Settlements, 2011). What are the drivers of banks’ domestic sovereign debt exposures? −

−

The literature focuses on banks’ risk- shifting incentives in their portfolio allocation decisions. Banks prefer the risk profile of domestic sovereign bonds because, as default risk increases, domestic bank equity holders can shift the associated ex post losses to bank creditors (Acharya and Steffen, 2015) or, if banks expect to be bailed out by government, downside risk is shifted to taxpayers (Farhi and Tirole, 2018). Another explanation for banks’ preference for domestic sovereign bonds relies on “financial repression” theories (9.1.1.2). The sovereign may coerce or incentivize domestic banks to buy domestic sovereign bonds at above market prices in order to reduce its financing costs. According to Ongena et al. (2019), during the euro area sovereign debt crisis, the rapidly increasing exposure of domestic banks in stressed countries (Greece, Ireland, Italy, Portugal, Spain) to their sovereign was at least in part the result of “moral suasion”, whereby governments under fiscal stress pressure domestic banks to purchase additional amounts of domestic sovereign bonds because market demand is weak. The need to do so stems from the fact that the government’s inability to roll over debt would damage its credibility and push sovereign bond yields up, raising debt refinancing costs. Domestic banks that received government support during the GFC or with weaker balance sheets were considerably more likely than foreign banks to increase their holdings of domestic sovereign debt.

9.2.2 How can the loop be loosened? The financial sector needs to be protected from the sovereign and, symmetrically, the sovereign needs to be protected from the financial sector. To protect the financial sector from the sovereign, supervision and regulation, in particular the regulatory treatment of sovereign bond holdings, may have to be re-examined: ­ −

The financial sector framework may have to be reinforced, notably in a currency union such as the euro area. Farhi and Tirole (2018) explicitly analyse the role of lax domestic financial sector supervision in sovereign debt renationalization and show that it gives rise to a rationale for banking unions in the form of delegation of financial supervision to a credible supranational authority. Indeed, the euro area has established post- GFC a Single Supervisory Mechanism along with the Single Resolution Mechanism and a Bank Recovery and Resolution Directive (Chapter 10). Measures are still needed to complete the Banking Union, such as to establish a European Deposit Insurance Scheme (IMF, 2019).

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−

However, as long as governments rely to a large extent on domestic banks for financing and banks have clear incentives to purchase sovereign debt for its favourable credit and liquidity characteristics and its use as collateral, single supervision and resolution will not be enough to break the doom loop. Indeed, the current regulatory framework in the EU may have led to excessive investment by banks in domestic sovereign bonds. Zero risk weights on sovereign bonds enable sovereign bond portfolios to increase without reducing Tier 1 capital ratios (Chapter 6). These zero weights and the absence of large exposure limits have contributed to strengthening links between banks and sovereigns because banks do not face any constraint with respect to their domestic currency sovereign exposures. The European Systemic Risk Board (2015) and the Basel Committee on Banking Supervision (2017) provide an extensive examination of policy options to reform the regulatory treatment of sovereign exposures and of their associated trade- offs.

From a financial stability perspective, it would be desirable for fiscal and tax policies to be free of any procyclical and debt biases: −

−

Fiscal policy should be able to generate surpluses in the upward phase of the cycle in order to provide flexibility in the event of a financial crisis. Procyclical fiscal policies increase macroeconomic volatility and risks to financial stability because they are conducive to higher leverage and asset prices increases in the upward phase of the cycle (Girouard and Price, 2004). Such policies amplify the volatility of tax revenues and blur the measure of cyclically adjusted budget balances. In good times, revenues increase more than the growth rate would suggest, due to higher tax revenues on transactions involving real and financial assets and on capital gains. In times of crisis, tax revenues decrease more than expected, the fiscal deficit and debt increase, as higher revenues in pre-crisis years were used to finance additional expenditures and not to reduce debt. Moreover, tax policy design should take into account the financial stability consequences of the pervasive debt bias which encourages higher leverage in advanced economies (9.3.1).

9.3 Structural policies Tax (9.3.1), housing (9.3.2), and competition policies in the financial sector (9.3.3) have an influence on financial stability.

9.3.1 Tax policy Tax bias towards homeownership (9.3.1.1) and debt finance (9.3.1.2) is pervasive and affects leverage decisions (Dallari et al., 2018).

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9.3.1.1 Tax policy and housing Tax deductibility of mortgage interest is widespread among advanced economies. A fully neutral taxation of owner- occupied housing would require full taxation of imputed rents and capital gains on housing, combined with mortgage interest deductibility. However, imputed rents and capital gains on primary residences are rarely fully taxed, creating a general bias towards homeownership. Moreover, deductibility is likely to favour wealthier households (IMF, 2011). Therefore taxation may have played a role in the boom and bust on the housing market and the rise in household debt observed in several economies, particularly in the US, before the GFC broke out (Chapter 2). Admittedly, the importance of this role is difficult to quantify. Given that there has generally been no significant change in the tax regimes applicable to real estate before the GFC, taxation was probably of a second order compared to economic and financial conditions (Hemmelgarn and Nicodème, 2010; Ceriani et al., 2011) such as the low level of long-term interest rates, the expectation of further increases in house prices, buoyant credit supply and, in the US in particular, the easing of mortgage lending standards. Nevertheless, tax incentives may amplify shocks that affect the supply or demand for housing through the real user cost of housing, leading to higher price volatility (Poterba, 1984). A real estate is both a consumer and an investment good. The decision to “consume” housing services is linked to the characteristics of the good. The decision to invest depends on the potential increase in the value of the good. The user cost of housing is defined as the sum of the costs associated with owning and using it, i.e. the interest not received on the capital invested in housing, the interest paid on the mortgage loan, depreciation, property taxes, capital gains or losses on resale (Hemmelgarn and Nicodème, 2010). Taxation frequently affects several of these costs, in particular through the more or less favourable treatment of capital gains, the possibility to deduct interest rates paid on mortgage loans from taxable income and the non-taxation of rents charged to owners. For example, in the US: −

−

−

The 1997 Taxpayer Relief Act quadrupled the non-taxable amount of capital gains, which may have provided an additional incentive to purchase housing. The 1986 Tax Reform Act, which disallowed consumers to deduct interest rates paid on consumer credit but maintained it in the case of mortgage loans, created perverse incentives, particularly in a context of rising house prices. Households were led to extract liquidity from their homes in order to finance their current expenses or to repay other loans (mortgage equity withdrawal), using the increase in the collateral value of their real estate assets to obtain an increase in their mortgage loans. The effect of the deductibility of interest rates on mortgage loans could have been amplified, in a context of rising house prices and low long-term interest rates, by subsequent measures, which made low-income households

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eligible for mortgage loans via the 2002 Single-Family Affordable Housing Tax Credit and the 2004 American Dream Down payment Act by reducing or even eliminating the down payment requirement (Ceriani et al., 2011). The IMF (2011) notes that a more level tax treatment across owner- occupied and rental housing would help reduce the current bias towards homeownership. It recommends that, in the absence of taxation of imputed rents and capital gains on housing, countries reassess policy tools such as mortgage interest deductibility, which should be capped and apply only to first mortgages on primary residences. Going a step further, Sommer and Sullivan (2018) simulate the effect of the elimination of the mortgage interest rate deduction on the US housing market using an equilibrium model of the housing market with endogenous house prices and rents. Contrary to widely held views, repealing the mortgage interest rate deduction would increase homeownership, decrease mortgage debt and improve welfare. Reduced house prices following the elimination of the deduction allow low wealth, credit- constrained households to become homeowners. Moreover, the price-to-rent ratio falls, shifting relative prices in favour of owning while boosting further homeownership. In addition, given the progressive nature of the US income tax code, housing consumption shifts from high-income to lower-income households, thereby increasing welfare. However, the authors note that the political feasibility of such a reform is an open question, given its distributional impacts, the young low-income households benefitting the most while older high-income households would bear high costs.

9.3.1.2 Tax policy and debt finance In most countries, corporate income tax allows deduction of the interest rate paid on debt. Distribution of dividends, by contrast, is rarely deductible because payments to equity holders are optional as they do not involve the same contractual obligation as the one involved in debt contracts. Interest rates paid on debt are seen as production costs; therefore, they are subtracted of earnings before tax. This interest deduction implies that debt financing is artificially cheaper than equity finance, distorting incentives and violating the principle of neutrality (Dallari et al., 2018). Indeed, according to Modigliani and Miller (1958), the value of a non-financial or a financial firm should be independent of its financing structure. This result is achieved in an environment of complete markets, without financial frictions and taxation. However, interest paid by companies and banks is generally deductible from corporate income tax, which could encourage them to borrow rather than to increase capital by reinvesting profits or issuing shares. Therefore, by encouraging higher leverage, tax policy may indirectly jeopardize macroeconomic and financial stability because highly leveraged firms are not likely to invest, affecting the potential growth of the economy, and the resulting increase in NPLs may lead banks to curb credit.

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The taxation of non-financial and financial firms does not appear to have played a particular role in the outbreak of the GFC, but high leverage has amplified the impact of the crisis on the economy (Alworth and Arachi, 2010). More generally, a substantial number of studies have demonstrated the pervasiveness of debt bias in the non-financial but also in the financial sector: −

−

In the non-financial sector, according to estimates by van Binsbergen et al. (2010) based on panel data on US companies from 1980 to 2007, the equilibrium net benefit of debt stands at 3.5% of asset value. Using a cross- country dataset containing 14 million firm-year observations in 24 advanced economies over 1995–2013, Dallari et al. (2018) show that debt bias is a significant driver of leverage even for small firms as well as for large firms. The magnitude of the debt bias is significant, explaining up to 27% of leverage. In the financial sector, de Mooj and Keen (2016), who review individual bank data from 82 countries over the period 2001–2009, show that a relatively high corporate tax rate, which amplifies the advantage of borrowing over the reinvestment of profits or the issuance of shares, is associated with higher leverage. On average, the tax sensitivity of banks’ leverage proves to be significant and about as large as for non-financial firms. As a result, the tax bias in favour of debt is likely to increase banks’ vulnerability to shocks and, consequently, the frequency and intensity of financial crises. Luca and Tieman (2019) show that the debt bias is pervasive for regular banks, investment banks and non-bank financial companies. The strength of financial sector debt bias seems to have diminished after the GFC but may increase again, now that most financial firms have rebuilt buffers.

The IMF (2016) notes that the macroeconomic and financial stability consequences of debt bias should be taken into account in tax policy design. Tax policies should aim at putting debt and equity finance on an equal footing. Options for reform of the current system include limiting or suppressing interest rate deductibility or introducing a similar deduction for equity. Notably, an Allowance for Corporate Equity (ACE), which establishes a symmetric tax treatment between debt and equity, has proved effective for mitigating debt bias in several countries. Such policies would strengthen non-financial and financial firms’ resilience: −

−

Karpavicius and Yu (2016) analyse how US non-financial firms’ characteristics and shareholder wealth would be impacted if tax deductibility of interest expenses were eliminated. Shareholders would lose approximately 3.5% of their investment, a result close to van Binsbergen et al.’s (2010) estimated value of net benefits of debt. Non-financial firms would become less levered. As a result, the number of defaults would be lower. Célérier et  al. (2017) take advantage of the staggered introduction of an ACE in Italy in 2000 and in Belgium in 2006 to test the impact of such a reform on bank asset composition and credit supply. The authors show that

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the resulting relative decrease in the cost of equity led banks to rely more on equity financing and to increase lending to firms. Therefore taxation can be an effective tool to contain bank leverage while maintaining credit supply.

9.3.2 Housing policy Tax policy (9.3.1.1) played a role in the outbreak of the housing bubble in the US. Distortive policies in favour of homeownership, which have tended to amplify the relationship between rising house prices and mortgage credit growth, may also have contributed. The aim of government intervention in the housing market is generally to provide affordable housing and to promote homeownership, one exception being Germany where most government policies focus on subsidizing renting, not homeownership. The rationale of government intervention is supported by research on homeownership’s positive effects upon the social outcomes for individuals and households (Fischer, 2017), even in economies which rely on market mechanisms. In addition to tax incentives, government participation takes many forms (IMF, 2011), with the US presenting unique features: −

−

Affordable housing policy mandates: The US housing Government Sponsored Enterprises (GSEs; i.e. Fannie Mae, Freddie Mac, Ginnie Mae…) have a specific mandate to provide affordable housing to low-income households. Other non-US GSEs do not generally have such a formal mandate. In some continental European countries, there also exists contractual savings systems or housing loans subsidized by the government. Housing finance agencies: The US GSEs’ distinct feature is their involvement in securitization markets (Fannie Mae and Freddie Mac, which had to be brought in government conservatorship in October 2008, Ginnie Mae) and mortgage insurance (through the Federal Housing Administration). Other non-US GSEs have generally limited or no portfolio accumulation.

What role did these unique features of US housing policy play in the run-up to the GFC? The GSEs Fannie Mae and Freddie Mac were created to provide liquidity in the secondary mortgage market, either by purchasing mortgages – meeting their underwriting standards and specific loan limits – to hold in their own portfolio or to package into MBSs (Chapter 2). As GSEs enjoy an implicit government guarantee, they have a funding advantage over other market participants estimated at about 30–40 bps, the effect of which is to reduce mortgage rates for all homeowners by 16–25 bps (Jaffee and Quigley, 2013). Therefore, the public cost of subsidy has been far more than the benefits of lower mortgage interest rates to borrowers. In 1992, they were given the task of promoting the distribution of mortgage credit to households with below-the-median incomes. Empirical evidence, analysed by Jaffee and Quigley (2013), fails to support claims that the GSEs’ housing goals were a primary source of the subprime crisis. The authors point that GSEs were not

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leading the market for high-risk lending as the subprime boom took off; however, they did exert a destabilizing influence on the mortgage market by actively acquiring risky mortgages as the subprime boom headed to its peak in 2007. Overall, the increase in house prices in the US from 2002 to 2006 is partly explained by the fact that, under the influence of a policy aimed at promoting homeownership and the resulting low mortgage rates, mortgage credit became more accessible to subprime borrowers. Securitization of loans introduced additional distortions (Chapter 2), notably by weakening the link between the mortgage loan and the lender, leading to lax credit standards (Fischer, 2017). In addition, house price increases may have encouraged homeowners – 65% of Americans in the early 2000s – to extract liquidity from their homes. Indeed, Mian and Sufi (2011) show that homeowners significantly increased their leverage as a result of rising house prices, particularly younger households and households with low credit scores whose home equity-based borrowing was subsequently affected by high default rates. The OECD (2011a) proposes four avenues for reflection on housing policy, which do not give particular priority to homeownership: −

−

−

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Improve prudential supervision of the mortgage credit market: Financial innovation and liberalization have widened access to mortgage credit and lowered its cost. However, in some countries, these developments may have amplified house price swings. In addition, the lowering of lending standards has weakened macroeconomic and financial stability. Macroprudential policies can help reduce the incidence and the severity of housing crises (Chapter 8). Increase the responsiveness of housing supply to demand by removing regulatory barriers and aligning the property tax base with market value, in order to encourage the supply of housing in countries where land is scarce. Increase mobility by removing regulations that strictly regulate rents, thus slowing down the provision of rental housing, and by increasing competition between intermediaries (real estate agencies, notaries) involved in real estate acquisition. Make housing policies more efficient and equitable by removing tax distortions (9.3.1), and providing social housing benefits rather than the direct provision of social housing.

9.3.3 Competition policy in the financial sector The theoretical consensus has long been that competition is detrimental to financial stability. This “competition-fragility hypothesis” (Beck, 2008) is based in particular on Smith (1984) and on Keeley (1990), and most often supports direct interventions (Chapter 5): −

Smith (1984) shows, in a theoretical framework à la Diamond and Dybvig (Chapter 1), that even in the absence of any need for deposit insurance, competition for deposits drives up deposit rates to the point where some banks fail. This result supports the regulation of bank deposit interest rates.

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−

Keeley (1990) highlights the role of banks’ charter value in shaping risktaking incentives. The charter or franchise is the administrative authorization to carry on banking activity. The charter value is the value of rents available to shareholders and managers. According to Keeley, increased competition between banks played an important role in the Savings & Loan crisis. Until the 1980s, restrictions on entry into the banking sector gave high value to bank charters. The increased charter values acted as a deterrent to risk-taking behaviour by increasing the opportunity cost of bankruptcy. This increase compensated for the perverse incentives resulting from a deposit insurance system with contributions independent of risks taken (Chapter 5). However, after the liberalization of branch openings, competition for deposits increased, driving up deposit rates and driving down bank charter values, providing incentives for banks to take on more risks. Keeley (1990) does not call for a restoration of entry restrictions but argues in favour of risk-adjusted deposit insurance premiums. Conversely, even in the presence of capital requirements (Chapter 6) liable to boost charter value and reduce risk-t aking, Hellmann et al (2000) show that deposit interest rate ceilings are still necessary to prevent excessive risk-taking.

However, an opposing theoretical view – the “competition-stability hypothesis” (Beck, 2008) – holds that less concentrated and more competitive banking environments are not detrimental to financial stability. −

−

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Boyd and De Nicoló (2005) argue that the potential impact of banks’ market power on firm behaviour should also be taken into account, which is not the case in models of the “competition-fragility hypothesis”. Indeed, bank risk is determined jointly by the borrowers and the banks. Less competitive and concentrated banking systems enhance banks’ market power which drives up the interest rate they charge to firms. In turn, these higher interest rates may be conducive to higher risk-taking by firms and to higher NPLs. Therefore, a less competitive and more concentrated environment may lead to systemic distress. Models of the “competition-fragility hypothesis” are partial-equilibrium set-ups. Allen and Gale (2004) show in a general equilibrium setting that a reduction in competition can certainly increase financial stability, but not increase – and most often reduce – welfare, due to a loss of economic efficiency. A certain degree of financial instability can therefore be socially optimal. Moreover, in the models of the “competition-fragility hypothesis”, there is no special role for banks as institutions endowed with some competitive advantage in screening and monitoring borrowers. Still, in a general equilibrium framework, De Nicoló and Lucchetta (2011) show that, if intermediation technology, i.e. the means used by banks to select and monitor borrowers, has increasing returns of scale (i.e. the cost is not proportional to the amount of credit, which is a realistic assumption) or is relatively effective (i.e. it involves low selection and monitoring costs, while being quite costly to implement),

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−

then perfect competition is optimal and conducive to the lowest level of risk. To this end, competitive pressures on banks must be maintained to encourage them to adopt the most efficient intermediation technologies, thereby reducing risks, rather than preserving banks’ profitability by providing them with rents. Corbae and Levine (2018) discuss the “competition- stability hypothesis” in a theoretical framework allowing for imperfect competition between banks and enabling to study the dynamics of banking market structure and, in particular, the entry and exit of banks. They find a competition- stability trade-off: increased competition leads to greater efficiency by reducing profit margins and bank charter values and prompting aggregate lending, but also to greater bank fragility. However, policy intervention – better bank governance (Chapter 4) and tighter leverage requirements (Chapter 6) – helps to mitigate greater bank fragility, preserving competition’s efficiency benefits.

For a new consensus to emerge in favour of the “competition-stability hypothesis”, empirical cross- country studies would nevertheless have to move in the same direction. However, evidence is mixed: −

−

−

Using data from 69 countries between 1980 and 1997, Beck et  al. (2006) highlight that the more concentrated the banking system is, the less likely a systemic banking crisis is to occur. However, following Claessens and Laeven (2004), the authors highlight the difference between concentration and competition: bank concentration is not an indicator of the lack of competition. Their work thus shows that the more severe the restrictions on entry or banking activities, the more fragile the banking system is, a conclusion that recalls the superiority of incentives compared to direct intervention. Working on a measure of competition applied to 45 countries over the period 1980–2005, Schaek et al. (2009) confirm the results of Beck et al. (2006). Competition appears to be always good, whether or not the banking system is concentrated, although concentration removes the possibility of crisis. To explain this dual observation, the authors suggest that banking competition is mainly local, while concentration is measured at the national level. Using banking data from 23 developed economies, Berger et al. (2009) point out that the market power of banks reduces their total risk exposure. However, they also show that market power increases the riskiness of the banks’ loan portfolio. They explain the divergence of results by the fact that banks with the strongest market power are also better capitalized.

The OECD (2011b) analyses post- GFC competition issues in retail banking: −

The characteristics of financial intermediation, including the considerable information asymmetries regarding risk levels between depositors and institutions and the barriers to entry linked to reputation and network effects, render competition in banking inherently imperfect, generating and sustaining rents.

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−

−

Moreover, size is not unrelated to systemic risk, which could lead to questions about the optimal size of financial institutions to avoid the “too big to fail” phenomena (Chapter 1). Vallascas and Keasey (2012) show that the systemic risk exposure of a bank increases with the size of the bank relative to the size of the economy in which it operates. Smaller economies need smaller banks. The explicit aid and guarantees of all kinds provided by governments to the financial sector during the GFC to avoid a systemic fallout have distorted the conditions of competition to the benefit of systemic institutions. Financial institutions must be able to fail, regardless of their size, interconnectivity or complexity, which requires the establishment of ex ante resolution mechanisms financed by the financial sector (Chapter 7).

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International Monetary Fund. (2011), “Housing Finance and Financial Stability - Back to Basics?”, World Economic Outlook, April, 111–117. International Monetary Fund. (2012), “The Interaction of Monetary and Macroprudential Policies”, Background Paper, December, www.imf.org/external/np/pp/ eng/2013/012713.pdf. International Monetary Fund. (2016), “Tax Policy, Leverage and Macroeconomic Stability”, IMF Policy Paper, No. 16/151. International Monetary Fund. (2019), “The Euro Area Sovereign-Financial Sector Nexus”, Global Financial Stability Report, April, 22–29. Jaffee D., Quigley J.M. (2013), “The Future of the Government Sponsored Enterprises: The Role for Government in the US Mortgage Market”, in E. Glaeser and T. Sinai (eds.) Housing and the Financial Crisis, Cambridge, MA: NBER, 361–417. Jordà O., Schularick M., Taylor A.M. (2016), “Sovereigns Versus Banks: Credit, Crises and Consequences”, Journal of the European Economic Association, 14(1), 45–79. Karpavicius S., Yu F. (2016), “Should Interest Expenses be Tax Deductible? “, Economic Modelling, 54, 100–116. Keeley M.C. (1990), “Deposit Insurance, Risk, and Market Power in Banking”, American Economic Review, 80(5), 1183–1200. Keister T. (2019), “The Interplay between Liquidity Regulation, Monetary Policy Implementation and Financial Stability”, Global Finance Journal, 39, 30–38. Kockerols T., Kok K. (2019), “Leaning against the Wind: Macroprudential Policy and the Financial Cycle”, Working Paper, No. 2223, European Central Bank. Kuttner K.N. (2018), “Outside the Box: Unconventional Monetary Policy in the Great Recession and Beyond”, Journal of Economic Perspectives, 32, 121–146. Laubach T., Williams J.C. (2016), “Measuring the Natural Rate of Interest Redux”, Business Economics, 51(2), 57–67. Leeper E.M., Walker T.B. (2011), “Perceptions and Misperceptions of Fiscal Inflation”, BIS Working Papers, No. 364. Levieuge G. (2019), “La politique monétaire doit- elle être utilisée à des fins de stabilité financière?”, Revue Française d’Economie, 3/vol XXXIII, 63–104. Logan L.K. (2018), “Operational Perspectives on Monetary Policy Implementation: Panel Remarks on ‘The Future of the Central Bank Balance Sheet’  ”, Remarks at the Policy Conference on Currencies, Capital, and Central Bank Balances, Hoover Institution, Stanford University, Stanford, California, Federal Reserve Bank of New York, 4 May. Lopez J.A., Rose A.K., Spiegel M.M. (2018), “Why Have Negative Nominal Interest Rates Had Such a Small Effect on Bank Performance? Cross Country Evidence”, Working Paper, No. 25004, National Bureau of Economic Research. Luca O., Tieman A.F. (2019), “Financial Sector Debt Bias”, Journal of Banking and Finance, 107, 105597. Madigan B.F. (2009), “Bagehot’s Dictum in Practice: Formulating and Implementing Policies to Combat the Financial Crisis”, in Financial Stability and Macroeconomic Policy, Kansas City: Federal Reserve Bank of Kansas City, 169–189. Mian A., Sufi A. (2011), “House Prices, Home Equity-Based Borrowing, and the US Household Leverage Ratio”, American Economic Review, 101(5), 2132–2156. Modigliani F., Miller M. (1958), “The Cost of Capital, Corporation Finance and the Theory of Investment”, American Economic Review, 48(2), 261–297. OECD. (2011a), Economic Policy Reforms 2011, http://www.oecd.org/economy/growth/ 46901936.pdf.

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OECD. (2011b), Bank Competition and Financial Stability, www.oecd.org/regreform/ sectors/bankcompetitionandfinancialstability.htm. Ongena S., Popov A., Van Horen N. (2019), “The Invisible Hand of the Government: Moral Suasion during the European Sovereign Debt Crisis”, American Economic Journal: Macroeconomics, 11(4), 346–379. Pfister C., Sahuc J.-G. (2019), “Unconventional Monetary Policies: A Stock-Taking Exercise”, Revue d’économie politique, 130(2), 136–168. Pfister C., Valla N. (2018), “ ‘New Normal’ or ‘New Orthodoxy’? Elements of a Central Banking Framework for the after- Crisis”, Working Paper, No. 680, Banque de France. Poterba J. (1984), “Tax Subsidies to Owner- Occupied Housing: An Asset-Market Approach”, The Quarterly Journal of Economics, 99(4), 729–752. Reinhart C.M., Rogoff K.S. (2009), This Time Is Different. Eight Centuries of Financial Folly, Princeton, NJ: Princeton University Press. Reinhart C.M., Rogoff K.S. (2010), “Growth in a Time of Debt”, American Economic Review: Papers and Proceedings, 100, 573–578. Reinhart C.M., Rogoff K.S. (2011), “From Financial Crash to Debt Crisis”, American Economic Review, 101, 1676–1706. Reinhart C.M., Sbrancia M.B. (2011), “The Liquidation of Government Debt”, BIS Working Papers, No. 363. Rochet J.-C., Vives X. (2004), “Coordination Failures and the Lender of Last Resort: Was Bagehot Right after All?”, Journal of the European Economic Association, 2(6), 1116–1147. Sargent T.J., Wallace N. (1981), “Some Unpleasant Monetarist Arithmetic”, Federal Reserve Bank of Minneapolis, Quarterly Review, 5, 1–17. Schaek K., Cihak M., Wolfe S. (2009), “Are Competitive Banking Systems More Stable?”, Journal of Money, Credit, and Banking, 41(4), 711–734. Shirakawa M. (2012), “Sustainability of Government Debt: Preconditions for Stability in the Financial System and Prices”, Banque de France, Financial Stability Review, 16, 169–182. Sims C.A. (2013), “Paper Money”, American Economic Review, 103(2), 563–584. Smets F. (2014), “Financial Stability and Monetary Policy: How Closely Interlinked?”, International Journal of Central Banking, 10, 263–300. Smith B.D. (1984), “Private Information, Deposit Interest Rates, and the ‘Stability’ of the Banking System”, Journal of Monetary Economics, 14(3), 293–317. Sommer K., Sullivan P. (2018), “Implications of US Tax Policy for House Prices, Rents, and Homeownership”, American Economic Review, 108 (2), 241–274. Stein J. (2012), “Monetary Policy as Financial- Stability Regulation”, Quarterly Journal of Economics, 127, 57–95. Svensson L.E.O. (2017), “Cost-Benefit Analysis of Leaning against the Wind”, Journal of Monetary Economics, 90, 193–213. Tanner E. (2013), “Fiscal Sustainability: A 21st Century Guide for the Perplexed”, IMF Working Paper, No. WP/13/89. Thornton H. (1802), An Enquiry into the Nature and Effects of Paper Credit of Great Britain, London: Hatchard. Trichet J.-C. (2010), “What Can Central Banks Do in a Financial Crisis?”, Susan Bies Lecture, Evanston, Illinois, April 27. Vallascas F., Keasey K. (2012), “Bank Resilience to Systemic Shocks and the Stability of Banking Systems: Small is Beautiful”, Journal of International Money and Finance, 31, 1745–1776. Van Binsbergen J.H., Graham J.R., Yang J. (2010), “The Cost of Debt”, Journal of Finance, 65(6), 2089–2136. Woodford M. (2016), “Quantitative Easing and Financial Stability”, Working Paper, No. 22285, National Bureau of Economic Research.

10 INSTITUTIONS

Financial stability policies are implemented by institutions. The organization and remit of the latter can be studied from a general point of view, which is also, in most cases, the national level (10.1). The international nature of financial activities and the construction of Europe also imply an institutional component at each of these levels (10.2; 10.3).

10.1 General issues The general aspects of institutional organization relate to its architecture (10.1.1) and governance (10.1.2). These two aspects are linked. Thus, while acknowledging that the specificities of each country must be taken into account, Nier et al. (2011a) highlight five desirable features of any institutional organization in charge of financial stability: Avoid complex and fragmented structures, which are detrimental to the identification of risks, circulate information between the different bodies and act swiftly as required in the event of a financial crisis. Give an important role to the central bank. So as to clearly identify responsibilities, have an authority or committee with a leading role and the mandate and powers to conduct macroprudential policy (Chapter 8). Avoid giving too large a role to the Ministry of Finance, so as not to risk compromising decision-making autonomy in other areas, such as monetary policy (Chapter 9) or microprudential policy (Chapter 6), and not to delay pre- emptive decisions in normal times. Make specific provisions for crises, without impeding the above-mentioned characteristics. The first two characteristics relate to institutional architecture (10.1.1), the next three relate to governance (10.1.2).

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10.1.1 Architecture Nier et al. (2011b) distinguish three main classes of architecture models. In the first model, there is full integration between the central bank and all financial regulatory and supervisory functions.1 In the second, known as twin peaks, the central bank is responsible for supervising institutions  –  sometimes only banks – and a different authority is in charge of financial markets. In the third model, the central bank is kept out of all microprudential supervision, except for the supervision of payment systems. Out of 50 countries responding to a 2010 International Monetary Fund (IMF) survey, 31 countries – including 19 emerging and 12 developed economies  –  have at least the central bank in charge of banking supervision, which links them to the first and second models. Nineteen countries – including nine emerging and 10 developed economies – have a financial supervisory authority and thus fall under the third model. Furthermore, the authors note that while in the 1990s the trend had been towards the adoption of the third model, involving the withdrawal of banking supervision from the central bank, there has been a shift towards the first two models since the outbreak of the crisis. This is illustrated in Table 10.1, which refers to the architecture of financial supervision in a number of advanced economies in 2020 (the term “central bank-backed” applied to the supervisor means that the supervisor has legal personality, but is chaired by the central bank governor, with the central bank lending its staff to the supervisor).

TABLE 10.1 Institutional architecture for regulation and supervision

Country

Insurance

Banks

Germany

Federal Financial Supervisory Authority (BaFin)

Deutsche Bundesbank: BaFin capital requirements and risk management BaFin NBB Autorité des services et marchés financiers (FSMA) Federal Reserve (bank Securities and Exchange holding companies Commission (SEC): and banks affiliated securities with the Federal Reserve System); Commodity Future Office of the Trade Commission Comptroller of the (CFTC): derivatives Currency (nationally chartered banks); Federal Deposit Insurance Company

Belgium National Bank of (since April Belgium (NBB) 2011) US (main Authorities of the 50 States, authorities) gathered into the National Association of Insurance Commissioners (NAIC)

Financial markets

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Country

Insurance

Banks

Financial markets

France (since 2010)

Prudential Supervision and Resolution Authority (ACPR) backed by the central bank Insurance Supervisor (IVASS) attached to the Banca d’Italia since January 2013 Financial Supervisor (Financial Services Authority [FSA]) Financial Supervisor (Financial Services Authority [FSA]) Prudential Regulation Authority (PRA; backed by the Bank of England) Financial Supervisor (FINMA) European Insurance and Pensions Authority (EIOPA): coordination and definition of common standards

ACPR

Autorité des marchés financiers (AMF)

Banca d’Italia

Financial Markets Supervisor (Consob)

FSA

FSA

FSA

FSA

PRA

Financial Conduct Authority (FCA)

FINMA

FINMA

European Banking Authority (EBA): coordination and definition of common standards

European Securities and Markets Authority (ESMA): coordination and definition of common standards

Italy

Japan

UK (until April 2013)

UK (since April 2013)

Switzerland

The EU

Source: Supervisory authority websites.

For the euro area, the Single Supervisory Mechanism, backed by the ECB in close coordination with National Supervisory Authorities

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In addition, some countries as well as the euro area have set up a body in charge of macroprudential coordination: −

− − −

In France, the Haut Conseil de Stabilité Financière (High Council for Financial Stability), chaired by the Minister of the Economy, gathering the Governor of the Banque de France (who has the exclusive power to propose actions to the Minister) as well as the head of the supervisory authorities (ACPR, AMF, Accounting Normalization Authority). In Germany, the Financial Stability Committee which is chaired by the Minister of the Economy. In the US, the Financial Stability Oversight Council (FSOC), chaired by the Secretary of the Treasury. In the integrated governance framework of the euro area, the European Central Bank (ECB) and the European Systemic Risk Board (ESRB) which is independent from the ECB, but chaired by its President. The Governing Council of the ECB is responsible for taking macroprudential decisions.

To be complete, one should add resolution authorities (Chapter 7) as well as deposit insurance funds (DIFs; Chapter 5). Both are closer to Finance Ministries as they may require taxpayer money. But the central bank is always associated to the decisions regarding resolution and deposit insurance. From a more analytical point of view, two questions arise: is there a need for one or more supervisors (10.1.1.1)? What should be the role of the central bank (10.1.1.2)?

10.1.1.1 Do we need one or more supervisors? As indicated above, during the 1990s, there was a move towards consolidation of financial supervision outside central banks, generally justified by the emergence of conglomerates covering all financial activities (banking, insurance, markets), and with the aim of facilitating the flow of information between supervisors in different areas. Masciandaro et al. (2013) study on 102 countries the impact of this movement on the resilience of countries to the GFC, measured by their economic growth during 2008–2009. They find a negative relationship, but the central bank’s involvement has no impact on resilience. However, the authors note that evidence suggests that fragmentation of responsibilities, as well as housing all supervisors in a single institution other than the central bank, is not conducive to financial stability: −

Nier et al. (2011a) stress that fragmentation is detrimental to financial stability, as evidenced in particular in the case of the US. Agarwal et al. (2014) exploit the fact that “state chartered” banks in the US are subject to dual supervision at regular intervals by both state and federal supervisors. The latter appear significantly less lenient than the former. In addition, some states are

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−

−

−

more lenient than others, and where state supervision is most lenient, bank failures and the percentage of banks in trouble are higher. According to the authors, this suggests that inconsistent supervision can reduce regulatory efficiency by delaying corrective action and inducing costly variability in the activities of regulated entities. In contrast, in 2007, when financial supervision was concentrated in a single authority outside the central bank (the FSA), the Bank of England, which remained the lender of last resort (Chapter 9), apparently did not have the information necessary to intervene quickly and effectively with Northern Rock whose failure was due to risky funding strategies. The absence in all countries at the outset of the GFC of an institution clearly in charge of macroprudential supervision is now widely recognized as a shortcoming. Edge and Liang (2019) find that, since the GFC, the number of financial stability committees has grown dramatically in number. However, according to the authors, only one-quarter of the 58 committees reviewed have both good processes and good tools to implement macroprudential actions and avoid the risk of policy inaction. Most financial stability committees seem to have been generally designed to improve communication and coordination among existing regulators. However, involving the Ministry of Finance broadens the political legitimacy of macroprudential policy but may also introduce a greater tendency to delay taking actions in response to the build-up of risks. Finally, the revision of the institutional architecture in many of the countries that had previously opted for an FSA-type financial supervisory authority, such as Belgium, Iceland, or the UK, as well as the fact that the latter two countries have experienced extremely costly financial crises suggests that the organization chosen – a single authority outside the central bank – had serious flaws.

It is therefore clear that there is a role for the central bank beyond the oversight of payment systems and intervention as lender of last resort (Chapter 9).

10.1.1.2 What role for the central bank? Various arguments have been put forward in favour of separating the activities of central banks (monetary policy and payments systems oversight) from those of microprudential supervisors, particularly banking supervisors, and in favour of combining them, both (10.1.1.2.1) theoretically and (10.1.1.2.2) empirically. 10.1.1.2.1 Theoretical arguments Three main arguments are mentioned in favour of separation (Goodhart and Schoenmaker, 1995; Di Noia and Di Giorgio, 1999; Blinder, 2010): –

Conflict of interest: In circumstances where the inflationary outlook deteriorates and the financial position of banks is fragile, the central bank could

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–

–

–

–

–

keep interest rates too low, in order to favour banks, which generally benefit from a positive yield curve. The notion of conflict of interest is linked to the notion of reputational risk, since the central bank’s failure to perform any of its tasks could harm the credibility of the institution as a whole, and thus its reputation, and, ultimately, the effectiveness of its actions. In both cases, however, a possible conflict of interest should be overcome if the central bank has more than one instrument at its disposal. In other words, the central bank, which remains responsible for the conduct of monetary policy, and thus for setting the short-term interest rate, should also have the instruments to ensure financial stability. A collateral benefit is that microprudential instruments could be used, such as interest rates, for countercyclical purposes, whereas they spontaneously operate in a procyclical manner (Chapter 6). Finally, one way to manage a possible conflict of interest is to have two decision-making bodies within the central bank, some of which are different in composition. For example, at the Bank of England, the Monetary Policy Committee plays the first role and the Financial Policy Committee the second, with the Prudential Regulation Authority, which is attached to the Bank of England, being responsible for microprudential supervision. Moral hazard: The expectation that the central bank would use its lenderof-last-resort capacity (Chapter 9) to assist banks in the event of difficulties that could lead banks to be less prudent in their risk-taking. However, as the central bank has, in any event, the capacity to act as lender of last resort, this risk exists even if the central bank is not in charge of banking supervision. Moreover, a lender- of-last-resort intervention can be expected to be better managed, i.e. more quickly and efficiently, if the central bank is in charge. Bureaucratic risk: Policymakers might consider it appropriate to limit the margin of “discretion” – the power – available to the central bank (Boyer and Ponce, 2012). Limiting the scope of the central bank’s powers would reduce the risk of “capture” of the supervisor (10.1.2.1). This could explain the finding by Dalla Pellegrina et al. (2013) on 88 countries in the second half of the years 2000–2010 that the more independent the central bank is in the conduct of monetary policy, the less likely it is to be entrusted with banking supervision. Four main arguments are put forward in favour of combining the activities of central banks and those of microprudential supervision (Goodhart and Schoenmaker, 1995; Di Noia and Di Giorgio, 1999; Blinder, 2010; Ampudia et al., 2019). The central bank’s concern for systemic stability: Systemic stability helps ensure the smooth functioning of the transmission mechanism of monetary policy to the economy. Conversely, a crisis situation impedes the transmission of monetary policy impulses as evidenced during the GFC. Economies of scale: Detailed and early information on the situation of banks is useful, even in normal times, for the conduct of monetary policy (Peek

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–

et al., 1999), for the protection of the payments system and for effective intervention as lender of last resort (Chapter 9). The independence of the central bank: As Blinder (2010) points out, this independent status, guaranteed by legal provisions regarding the appointment of its managers and the conditions for the exercise of their mandate, but also by the institution’s own budget, makes it a rather “singular” institution. The independence of the supervisor is considered a necessity (10.1.1.2) and would benefit from the independence of the central bank, thus being less subject to political interference and external pressures (Ampudia et al., 2019). Moreover, in such an institutional arrangement, it would be easier to account for interdependencies between price and financial stability and their designated policy instruments (Ampudia et al., 2019).

As regards macro- supervision, Masciandaro and Volpicella (2016), who review the literature on optimal central bank involvement, stress that policymakers are confronted with a trade- off: Potential net information gains (which increase if the central bank is also involved in micro- supervision) versus risks of capture, policy tool misallocation and of an over-powerful bureaucracy. On the whole, however, even the authors most opposed, for reasons of political economy (to avoid “politicization” of the institution), to an extension of the central bank’s mandate to financial stability want it to conduct macroprudential policy (Calomiris, 2010). While the theoretical arguments are largely in favour of the combination of roles, those of an empirical nature are somewhat more ambiguous. –

In a pro-separation direction, Di Noia and Di Giorgio (1999) study 24 OECD countries over the period 1960–1996, and find that the inflation rate is higher and more volatile in countries where the central bank has sole responsibility for banking supervision, which seems to support the conflict of interest argument. One objection, however, is that even among OECD countries, few central banks, with or without responsibility for banking supervision, were independent throughout the period under review. However, on the basis of 60 countries over the period 1985–2005, Klomp and de Haan (2009) find a negative relationship between independence and financial instability. However, this result mainly reflects the “political” independence of the central bank – i.e. its ability to choose its objectives – rather than its instrumental independence – i.e. its autonomy in setting the level of its interest rates. Moreover, these authors find that where the central bank has an explicit mandate for financial supervision, financial instability is lower than elsewhere. One interpretation of the results could therefore be that central bank independence is not a sufficient condition for the effective pursuit of financial stability: the mandate given to the central bank must also be clear, as central banks are calling for (BIS, 2011, 10.1.1.2). Finally, Eichengreen and Dincer (2011) observe 140 countries from 1998 to 2010; they find that where

294 Institutions

–

financial supervision is carried out by an independent government agency, bad loans are smaller, banks have to hold less capital, lending rates are higher and banking crises are less frequent. They find opposite results where supervision is carried out by the central bank, but especially when it is entrusted to a dependent government authority. Regrettably, Eichengreen and Dincer did not distinguish between central bank independence (or not), a situation that is still quite rare worldwide and, like Klomp and de Haan (2009), whether or not the central bank has an explicit mandate for financial supervision. In a direction favourable to the combination of activities, Goodhart and Schoenmaker (1995) review 104 bank failures in 24 countries during the 1970s and 1990s: Fewer failures occur under combined regimes. Nier et al. (2011b) with respect to the GFC confirm this result: where there is close integration between the central bank and the supervisor (identity or affiliation), bank failures are lower, public capital injections are lower and guarantees provided by the authorities are lower. Doumpos et al. (2015), who analyse a sample of 1,756 commercial banks from 94 countries over the period 2000–2011, find that the independence of central banks influenced the soundness of banks, particularly during the GFC and in the case of smaller banks. Moreover, supervisory unification and central bank involvement appear to have mitigated the adverse effects of the GFC.

Masciandaro and Volpicella (2016), who analyse institutional settings in 31 advanced and emerging market economies, find mixed results. Central bankers in charge of micro supervision and less politically independent are more likely to get extended macroprudential powers, in line with the theoretical “bureaucratic risk” and “economies of scale” arguments. Overall benefits from the integration of monetary policy and supervisory functions seem tangible: a better coordination of policies reduces the scope and inefficiencies associated with a coordination failure and shield the supervisor from regulatory capture (10.1.2.1). Costs may be limited and could be minimized with an adequate organizational design (Ampudia et al., 2019).

10.1.2 Governance The debate on the governance of financial stability institutions is closely related, for both historical and theoretical reasons, to the debate on the “capture” of the supervisor (10.1.2.1). This debate focuses on the independence and accountability of these institutions (10.1.2.2).

10.1.2.1 Capture and the revolving door A captive regulator2 is one who identifies the satisfaction of the interests of the profession he regulates with the public interest: the regulator has been “captured” by the profession.

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The analysis of capture is part of the positive approach to public intervention (Chapter 5). As Laffont and Tirole (1991) and Laffont (1999) point out, capture is more likely to be effective if an interest group is highly concentrated and organized, has high stakes to defend and can hide behind information asymmetries (Chapter 1). Such may result from the technical and complex nature of its activities, making their control by the principal – in this case, the legislator – very difficult. Indeed, the economic drivers of regulatory capture have their roots in the same concepts that drive the need for regulation: information asymmetries and externalities. According to Hardy (2006), these characteristics are all met by the financial sector and other capture factors, specific to this sector, are added. Organizational factors: supervisors are often in contact with the industry, whether when drafting regulations – they are often even obliged by law and regulation to consult with the industry before adopting a measure – or during supervision, particularly during on-site inspections (Chapter 6). Supervisors need the cooperation of banks to work effectively, for example, to have access to the documentation and data they need, or to keep abreast of industry innovations. Regulated institutions offer higher salaries than supervisory agencies, allowing supervisors to capitalize on their knowledge of how the latter operate and reducing their incentive to oppose bank managers. In many countries, the agencies have a more or less explicit mandate to promote their financial centre. Technical factors: the regulation applicable to the banking sector is often very complex, with subtle interactions between its various components. Highly specialized skills and a large amount of data are required for the conduct of banking supervision. The requirement of confidentiality is a legitimate concern. These factors make it very difficult for an outside observer to verify whether supervision has been impartial and for supervisors to know whether they are acting in the long-term public interest. Historically, the capture theory was largely developed in the wake of the savings and loan bank crisis in the US in the early 1980s. In the context of an agentprincipal representation of the relationship between supervised institutions and supervisors on the one hand and politicians and taxpayers on the other, Kane (1989) analyses the conflicting incentives to which supervisors are subject. The modelling used, in which institutions are constantly developing ways of shifting risks back to taxpayers, leads him to distinguish between three regimes. In the first one, supervisors are gradually getting used to innovations, so that they are always “one step behind”. In the second, refusing to recognize risks whose disclosure would damage their reputation, they “turn a blind eye” (regulatory forbearance). In the third, they have to admit reluctantly the cost of remedying the increasingly glaring shortage of capital in institutions. The solution, according to Kane (1989), would be to give the supervisor the resources to restructure the incentives, i.e. to increase the level of resources available to the regulator allowing him to pay higher wages. However, the author asks, but does not answer, the question of how to make this strategy compatible with the career interests of policymakers. Taking the same type of approach, where the regulator aims to defend its interests by refusing to acknowledge its mistakes, thus increasing the

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social cost of inevitable decisions, Boot and Thakor (1993) suggest reducing the interests at stake by reducing the supervisor’s margin of discretion, following an approach inspired by the credibility literature (Kydland and Prescott, 1977). To this end, they suggest specializing institutions (10.1.1) by depriving the banking supervisor of the power to close an institution, not having the supervisor appointed through a political process if the previous condition is not met, adopting rules for automatic bank closures, strengthening market discipline (Chapter 4) and increasing the accountability of supervisors. Empirically, does the issue of capture carry a stake beyond the specific case of savings and loan? Using data for 107 countries in 1999, Heinemann and Schüller (2004) show that, where the influence of banks as measured by the economy’s dependence on their financing is significant, they do not use this influence so much to erect barriers to entry, contrary to Stigler’s (1971) intuition. Igan and Lambert (2019) discuss whether financial sector lobbying in the US – with expenses estimated at $7.4 billion from 1998 to 2016 – led to regulatory capture. They focus on the evidence on financial regulation, supervision and outcomes during the GFC. Their findings are consistent with the presence of regulatory capture, which lessens the support for tighter rules and enforcement. They suggest enhancing the transparency of regulatory decisions and placing check and balances in the decision-making process. One possible manifestation of regulatory capture is the existence of a “revolving door”, which refers to public office holders or public servants taking positions in the private industry and vice versa (Igan and Lambert, 2019). According to Bond and Glode (2014), initial employment at a financial regulator should be the most frequent case, an intuition that is observed empirically in the US (Shive and Forster, 2017). The revolving door may facilitate the transfer of knowledge between regulators and financial firms (regulatory schooling hypothesis), all the more so if regulators favour complex rules because schooling in these regulations enhance regulator earnings should they transition to the private sector (Lucca et al., 2014). Alternatively, firms may also benefit from a preferential treatment by the regulator while the individual is employed in the regulatory sector (quid pro quo behaviour). Empirical evidence available in the US (Lucca et al., 2014; Shive and Forster, 2017) is consistent with the regulatory schooling hypothesis.

10.1.2.2 Independence and accountability On the positive side, governance arrangements can be seen as the result of an unobserved variable: the optimal combination of degrees of independence and accountability consistent with the preferences of the policymaker (Masciandaro et  al., 2008). Following the literature on credibility (Kydland and Prescott, 1977), (10.1.2.2.1) independence can be seen as enhancing time consistency and (10.1.2.2.2) accountability as a complement to independence, both as a counterpart and a guarantee of the latter.

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10.1.2.2.1 Independence as a credibility factor Supervisory independence has two dimensions: vis-à-vis political power and visà-vis the profession (Quintyn and Taylor, 2002); in this second sense, it opposes capture (10.1.2.1). As independence, to be effective, must be legally founded, it is necessary to examine, from a normative point of view, under what conditions the delegation of a function to an agency by the policymaker can be effective and, from a positive point of view, when it takes place. Alesina and Tabellini (2004) discuss this topic based on two assumptions: the motivations of bureaucrats and politicians are different; Agencies’ tasks must be defined ex ante and cannot be contingent on the occurrence of too large shocks in the environment and public preferences, as any bureaucracy must both be assured of a certain permanence and have limited discretion. From a normative point of view, Alesina and Tabellini (2004) show that bureaucrats are then more efficient than politicians when the following conditions are met: – – – – –

Differences in performance are due more to individual talent or technical ability than to effort. There is no uncertainty about the preferences of the public and flexibility is therefore not essential. Time consistency is a problem. Minority, but powerful, interest groups have important issues to defend. There is no need to take into account the complementarities between economic policies and to compensate potential losers.

On the whole, these conditions appear to be met in the area of financial supervision. In particular, applying to this area, the optimal contract theory developed in the monetary policy literature to preserve time consistency (Rogoff, 1985; Walsh, 1995). Ponce (2010) shows that, in the same way as for the central banker, the supervisor’s incentives to implement the optimal contract are maximized when he is independent, legally protected, and accountable. Moreover, while there are interactions between financial stability and economic policies, in particular fiscal policy, they manifest themselves mainly as disruptions imposed on the former by the latter (Chapter 9). Conversely, compensation of depositors when a bank is closed implies that deposit insurance should not be the responsibility of the supervisor. On the positive side, Alesina and Tabellini (2004) indicate that politicians delegate when: – – –

The rents at stake are not very substantial. The tasks to be performed are risky, in the sense that failure is possible. The policies pursued are not redistributive.

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Applied to financial stability, these criteria provide a much more ambiguous result than the positive criteria, notably because rescuing institutions may have important fiscal consequences (Chapter 9). This may explain the reluctance of political authorities to clearly specify central banks’ mandates for financial stability (Oosterloo and de Haan, 2004), against their request (BIS, 2011), or to grant them the necessary powers to pursue this mandate. Quintyn et al. (2007) identify four dimensions of supervisory independence: –

–

–

–

Institutional independence: The agency has a legal status; the law recognizes its independence; and the president of the agency and its senior staff are appointed by the two branches of political power (executive and legislative). Decisions are taken by a college and not by an individual; agency staff have legal immunity for actions they undertake in good faith. No Member of Parliament or government representative participates in the decision-making college. The Minister of Finance cannot oppose a decision of the college. The criteria for dismissal of the president of the agency are clearly defined by law. Regulatory independence: The agency has a high degree of autonomy in setting prudential rules and regulations for the sectors under its supervision, within the confines of the law. Supervisory independence: Concerns the independence with which the agency is able to exercise its judgement and powers in such matters as licensing or enforcement of sanctions. Budgetary independence: The agency is financed via a levy on regulated entities. It does not need to require the government’s prior approval of its budget. It sets autonomously the level and wage structure of its staff. It recruits and defines its internal organization autonomously.

Masciandaro et al. (2008) apply these criteria to 55 countries in the mid-2000s. For a maximum level of independence of one, they find a mean of 0.69 (France is at 0.63) and a standard error of 0.17. 10.1.2.2.2 Accountability as a complement to independence Perhaps even more so than for monetary policy, accountability, i.e. the obligation to explain one’s actions transparently to governments and the public, is important for the financial supervisor (Ponce, 2010): – – – –

The supervisor must have far-reaching powers, which may apply to specific entities, including the power to grant and revoke licences. His field of intervention, financial stability, is not easy to define (Chapter 1). Similarly, it is often difficult to establish a close link between the use of the instruments at its disposal and the attainment of its objective. He must avoid capture.

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In particular, independence plays only a limited role in preventing capture through, for example, the freedom to determine staff salaries. From the point of view of the profession, it is even more desirable to capture a supervisor if he or she is more independent. Instead, accountability is essential to avoid capture, including “self- capture”, which would allow the supervisor to pursue bureaucratic objectives (Levine, 2011). It thus plays a complementary role to independence. Quintyn et al. (2007) identify seven dimensions of accountability: – –

–

–

– –

–

Mandate: The institution’s mandate is defined by the law. As noted above, this is rarely the case for central banks (Oosterloo and de Haan, 2004; BIS, 2011). Accountability to the legislative branch: The law requires an annual report to the Parliament. It provides for the possibility of regular hearings (e.g. quarterly). The Minister of Finance does not present the annual report to Parliament. Accountability to the executive branch: The law requires an annual report to be submitted to the executive. It provides for the possibility of regular, for example, quarterly, meetings with the Minister of Finance and ad hoc meetings. Accountability to the judiciary: Regulated entities have the right to apply to a judicial authority for a review of the decisions of the agency. Appeals are heard by specialized judges. The law provides for penalties in case of faulty supervision. Budgetary accountability: This procedure applies for the ex post presentation and discussion of the agency’s budget. Transparency: Individual actions and decisions taken by the supervisor are made public (e.g. on its website). The agency has issued a communiqué on its mission. The annual report is available to the public. The public may request information. The law provides that the supervisor must consult a consumer protection body before adopting general measures. Others: The law requires ex ante consultation with the profession before adopting new regulations. It provides for the same obligation towards the public. An internal and external audit system is in place.

Applying these criteria to the same countries and over the same period as for independence, Masciandaro et al. (2008) find that accountability is less well ensured overall than independence: for a maximum of one, the average is 0.58 (France is 0.67), with a standard deviation of 0.11.

10.2 International aspects The main international institutions active in the field of financial stability are presented first (10.2.1), followed by proposals for wide-ranging reforms of these institutions and, as an alternative, suggestions for improving the existing framework (10.2.2).

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10.2.1 Institutions The institutions at least partially dedicated to international financial stability can be grouped around three poles: the groups of countries (G7/G8/G20) meeting either at the level of heads of state or at the level of finance ministers and central bank governors (10.2.1.1), the International Monetary Fund (IMF; 10.2.1.2), and the Bank for International Settlements (BIS) and the institutions it hosts (10.2.1.3).

10.2.1.1 Groups of countries The G7 is a forum that has brought together Canada, France, Germany, Japan, Italy, the UK, and the US since 1976, with the EU also participating since 1977 as well as the ECB since its creation in 1999. In 1997, the G7 became the G8 and finance ministers and central bank governors continued the practice of meeting four times a year to exchange views and deal in particular with emergency situations in the financial markets, with public interventions in the form of communiqués. The G20 was formed in 1999 by the addition of the G7 participants, Australia and 11 emerging countries (Argentina, Brazil, China, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey), notably in response to the financial crises of the second half of the 1990s (Chapter 2), as well as the EU. It has established itself as the main forum for international financial cooperation, reflecting the growing importance of emerging countries in the world economy: member countries account for 86.5 of world nominal GDP in 2018 (89.6% in 1999), compared with 45.8% for the G7 countries (65.5% in 1999).3 It meets annually at the level of heads of state and several times a year at the level of ministers and central bank governors. However, Lo Duca and Stracca (2015) show that G20 summits do not have a strong, consistent, and durable effect on any of the markets that they consider, on the basis of equity returns, bond yields, and measures of market risk such as implied volatility, skewness, and kurtosis between 2007 and 2013. They thus suggest that the information and decision content of G20 summits is of limited relevance for market participants.

10.2.1.2 International monetary fund Created in 1945, the IMF is, with 189 member states, an almost universal institution. According to Article 1 of its Articles of Agreement, the Fund has five fundamental objectives: to promote international monetary cooperation; to facilitate the expansion and balanced growth of world trade; to promote exchange rate stability; to help establish a multilateral system of payments; and to make its resources (subject to adequate safeguards) available to countries facing balance of payments difficulties. The IMF thus contributes indirectly to international financial stability, since it does not make explicit reference to it in its missions. The Fund’s resources are made up of quotas paid by member states, according to the weight of the countries’ economies. They reached special drawing rights

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(SDR) 477 billion at end 2019 (about $661 billion). In addition, the IMF may rely, with the agreement of its creditors, on permanent multilateral borrowing mechanisms, notably the New Arrangements to Borrow (NAB) up to SDR 182 billion (around $253 billion). A third line of defence is made of commitments by countries to increasing the IMF’s resources in the form of bilateral loan agreements with a maturity of two years, renewable twice for one year, totalling SDR 317 billion ($440 billion). The last two funding sources are periodically reviewed by countries. Some member countries flagged their reluctance to the renewal of these funding facilities. The IMF’s means of action are twofold: surveillance (10.2.1.2.1) and financial assistance (10.2.1.2.2). 10.2.1.2.1 Surveillance The IMF intervenes in the context of consultations to provide advice to member states. In particular, according to Article IV of the Fund’s Articles of Agreement, the Fund shall exercise close surveillance over the exchange rate policies of the Member States (…) each Member State shall provide the Fund with the information necessary for such surveillance and, at the request of the Fund, shall hold consultations with the Fund on such policies. In practice, Article IV consultations result in an annual mission to the major economies, less frequently to the others. Since 1999, the Fund has introduced Financial Sector Assessment Programs (FSAPs) in its Article IV consultations, normally once every five years, for countries or areas whose financial sectors it considers “systemically important”. It is a comprehensive stock-taking exercise conducted at a lower frequency than Article IV consultations to detect possible weaknesses in the financial system, on the basis of granular supervisory data and in-depth assessments of a country’s financial sector. However, the publication of the assessment of the stability of the financial system to which these programmes lead is not mandatory. From 1999 to 2018, the IMF conducted more than 350 FSAPs across 144 jurisdictions, i.e. over three- quarters of its members and 99.7% of global financial assets. 10.2.1.2.2 Financial assistance Pursuant to Article 1 of the IMF’s Articles of Agreement, the loans it grants are designed to contribute to the financing of balance of payment deficits. However, this condition is interpreted broadly, as the need for external financing may be either actual or potential. In addition, the IMF has to resort to guarantees; in the most frequent absence of forced recourse against governments, these are the result of “conditionality”: “an IMF- supported economic programme is prepared

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by the national authorities in close cooperation with IMF staff, and financial assistance remains conditional on the effective implementation of the programme”. Financial assistance is basically of two kinds: –

–

Stand-by arrangements (SBAs), which are the best known and for which conditionality is applied ex post, i.e. after the programme is concluded. In principle, SBAs are granted for a period of 6–36 months and are subject to access limits (200% of the quotas annually and 600% cumulatively). Prevention tools, for which conditionality is essentially exercised ex ante, according to a qualification process. The purpose of these tools is to protect countries with sound economic fundamentals against the risk of speculative attacks from runs or “contagion” (Chapter 1) phenomena affecting countries considered as “innocent bystanders”. Set up in the wake of the Asian financial crises of the mid-1990s and reformed several times, they are of two kinds: the flexible credit line (FCL) and the precautionary and liquidity line (PLL). The criteria for accessing the FCL are more demanding, as countries with access to the PLL may also have a balance of payments financing requirement at the time of the agreement. FCL can be activated for a period of 12–24 months and is not subject to access limitations. The duration of a PLL can range from 6 to 24 months, with high access limits (500% of quotas in the first year, 1,000% in the second one).

The IMF’s interventions, in particular SBAs, have given rise to debate: –

–

IMF’s interventions evolved quite significantly over time, away from its initial mandate. As shown by Reinhart and Trebesch (2016), IMF initially provided short-term loans to address Balance of Payment deficits by advanced countries. Starting in the late 1970s, the IMF programmes increasingly involved lending to countries with a wider range of crises (apart from those related to foreign exchange), including banking and sovereign debt crises. In dealing with potentially unsustainable debt cases and in moving towards larger and longer-term loan packages, the institution became more involved in lending into sovereign default (often chronic), hence acting as a development agency engaged in long-term lending. The 2008 crisis ushered in a very significant rise in the volume of lending (in real terms) directed at the higher-income economies: from 2008 to 2016, the IMF loaned more than $200 billion, of which about two-thirds went to advanced economies like Greece, Iceland, Ireland, and Portugal. By focusing again on lending to advanced countries, the IMF temporarily returned to an earlier pattern. But at end 2019, Greece only accounted for 10% of IMF exposures, the rest being made up of emerging and low-income countries: Argentina, Ukraine, and Egypt were among the largest borrowers from IMF in 2019. There are arguments against IMF interventions, sometimes advocating their elimination, with the IMF being confined to a surveillance role, usually

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–

with strict limits on the amount. First and foremost, the potential intervention of the IMF is seen as creating moral hazard, diminishing both the incentives of member countries to pursue prudent economic policies and ensure their financial stability and those of private lenders to monitor debtors (Vaubel, 1983; Meltzer Commission, 2000; Kremer and Pfister, 2001; Lee and Shin, 2008, although Li et al., 2015, on the basis of meta-analysis of available research, conclude that “In short, with respect to moral hazard, the empirical evidence is far from conclusive”). The action on incentives is all the more negative because adjustment measures, which are unavoidable, have a cost (debtors therefore systematically tend to defer them, which reinforces the cost) and IMF loans have an element of subsidy (the cost is partly passed on to the global community). The fact that the IMF, unlike a central bank, has limited resources can also have counterproductive effects; at the very least, the IMF’s provision of the requested liquidity can be the trigger for a run. In addition, conditionality is poorly enforced and does not appear to increase the chances of a programme’s success (Dreher, 2009), and there is no consensus on what might constitute an optimal programme; indeed, the impact of IMF interventions on economic growth appears to be negative (Barro and Lee, 2005). Finally, the perception of a “seniority” of IMF loans, which is justified since these loans have almost always been repaid, leads to a “dilution” of private creditors: private creditors may feel that as the IMF takes their place, it may be necessary to impose even more severe constraints on their funds or haircuts in order to restore the financial health of the debtor country. In addition, there is a specific debate on IMF interventions in dealing with sovereign defaults. Sovereign defaults plagued financial history, even if cases of full repudiation are rather infrequent. Indeed, Meyer et al. (2019), compiling a new database of foreign currency government bonds traded in London and New York between 1815 and 2016, covering 91 countries, show that, as in equity markets, the returns on external sovereign bonds have been sufficiently high to compensate for risk. IMF policy changed over time. Committeri and Spadafora (2013) study the evolution of IMF’s policy regarding “exceptional access” to Fund financing (i.e. above the normal limits). The first phase starts from the Mexican crisis of 1994–1995, where IMF moved from an initial regime that allowed greater case-by-case discretion in the use of the Fund’s financial resources to a new, more systematic, and rule-based one, designed to make Fund lending more predictable while preserving some flexibility. IMF established a comprehensive “exceptional access” policy framework in 2002. Under this framework, the IMF could only provide large-scale financing in capital account crises under strict conditions of debt sustainability. However, in 2010, while Greece’s problems were the most acute, threatening to lead to the break-up of the euro area, the IMF created a “systemic exemption” for cases where there were significant uncertainties around debt sustainability. In such cases, the exemption

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–

allowed large- scale financing to go ahead without a debt reduction operation if there was a high risk of systemic international spillovers. However, in 2016, the IMF dropped the systemic exemption, as it had provided wrong incentives. Regarding the effectiveness of these interventions, evidence is mixed. According to Jorra (2012), programmes have been shown to increase the likelihood of subsequent sovereign defaults. But ECB (2019) stresses that one area in which the effectiveness of IMF programmes has proven less than satisfactory is with serial borrowers. Balima and Sy (2019), using a panel of 106 developing countries from 1970 to 2016, find that IMF- supported programmes significantly reduce the likelihood of subsequent sovereign defaults by around 1.3 percentage points (from an average of 3.5 percentage points). In their sample, a country that signs a programme with the IMF typically experiences a slight improvement in its sovereign credit rating and a decrease in both government debt-to- GDP and fiscal deficit-to- GDP. There are also concerns regarding demand for IMF assistance. On the one hand, Poulain and Reynaud (2017), using a panel of 91 advanced, emerging, and frontier economies over 1992–2014, show that global factors and interconnectedness, as proxied by a country’s potential exposure to economic spillovers from trade partners, together with more traditional idiosyncratic factors, have a significant impact on the probability that a member country obtains financial assistance from the IMF. On the other hand, Andone and Scheubel (2019) show that when controlling for the success of past programmes, a country is less likely to approach the IMF for help if in the past it experienced an aboveaverage number of conditions for disbursement (i.e. “harder” conditions).

Conversely, there are other arguments for the effectiveness of the Fund’s interventions and for increasing its financial resources to such an extent that if they were sufficient, the mere prospect of their use would nip in the bud the possibility of a run (Fisher, 1999). The main argument here is that of “catalytic finance”, whose logic is that of a “virtuous circle”. Allowing a lack of coordination between lenders to be resolved, IMF loans would make a run less likely by increasing the number of private investors willing to lend; the incentive to implement adjustments would thus be increased (Corsetti et al., 2006; Morris and Shin, 2006). Indeed, conditionality would have a signalling effect: by accepting it, the recipient country would signal in a situation of information asymmetry (Chapter 1) that it belongs to the “right” type of borrower, which would facilitate its access to financial markets. In addition, conditionality would facilitate the reorientation of economic policy: by “tying its hands”, the borrowing country would gain credibility. Indeed, IMF programmes are relatively financially efficient: a country is less likely to suffer a sudden stop in net capital inflows in the years following its participation in an IMF programme (Eichengreen et al., 2008). Furthermore, the latter improves the borrowing conditions of a country whose debt burdens and foreign exchange reserves are in an intermediate zone, so that the “catalytic” effect of IMF interventions appears to be working well in countries whose financial situation is neither very good nor

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very bad. Finally, the “seniority” of IMF lending would have a positive aspect, as it allows the IMF to lend more at lower rates, reducing the likelihood of a short-term liquidity crisis and a longer-term solvency crisis (Saravia, 2010). This would also be the case because the possibility of “dilution” should encourage private creditors to monitor debtor countries more closely, thereby reducing moral hazard. This debate has prompted the IMF to adjust its financial assistance modalities, with the view to developing intervention policies more consistent with its initial mandate, notably in the direction of behaving like a central bank discount window – i.e. being willing to extend a substantial volume of credit on short notice (Reinhart and Trebesch, 2016). This triggered different proposals for the creation of prevention tools. First, the Rapid Credit Facility (RCF) seeks to provide quick loans with limited conditions to low-income countries facing a balance of payments crisis. Second, the already mentioned FCL, enacted in 2009, has the specific goal of reducing the risk of stigma. FCL loans are granted for crisis prevention and crisis mitigation in more stable economies – i.e. for countries with very strong policy frameworks and before the economy are at severe risk. Third, the already-mentioned PLL is aimed at countries with essentially sound economic fundamentals but with a limited number of vulnerabilities that disqualify them from using the FCL. In particular, the ex ante qualification process should reduce the moral hazard and the absence of at least theoretical access limits (FCL) or high level of limits (PLL), acting as a sword of Damocles on the risk of run. Nevertheless, these instruments were hardly met with success, perhaps because many potentially eligible countries were afraid to report vulnerability if they applied to the facility (the “stigma effect”; Kremer and Pfister, 2001). In any case, as of 2019, only three FCL (Colombia, Mexico, Poland) and two PLL (Macedonia, Morocco) agreements had been concluded at some point in time. Essers and Ide (2019) review these experiences. They conclude that the likelihood of the participation in the FCL is explained by higher exchange market pressures in the run-up to the FCL’s creation, lower pre-FCL bond spreads, lower inflation (both correspond with the official qualification criteria for eligibility of FCL applicants), a higher share in US exports and a higher propensity of making political concessions to the US (the IMF’s largest shareholder). However, there are generally limited beneficial effects, which, in the case of reduced spreads, became visible only a considerable time after the respective FCLs were first approved. The EPG (2018) Report makes proposals to extend the IMF’s resources in large and severe global crises, by lending on the basis of unused SDRs from member country savings, currently amounting to approximately $150–200 billion. The other mechanism would be allowing the IMF to borrow on international financial markets.

10.2.1.3 Bank for international settlements and associated institutions Often referred to as “the central bank of central banks”, the BIS is the oldest of the international financial institutions. Created in 1930 to settle the reparations imposed on Germany under the Treaty of Versailles, it is a public limited company whose shareholders are central banks, of which there were 62 in 2020. The

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tasks of the BIS are to promote and facilitate cooperation among central banks, to maintain a dialogue with other authorities responsible for promoting financial stability, to conduct studies on economic policy issues facing central banks and financial supervisory authorities, to act as a counterparty to central banks in their financial transactions and to act as agent or administrator in connection with international financial operations. The Governors of the member central banks meet every two months at the BIS headquarters in Basel to discuss monetary policy and financial stability issues. The BIS also has standing committees, which report to the Governors and play an important role in financial stability: –

–

–

The Basel Committee on Banking Supervision (BCBS) provides a forum for regular cooperation on banking supervision issues. Its objective is to improve the understanding of key supervisory issues and the quality of banking supervision worldwide. In particular, it set international standards for liquidity and solvency standards (Chapter 6). The Committee on the Global Financial System (CGFS), formerly known as the Euro- Currency Standing Committee, established in 1971 to monitor international banking markets and their monetary policy implications, has a mandate to identify and assess potential sources of stress in international financial markets, to develop understanding of the workings of these markets and to promote improvements in their functioning and stability. The Committee on Payment and Settlement Systems (CPSS) contributes to the strengthening of the financial market infrastructure, in particular by setting standards, such as the principles for financial market infrastructures, which the BIS has defined jointly with the International Organisation of Securities Commissions (IOSCO) (Chapter 3).

The BIS also hosts the secretariats of a number of independent organizations that do not report to Governors. These include the Financial Stability Board (FSB), the International Association of Insurance Supervisors (IAIS), and the International Association of Deposit Insurers (IADI). In particular, the FSB brings together national authorities responsible for financial stability in the main international financial centres, international financial institutions, international regulatory or supervisory bodies and expert committees of central banks.

10.2.2 Extensive reforms or improvements to the existing framework? Proposals for wide-ranging reforms (10.2.2.1) and for improving the existing framework (10.2.2.2) are presented in turn.

10.2.2.1 Comprehensive reforms The actions of international institutions acting in the area of financial stability are not immediately applicable. The G7 and the G20 make recommendations.

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IMF financial interventions must be requested by the beneficiary countries and approved by the Member States. The standards drawn up by the BIS Standing Committees must be transposed into the domestic legal order with, in the case of the EU, the intermediate intervention of a European directive or regulation. It is to these institutional limitations that proposals for wide-ranging reforms, most of which were made in the second half of the 1990s in the wake of the Asian crises (Kremer and Pfister, 2001), are attempting to respond. These proposals, in analogy with the prevailing order in the architecture of national institutions (10.1.1), aim to establish an international lender or quasi-lender, capable of providing liquidity in virtually unlimited quantities in order to prevent a crisis or limit its effects (10.2.2.1.1) and a financial regulator (10.2.2.1.2). More often than not, they also aim to contain financial instability caused by poor public financial management (Chapter 7), which can lead to sovereign default. 10.2.2.1.1 Provision of liquidity Lerrick and Meltzer (2003) put forward a proposal aimed at preventing panic or contagion in international banking and financial markets while limiting moral hazard: during the period of a sovereign debt restructuring, the IMF would provide liquidity by guaranteeing a floor price for the debt. The latter would be 15%–20% below a minimum restructured value announced by the sovereign following an estimate made in consultation with the IMF; if the minimum value has been properly estimated, the guarantee should therefore not come into play. Stockman (2003) notes that the proposal raises several difficulties: –

–

–

How to determine the restructured minimum value and the guaranteed floor? Too high levels would force the IMF to intervene; levels that are too low would allow prices to collapse. In particular, political factors could induce the IMF to hold levels too high, in order to protect creditors and friendly countries. How can the private sector be convinced that the sustainability of the sovereign’s public finances has been restored, given the difficulty of defining this notion (Chapter 7)? IMF intervention should therefore continue to be conditional. How to ensure the credibility of the IMF’s engagement? High resources could contribute to this, but could also lead to political pressure for interventions.

Eichengreen (2011) makes two much more radical proposals, since they effectively give the IMF sovereign status: –

–

Make IMF staff responsible for issuing SDRs, whereas this is now subject to approval by a qualified majority (85%) of member states’ quotas. This reform would make SDRs a reserve currency allowing the IMF to intervene in a potentially unlimited way, in the manner of a true lender of last resort. Make the IMF play the role of an insurer against systemic risk. Insurance premiums would either be paid directly by the banks to the IMF, which, in

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the event of a systemic crisis, would make payments to the same banks, or collected from national authorities, which would turn to the institutions to collect the premiums and distribute the money from the IMF. The moral hazard associated with this proposal would be mitigated by excluding from the scheme those countries where a FSAP would have diagnosed significant problems. The first proposal would create moral hazard and, because of the possibility of exchanging SDRs for reserve currencies, would deprive SDR-issuing countries of their monetary sovereignty (Kremer and Pfister, 2001). For example, Rogoff (1999) notes that currency competition is useful for disciplining issuers, that there are differences in economic cycles between countries, and that international liquidity provision can be made by reserve currency issuers in the event of a global crisis (10.2.2). The second proposal suffers from a lack of credibility. Assuming it is implemented, IMF staff would then face an overwhelming responsibility in choosing to exclude a country, and that decision would likely be taken only when it was unavoidable and therefore too late to be useful. Above all, governments play the role of ultimate insurer against systemic risk at the national level (Chapter 8), and unlike governments, the IMF cannot levy taxes. These proposals are therefore unrealistic. In addition, in a period where the shortage of safe assets is expected to become permanent, creating an increase in the price of safe assets, or equivalently, a decline in global safe interest rates, additional constraints are put on monetary policy, which reaches the effective lower bound (Caballero et al, 2017). Many proposals are made in the European context to address that issue (10.3). At the global level, the provision of international safe assets may also come from financial engineering, as suggested by Brunnermeier and Huang (2018): pooling and tranching of a pool of sovereign assets provides an additional protection and avoids self-fulfilling fire sales of assets in crisis times. While the sovereign bond of an emerging economy might lose its safe asset status after an adverse shock, a senior bond that is backed by several sovereign bonds does not. The overall approach by these authors involves tranches, i.e. it combines a number of risky assets into a pool, and then creates a series of derivative assets. The most junior tranche of these assets bears all the losses, up to a certain percentage of the total. Intermediate (or mezzanine) tranches bear losses above that amount. The most senior tranches are the safest, since they only bear losses after all the lower tranches have been wiped out. Of course, junior tranches also need to offer a higher rate of return to offset their greater risk, while the most senior and safest tranches pay the lowest rate of return. Hence, flight-to-safety capital flows do not have to leave the country. By pooling many sovereign bonds and tranching the pool, governments can exploit diversification benefits and increase the size of the senior tranche, thereby increasing the total quantity of safe assets (GloSBSies) supplied by and for emerging economies.

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10.2.2.1.2 Regulation The proposals in the field of international financial regulation are to create two institutions: –

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A resolution authority for international banks (Eichengreen, 2011). This proposal is intended to take account of the limits to international cooperation in the event of default (10.2.2). Even in a so- called “universalist” approach, where a single jurisdiction would be responsible for the resolution of an international bank, it is not easy to determine which international jurisdiction to choose between the one where the institution has its head office and the one where it has the largest part of its assets, or even of the deposits it collects. Rogoff (1999) argues that such an institution would not have the power to enforce its decisions, but a counter- objection is that private creditors should find it advantageous, in order to coordinate, to have an institution capable of distributing the necessary contributions among themselves. A World Finance Organization (WFO). Just as the World Trade Organization (WTO) sets out principles for trade policy, the GWO would establish prudential policy principles that member countries would be obliged to abide by (Eichengreen, 2011). In addition, membership in the GFW would be mandatory for all countries wishing to provide access to foreign markets for the institutions they have approved. However, given the role already played by the major international banks in financing the global economy, these constraints would be likely to apply only to emerging economies, since their banks remain predominantly domestic. Moreover, existing institutions (10.2.1) already play a very important role in the development of prudential policy principles.

10.2.2.2 Improvements to the existing framework This includes in particular from public authorities the reform of the Global Financial Safety Net (GFSN), i.e. the resources available to countries in case of crisis. Indeed, a multilayered GFSN has emerged in the wake of the 2008 crisis, including multilateral institutions like the IMF, bilateral and regional financing arrangements and individual countries’ own reserves (IMF, 2017). There are three ways of improving the existing framework: those available to countries (10.2.2.2.1), those involving the private sector (10.2.2.2.2) and those enabling national authorities to cooperate better (10.2.2.2.3). 10.2.2.2.1 Channels available to countries These paths consist first of all of “self-insurance”, but also of mobilizing national savings through financial development: –

Self-insurance: Emerging countries can insure themselves against runs by increasing their level of foreign exchange reserves. Various indicators have

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been proposed for this purpose, such as the “Guidotti rule”, which proposes that foreign exchange reserves should be higher than the expected service on the external debt in the coming year, thus providing an incentive to borrow at longer maturities, thereby reducing liquidity risk (Kremer and Pfister, 2001). The advantages of self-insurance are the certainty and availability of resources, provided that reserves have been invested in short-term securities traded in highly liquid markets, as are normally those of the major reserve currency-issuing countries. The disadvantages are the low return on investment in liquid securities, the risk of a shortfall in the amount of reserves and the undesirable impact on foreign exchange and international payments if the amount of reserves is high (Moessner and Allen, 2010b). Jeanne and Rancière (2011) develop a formula that takes into account the opportunity cost of holding foreign exchange reserves, the probability of a sudden stop, its cost in terms of lost production and the risk aversion of the self-insured country. In view of these parameters, the level of reserves held by many emerging countries seems reasonable to them; however, the level of reserves held by emerging Asian countries (Korea, Malaysia, the Philippines, and Thailand) could only be explained by the high cost of crises and strong risk aversion. It should be noted however that these countries had found the IMF programme conditions experienced in the second half of the 1990s humiliating. In addition, reserves accumulation is not without risk. Steiner (2014) argues that the “local” view, which holds that reserves may prevent domestic crises, overlooks the risk that the accumulation of reserves relaxes the financing constraint of the reserve currency country and may cause a financial crisis in the “centre”, which would then be transmitted globally. Financial development: One reason that often makes emerging economies dependent on capital inflows is that domestic savings are invested abroad in the absence of sufficiently attractive and diversified investment opportunities. If accompanied by the establishment of a good legal, technical, and supervisory infrastructure, financial development, including the development of public debt and equity markets, should contribute to the financial stability of these economies.

10.2.2.2.2 Private sector involvement Private sector involvement (bailing in) reduces moral hazard by making private creditors more accountable by encouraging them to monitor their risk-taking, particularly when it is accompanied by limits on IMF involvement that could only be exceeded in exceptional circumstances (Haldane and Kruger, 2001; Kremer and Pfister, 2001; Kroszner, 2003). It requires the establishment of mechanisms for coordination among creditors and between creditors and debtors. These are of three kinds: –

The inclusion of collective action clauses (CAC) in public borrowing contracts. CACs facilitate the renegotiation of debt contracts by defining ex ante

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–

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the decision rules  –  particularly quorum rules  –  that must be respected in order to change the characteristics of the issue strains (duration, rate, repayment of principal, etc.), thus preventing a minority of holders from blocking the renegotiation process. Initially used by emerging countries, CACs have gradually been introduced in new bond issues by euro area Member States from 1 January 2013. To the extent that they make it easier for the issuer to restructure its debt, they may appear to be a factor of moral hazard, but in fact they play the opposite role, inducing creditors to charge credit risk premiums. The organization of the creditor bankers. An example is provided by the Vienna Initiative launched in 2009. With the support of international financial institutions (European Investment Bank, European Bank for Reconstruction and Development, World Bank), this enabled the participating banks to maintain their level of commitment to countries benefiting from European Union and IMF programmes (Bosnia-Herzegovina, Hungary, Latvia, Romania, Serbia), without any negative repercussions for countries to which these banks were not committed. It is therefore a concrete example of “catalytic finance”. The establishment of a forum for resolving disputes over sovereign debt (Haldane and Kruger, 2001). It would have a set of options at its disposal to resolve a sovereign crisis, voluntarily or not. Under the first, voluntary route, securities exchanges and debt rescheduling agreements could be concluded; under the second, non-voluntary route, suspensive periods could be applied (Haldane and Kruger, 2001). The role of the forum could be recognized by inserting a clause in the contract of each debt instrument providing that it is the place where a potential conflict would be resolved (Kroszner, 2003). Finally, failing the creation of a forum, a code of conduct for restructuring sovereign debt could be developed.

Eichengreen and Woods (2015) argue in favour of the IMF or another multilateral institution that would have the powers of a binding arbitral tribunal – the international equivalent of a national bankruptcy court – to impose restructuring terms on dissenting creditors. However, the resistance to such proposals is strong. This is especially true of variants that seek to appoint the IMF as international bankruptcy judge or binding arbitrator, because the IMF is perceived as “too closely affiliated with creditors.” 10.2.2.2.3 Cooperation Cooperation between national authorities can be organized in the two areas for which institution-building has been proposed (10.2.2.1). –

Regulation: The aim is to avoid a “race to the bottom”, where competition between countries would lead national regulators to be increasingly lenient towards institutions. Of course, it is possible to design a framework in which, sensitive to the systemic risk created by banks in poor financial situations,

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the strongest among them come together to encourage a captive regulator (10.1.2.1) to adopt more restrictive regulations than the social optimum would require (Hardy, 2006). Financial centres could thus gain a competitive advantage through their reputation for stability. Nevertheless, certain conditions, particularly within the euro area (10.3), favour centralization or, at least, very close cooperation: the benefits of the latter approaches increase and their costs decrease with financial integration and homogeneous financial structures of the participants (Dell’Ariccia and Marquez, 2001). Similarly, Beck and Wagner (2016) show that supranational supervision is more likely to be welfareenhancing when externalities are high and country heterogeneity is low. Provision of liquidity: This can be organized multilaterally or bilaterally (Moessner and Allen, 2010b). Examples of pooling are provided by the Chiang Mai Agreement, which was established between Far Eastern countries after the Asian crises, and by the IMF. Their advantage is that they save reserves, unless all participating countries are affected at the same time in the case of regional arrangements, their disadvantage is that they may be a factor of moral hazard and also, in the case of the IMF, the possibility of a delay in the granting of assistance. The disadvantage of moral hazard can be seen in the bilateral swap agreements set up by the major central banks during the Great Financial Crisis; however, it is limited by the fact that each central bank chooses its counterparties and that the latter provide refinancing to the institutions under their jurisdiction at their own risk. The main advantage of these swap agreements is threefold. First, they respond to the development of the international financial activities of the major banks (the latter can call on their central bank, which then acts as lender of last resort (Chapter 9), for their activities in national currency but not for those in foreign currencies). Second, they avoid the national interbank market being disrupted by requests for refinancing from foreign institutions via their subsidiaries established in the country or zone that issues the requested currency (this argument applies above all to the dollar). Third, they are potentially unlimited, making the institution of an international lender of last resort superfluous (Chapter 9). The latter feature became evident when, on 13 and 14 October 2010, the Fed lifted all limits on the amount of credit lines it extended to the ECB, the Bank of England, the Bank of Japan, and the Swiss National Bank; in fact, drawings on the Fed peaked at $583 billion on 17 December 2008 (Moessner and Allen, 2010a). In November 2013, swap agreements between the ECB, the Bank of Canada, the Bank of Japan, the Bank of England, the US Federal Reserve, and the Swiss National Bank turned permanent. Later, a number of bilateral swaps have been agreed between major and smaller countries. For example, Japan has announced its intention to revive its US dollar swap lines with Malaysia, Singapore, and Thailand, and to expand the one with the Philippines; it has also expanded its existing lines with India and Indonesia. China has also concluded local currency swap arrangements with a number of countries, partly with a view to promoting its trade and investment interests (Trésor Economics, 2018).

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10.3 European aspects These aspects concern primarily the euro area and draw on both general aspects (10.1) and international aspects (10.2). Indeed, the single market for financial services and the single currency act as powerful forces for financial integration at the national level, but also facilitate contagion (Chapter 1) between euro area economies. In the euro area, runs in vulnerable countries can take both the form of traditional bank runs (Chapter 1) and the form prevailing at the international level (10.2.1.2): the drying up of refinancing of the banking system by non-resident banks, the flight of deposits abroad and the sale of securities, in particular sovereign securities, issued by residents. These manifestations of tension are likely to jeopardize the transmission mechanism of the single monetary policy, or even the euro area itself, if the risk premiums on debtors in countries under stress include a redenomination premium.4 They were managed by the ECB’s non-standard monetary policy measures: full allotments in refinancing operations replacing the Eurosystem’s role as a creditor of non-resident banks in vulnerable countries, as of October 2008; the Securities Market Programme (SMP) as of May 2010; and the announcement in August 2012 of the Outright Market Transactions (OMTs) (Chapter 2). Providing liquidity (Chapter 1) without remedying possible solvency problems, these actions nevertheless only save time. Reforms of the European institutions have therefore been initiated and new institutions created, adapting both the economic governance of the euro area (10.3.1) and that of its financial system (10.3.2).

10.3.1 Economic aspects Tirole (2012) reminds that the euro crisis has its origins in a debt and competitiveness crisis that was fuelled by the weakness of the European institutions. In particular, the no bailing out rule laid down in the Treaty on European Union implied that the private sector would have to pay in the event of default. However, both the prudential treatment of euro area sovereign securities, which get a (close to) zero credit risk weight (Hannoun, 2011, Chapters 6 and 9), and the ECB’s intervention during the abovementioned crisis heralded a pooling of risks (10.3.1.1). The alternative way to avoid or limit the impact of a repetition of the sovereign debt crisis, reported by Tirole (2012), namely the enactment of credible rules, was partially followed (10.3.1.2).

10.3.1.1 Risk pooling Farhi and Werning (2017) show that, if financial markets are incomplete, the value of gaining access to any given level of aggregate risk sharing is greater for countries that are members of a monetary union. Various proposals were made to introduce a developed form of risk pooling through the joint issuance of public debt securities by euro area governments, referred to as eurobonds (10.3.1.1.1). The approach adopted, which consists in setting up conditional financial assistance schemes for euro area countries in difficulty (10.3.1.1.2), is more in line with the IMF’s modus operandi (10.2.1.2).

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10.3.1.1.1 The issuance of eurobonds Various proposals have been put forward to facilitate the return to better fortunes in countries with the most difficult public finance situations, through the joint issuance of public securities, while at the same time seeking to limit moral hazard as much as possible (Chapter 1), by having recourse to market discipline (Chapter 4). The idea of common issuance is not new. It was suggested as early as the late 1990s by the Giovannini Group in order to provide issuers, especially smaller ones, with lower rates because of greater liquidity (Giovannini Group, 2000). However, in its Green Paper on the feasibility of introducing stability bonds, the European Commission (EC) estimates that the rate cut would be small: once common issues have fully replaced national issues, it would be seven basis points for Germany, nine basis points for countries with AAA-rated issues and 17 basis points for all euro area countries (European Commission, 2011). As pointed out by Tirole (2012), most proposals for common issues are based on a mutual and joint guarantee (MJG) from participating countries (issues are made on a joint account basis and the other participants take over the repayment burden of defaulting participants). Proposals for the issuance of eurobonds also often refer to the 60% of GDP reference value provided for in the Treaty on European Union for the public debt ratio. Three proposals were put forward by academics that at least partially incorporate a JMG: –

Delpla and von Weizsäcker (2010) proposed converting up to 60% of GDP of the government securities issued by each euro area country into so- called “blue bonds”, which would be subject to MJG. The rest of the government debt would be issued in the form of “red bonds”, not guaranteed by the common framework, and junior to the blue bonds. The transition to the new regime would take place gradually, as the initial debt is rolled over and new issues are made. An independent Stability Council would propose an annual allocation of issuance permits of blue bonds, which would have to be approved by the national parliaments, with a negative vote implying no participation for the coming fiscal year (the country would, during that year, give up the benefit of blue bonds and the bonds issued during that year would not be guaranteed). As a result, the quality of the blue bonds issued could vary if the most creditworthy countries, which would have nothing to gain from the scheme, refused to participate in certain years. Moreover, the gain for the most vulnerable countries could be marginal. Indeed, if the criterion of “juniority” of red bonds is credible, the rate of red bonds, which would bear the residual risk, should increase significantly. In the limit, as a result of Modigliani and Miller’s (1958) theorem, according to which the average cost of financing does not depend on the structure of financing, this increase could offset the fall in rates on blue bonds resulting from participation in the mechanism of the strongest economies and from the possible increased liquidity of securities issued by a European debt agency.

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The German Council of Economic Experts (Bofinger et al., 2011; Bofinger et al., 2012) has proposed, on the contrary, the transfer of debt in excess of 60% of GDP to a European Debt Redemption Fund, for which the participating euro area countries, i.e. all but those under programme, would be mutually and jointly liable. As in the previous case, the mechanism would be introduced gradually, in line with new issues and as the initial debt is rolled over. In addition, it would be transitional, lasting for 20–25 years, with funds to repay the debt transferred to the Fund being allocated to it and “debt brakes” (e.g. an automatic rule limiting public expenditures) being put in place at the level of the participating countries to prevent the 60% threshold from being crossed in the future. Participants would use guarantees (i.e. foreign exchange and gold deposits by Member States of up to 20% of the transferred debt) to manage the risk of default. Finally, the Fund would be managed independently and could impose sanctions, in the form of interest surcharges, on countries that fail to meet their commitments. In fact, this proposal would result in a most significant surrendering of sovereignty and has faced political opposition. Hellwig and Philippon (2011) suggest that a debt management office should replace all euro area sovereign debt issuance, up to 10% of each member country’s GDP, with issues of European bills (eurobills) with maturities of less than one year, benefiting from MJG. The advantage would be to ensure the de facto “seniority” of European issues, thus limiting the moral hazard inherent in any mutualization. However, the issuance of treasury bills by governments would be prohibited, limiting competition between issuers, and eurobills would become the main, if not the only, Tier 1 sovereign asset with regard to liquidity standards (Chapter 6), which would create artificial demand. The proposal is thus very constraining.

As Tirole (2012) points out, the short-term disadvantage of any proposal that includes JMG is that it involves cross- subsidies (some issuers are winners over the status quo, others are losers), riskier debt refinancing and legal problems, particularly with regard to the application of seniority clauses. Moreover, in a longer-term perspective where the economic and financial environment would be stabilized, a domino effect could occur if the a priori candidate country for the role of “insurer”, i.e. Germany, was not in a position to play this role. Finally, Tirole (2015) shows that the optimal pact between countries that differ substantially in their probability of distress is a simple debt contract with market financing, a borrowing cap, but no joint liability. A simple debt contract with joint liability would be an optimal contract under rather strict conditions (i.e. between countries symmetrically exposed to shocks with an arbitrary correlation, if shocks are sufficiently independent, spillovers sufficiently large, liquidity needs moderate and available sanctions sufficiently tough). Overall, the abovementioned proposals are unlikely to be optimal, at least in short to medium term. However, a proposal, which can be seen as pertaining essentially to  financial

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engineering, does not provide for a JMG (Euronomics Group, 2011). It would consist of having the stock of sovereign debt of euro area countries, up to 60% of each country’s GDP, purchased by a European debt agency, which would issue two types of securities to finance itself. The first type of securities, referred to as euro safe bonds (ESBies), would be senior on the repayments of principal and interest received by the agency on the stock of securities it holds, the other securities, referred as euro junior bonds (EJBies), being junior. With diversification and seniority, ESBies would offer a “double protection” while avoiding debt mutualization. According to the authors’ estimates in 2011, in order to buy the €5.5 trillion sovereign securities concerned on the secondary market, the Agency could issue €3.8 trillion ESBies, rated AAA, and €1.7 trillion junior securities, remunerated at about 6%. The authors justify their proposal by the fact that the private sector would not be able to mount an operation of this scale. This proposal was reformulated by suggesting that financial intermediaries use “a welldiversified portfolio of euro area sovereign bonds” to back the issuance of ESBies and EJBies (Brunnermeier et al., 2016). The targeted issuance of ESBies would be around €1.5 trillion or one- quarter of total euro area public debt at the time. Finally, the latter proposal was renamed sovereign bond-backed securities (SBBSs) and adapted in an ESRB (2018) report. SBBSs would be securities with varying levels of seniority backed by a diversified portfolio of euro- denominated central government bonds. The cover pool would be weighted based on participating Member States’ contributions to the ECB capital key. The senior layer would be 70% thick, with the 30% of subordinated securities divided into a 20% thick mezzanine security and a 10% thick junior security. Issuance of SBBSs could be arranged by private entities or by a public entity. In fact, these proposals amount to having Delpla and von Weizsäcker’s (2010) proposal executed by the financial markets, with a priori minimal public intervention and at the risk of investors. As such, they raise the same issues as regards the possible gains of both most and least vulnerable issuers. They also raise their own issues, inter alia: why not let investors make their own diversification? Would an SSBS issuer be allowed to default or could he expect being bailed out? What would happen if debt backing the senior layer is downgraded making senior SBBSs riskier than expected? Rather than common issues or having recourse to financial engineering, another more indirect way to promote risk pooling would be to reduce the home bias in sovereign exposures (Bénassy- Quéré et al., 2018). This would be one way of “breaking the doom (or diabolic) loop” between euro area sovereigns and their domestic financial systems (Farhi and Tirole, 2017), the other one being deposit insurance (10.2.2.2). Under this proposal, and in order to strengthen incentives to diversification in sovereign bond holding, “sovereign concentration charges” would require euro area banks holding sovereign exposures to any euro area country in excess of a threshold to hold additional capital. However, by increasing market frictions, this proposal could make it more difficult for both high- and low-debt countries to issue debt. By diverting capital requirements from their objective of promoting a safe risk management, it could also entail a

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heightened risk of contagion (Chapter 1). By contrast, taking credit risk on sovereign bonds into account for the computation of capital requirements would be simpler, market neutral and more consistent with financial stability objectives. 10.3.1.1.2 The path taken The European institutions first reacted in a piecemeal fashion to the euro area sovereign debt crisis, in order to address the most pressing issues, namely the risks of sovereign default and contagion on the euro area financial markets. In May 2010, intergovernmental loans to Greece were set up. In June 2010, two provisional institutions were created: the European Financial Stability Mechanism (EFSM), guaranteed by the EU and with a lending capacity of 60 billion euros, and the European Financial Stability Fund (EFSF), a private company owned by the euro area countries and with a lending capacity of 440 billion euros. The EFSF was authorized to intervene under three mains forms: –

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By means of loans to euro area states in financial difficulty and purchases in the primary and secondary markets of their public debt, under conditional programmes. To finance the recapitalization of financial institutions, through loans to Member States, even when they have not signed a macroeconomic adjustment programme (this was done for Spain in 2012). To make available to countries meeting certain criteria the preventive tools, the precautionary conditioned credit line (PCCL) similar to the IMF’s FCL and the enhanced conditions credit line (ECCL) similar to the PLL, in spite of the lack of success of the IMF’s preventive tools (10.2.2.2).

Regarding the impact of the creation of the EFSF, Horváth and Huizinga (2015) find that the main private beneficiaries were bank creditors, and that countries with banking systems heavily exposed to southern Europe and Ireland benefited. The creation of the EFSF also benefited the sovereigns of the latter countries – the so-called “GIIPS” – both directly, as their CDS spreads decreased, and indirectly through its impact on national banking systems. They conclude that the creation of the EFSF strengthened the perceived reliability of the financial safety net in the euro zone. However, this was no free lunch as the EFSF, in fact, transferred some creditworthiness from the non- GIIPS euro zone countries to the GIIPs countries, making the debt of the sovereigns and of the banks holding it more expensive. In October 2012, a permanent structure was set up in the form of an intergovernmental body with a capital of €80 billion and a lending capacity of €500 billion – the European Stability Mechanism (ESM). The ESM has taken over the remit of the EFSF and the EFSM (however, the latter will remain operational until all its claims have been settled) and is also able, since the introduction of the Single Supervision Mechanism (SSM) (10.3.2.2), to recapitalize financial institutions directly.

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The ESM is governed by a Governing Council composed of the Finance Ministers of the euro area, with the European Commissioner for Economic and Monetary Affairs and the President of the ECB as observers. Three features aim to limit moral hazard but also make ESM decision-making quite cumbersome: –

– –

The most important decisions taken by the ESM, in particular the granting, terms and conditions of financial assistance, are decided “by common agreement”, i.e. unanimously. However, an emergency procedure foresees a majority or 80% or 85% of the weighted votes, which de facto gives a veto right to Germany or France. The IMF’s technical and financial participation in the ESM interventions is sought. The same applies to private sector involvement, even if the macroeconomic adjustment programme does not reduce public debt to a sustainable level.

The German Council of Economic Advisors has proposed that the ESM could implement a procedure for orderly restructuring of sovereign debt in the euro area, which currently does not exist (Andritzky et al., 2016). Finally, on 20 July 2020, in a response to the Covid-19 crisis (Chapter 11), the 27 European states reached an agreement on a €750 billion recovery plan financed through the issuance of debt by the EU Commission and thus involving JMG. As pointed by Pfister and Valla (2020), this debt can of course only be repaid through higher contributions from the Member States to the European Commission’s budget but, like any loan from a European or international organisation, it has the accounting advantage of not being included in the debts of the Member States. According to the same authors, this does not mean that eurobonds are a bad idea, only that they are not a panacea. On a more positive note, the issuance of eurobonds can be an opportunity to transfer competences to the European level, thus contributing to the implementation of structural reforms that would better homogenise the Eurozone and support the public finances of all member countries.

10.3.1.2 Enactment of rules In order to counter the “deficit bias”, proposals from academic research recommend the implementation of a combination of fiscal rules and institutions (10.3.1.2.1). They were partly followed up with the adoption the European Fiscal Compact (SGP) (10.3.1.2.2). 10.3.1.2.1 Academic recommendations Within monetary unions, fiscal rules can be particularly useful since the consequences of deficits (increased risk premiums, financial fragility) are largely borne by the partner countries (Leiner-Killinger and Nerlich, 2019). However, fiscal rules must be applied consistently to be credible. This has not been the case for

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the SGP, a set of rules designed to ensure that countries in the EU pursue sound public finances and coordinate their fiscal policies, and the credibility of the SGP has thus been undermined (Tirole, 2012). Indeed, using real-time data for 19 countries participating in the euro area over 1999–2015, Eyraud et al. (2017) provide evidence of fiscal procyclicality, excessive deficits, distorted budget composition and poor compliance with fiscal rules in the euro area; however, contrary to a common idea, they do not find conclusive evidence of bias in procedures in relation with country size. To a large extent, this poor compliance derives from the fact that the enforcement of the SGP is the responsibility of the EC and the Economic and Financial Affairs Council. The latter one is judge and jury since it is composed of the ministers of finance of the Member States, and “porkbarrelling” can take place within it as the Council decides on many other issues than the application of the SGP. Enforcement should therefore be a matter for the European Constitutional Court (Tirole, 2012). Other institutions, such as fiscal policy councils, can also play a role in avoiding that fiscal policies jeopardize financial stability (10.1.2.2). In particular, the involvement of the fiscal policy council in the process of drawing up macroeconomic forecasts can be a decisive element. In the Netherlands, for instance, macroeconomic forecasts produced by a technical agency are used as a basis for the government forecasts of the public deficit. Indeed, Frankel and Schreger (2013) note that government forecasts of economic growth and public deficit in the eurozone are systematically optimistic, with a particularly strong bias when the public deficit is above 3% of GDP (the “reference value” in the Treaty on European Union). However, the bias is reduced among countries that implement national balanced budget rules or where independent bodies publish their own forecasts. 10.3.1.2.2 The European fiscal compact As a result of the poor implementation of the SGP, it was complemented with the adoption of the European Fiscal Compact (formally, the Treaty on Stability, Coordination and Convergence – TSCG), which entered into force on January 2013. The Fiscal Compact is an intergovernmental treaty and, as such, is not part of EU law. It has two main components (ECB, 2012a): –

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A balanced budget rule, including an automatic correction mechanism. The fiscal rule is deemed to be fulfilled if the structural balance, i.e. the cyclically adjusted balance net of one- off and other temporary measures, corresponds to the country’s own medium-term objective (MTO) set in the SGP, subject to a limit of 0.5% of GDP (this limit may be increased to 1% when the debt ratio is below 60% as well as in exceptional circumstances). The Commission was asked to propose common principles for an automatic correction mechanism “without prejudice to the prerogatives of national parliaments”. A strengthening of the excessive deficit procedure, with a greater role for the public debt criterion and a stronger degree of automaticity in principle in the

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implementation of sanctions. Member States with a government debt ratio above 60% must reduce the gap from 60%, at an average rate of 120th per year. However, this provision is of little practical value, as it will only enter into force after a period of three years after the end of the current excessive deficit procedure. A so- called reverse qualified majority rule is also introduced, allowing a Commission proposal to impose sanctions to be adopted or non-compliance with the SGP, unless the Council rejects it by qualified majority. Nevertheless, the Council will continue to be the guarantor of the implementation of the SGP. Moreover, as Wyplosz (2012) notes, “the Commission has its own broad and complex agenda”. The transposition of the SCGT into national law is supervised by the Court of Justice of the European Union, but effective compliance with the Pact falls within the competence of national fiscal policy councils, which have thus been created in the countries where they did not exist, with various degrees of autonomy.

10.3.2 Financial system aspects Since the creation of the euro area, the issue of financial system governance has been closely linked to the issue of burden- sharing in the event of the resolution of cross-border institutions (Goodhart and Schoenmaker, 2006). Indeed, national regulators, seeking to preserve financial stability in their jurisdictions, are effectively protecting the domestic activities of institutions, possibly to the detriment of their international activities. As long as the latter are not highly developed, their regulation, supervision, and possible rescue can be effectively organized at the national level, at the cost of enhanced coordination (ECB, 2007). On the contrary, as international activities expand, national financial systems become more vulnerable to external shocks: the sovereign debt crisis in the peripheral euro area countries has thus spread to the entire euro area. Beyond a certain point, a “triangle of financial incompatibility” (Schoenmaker, 2011), responding to Mundell’s (1953) triangle of monetary incompatibility, according to which it is no longer possible to have together freedom of capital movements, exchange rate fixity, and autonomy of monetary policies, emerges. In this case, it is no longer possible to have together financial integration, financial stability, and autonomy of financial stability policies. As a consequence, Schoenmaker (2011) notes that unless the benefits of financial integration are foregone, financial stability policies must be transposed to the European level. Policymakers reached the same conclusion fairly soon after the start of the GFC, leading to the establishment of the European System of Financial Supervision – ESFS (10.3.2.1). However, this system continued to be based mainly on national foundations. With the euro area sovereign debt crisis, it became clear that there was a need to move to a federal structure, with the creation of a banking union in line with the monetary union (10.3.2.2), which is being established since mid-2013.

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10.3.2.1 The European system of financial supervision The ESFS includes the European and the national supervisory authorities. At the end of 2010 and early 2011, the European authorities were created as four independent institutions, in which a Board of Supervisors (BoS) is in each case the main decision-making body. Three authorities are in charge of the regulation and supervision of financial activities for, respectively, banks, financial markets, and insurance and occupational pensions: –

–

–

The main task of the European Banking Authority (EBA) is to contribute, through the adoption of Binding Technical Standards (BTS) and Guidelines, to the creation of the European Single Rulebook in banking. The Single Rulebook aims at providing a single set of harmonized prudential rules for financial institutions throughout the EU, helping create a level playing field and providing high protection to depositors, investors, and consumers. The Authority also plays an important role in promoting convergence of supervisory practices to ensure a harmonized application of prudential rules. Finally, the EBA is mandated to assess risks and vulnerabilities in the EU banking sector through, in particular, regular risk assessment reports and pan-European stress tests. The BoS is composed of the EBA’s Chairperson, and of the 28 national supervisory authorities, where applicable accompanied by a representative of the national central bank, with Observers from the EC, the ESRB, the ECB and the two other European authorities. The European Securities and Markets Authority (ESMA) assesses risks to investors, markets, and financial stability, completes a single rulebook for EU financial markets, promotes supervisory convergence, and directly supervises credit rating agencies and trade repositories. In addition to the ESMA Chair, the BoS is composed of the heads of the national competent authorities (NCAs) in the EU and the European Economic Area (EEA) responsible for securities regulation and supervision with non-voting representatives from the EC, the ESRB, the two other European authorities and the European Free Trade Association Surveillance Authority. The European Insurance and Occupational Pensions Authority (EIOPA) is responsible for helping keep the financial system stable, ensuring markets and financial products are transparent and helping protect insurance policyholders, pension scheme members and beneficiaries. The BoS is made up of EIOPA’s chairperson, appointed by the BoS and confirmed by the European Parliament, voting members (the relevant authority in each EU country) and observers (representatives of the EC, the ESRB and the two other European authorities). As a matter of fact, the EIOPA essentially coordinates national supervisors who keep final authority. Particularly in a context of persistently low interest rates, one issue is thus whether a more centralized role might not be given to EIOPA within a European Insurance Union, with EIOPA

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ultimately supervising significant groups directly (Schoenmaker, 2016). Such a role could also be given to the ECB, in parallel with its role as the euro area bank supervisor. The ESRB is responsible for the macroprudential oversight of the EU financial system and the prevention and mitigation of systemic risk. It is chaired by the President of the ECB, hosted and supported by the ECB. The General Board, chaired by the President of the ECB is the ESRB’s decision-making body. It discusses current macroprudential developments and, where necessary, issues recommendations and warnings. The Steering Committee supports the organization of the General Board meetings. It reviews analysis presented by the ESRB advisory bodies (Advisory Technical Committee [ATC] and Advisory Scientific Committee [ASC]) and discusses the macroprudential policy agenda of the ESRB. The members with voting rights of the General Board are the members of the General Council of the ECB (i.e. the members of the Executive Board of the ECB and the Governors of the national central banks of the EU), one member of the EC, the chairpersons of the three European financial supervisors (see above), the Chair and the two ViceChairs of the ASC, the Chair of the ATC. The ESRB has a broad remit, covering banks, insurers, asset managers, shadow banks, financial market infrastructures and other financial institutions and markets. In pursuit of its macroprudential mandate, the ESRB monitors and assesses systemic risks. Furthermore, the ESRB’s main power is to issue warnings and recommendations, which are made public, and act as a powerful incentive on national institutions not to delay action. However, the ESRB has no binding macroprudential powers, its role being mainly to coordinate the implementation and activation of macroprudential instruments by national macroprudential authorities through opinions and recommendations.

10.3.2.2 Banking union The idea of creating a banking union in Europe emerged in the spring of 2012 in the wake of the Greek debt restructuring. It has two aims (Pisani-Ferry and Wolff, 2012): –

Completing the single market and better aligning the incentives of national supervisors, ensuring a more level playing field and facilitating the resolution of cross-border bank failures. Indeed, national authorities may unduly favour their national banking system and economy, without regard for external consequences that manifest themselves beyond their sphere of influence (Goyal et al., 2013). In particular, in good times, national authorities may allow excesses to develop since, owing to the close financial links within the monetary union, they are justified in anticipating that other countries and the ECB will provide support (ECB, 2012b) in the event of difficulties in their banking systems. In bad times, national authorities may stall, waiting for this support, hesitating to take remedial action, especially if they are not independent, and thus aggravate the cost of the banking crisis. The banking union must make it possible to reduce this source of moral hazard (Chapter 1).

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–

Loosening the link between sovereigns and banks, which leads to a “diabolic loop” (Brunnermeier et al., 2016), where the deterioration of the situation of the banking system degrades public confidence in the sovereign, due to the anticipation of bailouts of TBTF institutions (Chapter 1), while the holding by banks of sovereign securities, whose prices are falling, degrades public confidence in the banking system. In this regard, Gros (2013) suggests that ending incentives for banks to hold sovereign debt should also help to loosen the link between sovereigns and banks. He suggests various ways of doing this, including no longer assigning a zero credit risk weight to sovereign securities and no longer treating sovereign securities as systematically liquid (Chapter 9).

At the June 2012 European Council, a roadmap was drawn up for the gradual establishment of a banking union based on the three complementary pillars of any systemic risk prevention system (Chapter 1): a single supervisory mechanism to ensure the application of regulations (10.3.2.2.1); a single resolution mechanism (SRM) to carry out the necessary restructuring as quickly and efficiently as possible, limiting the cost of banking crises and maintaining the credibility of the supervisor (10.3.2.2.2); and a Union-wide DIF (10.3.2.2.3). 10.3.2.2.1 The single supervision mechanism The SSM comprises the ECB and the national supervisory authorities of the participating countries. It was adopted in September 2012 by the European Council with the choice of entrusting banking supervision to the ECB. Several factors have guided this choice: –

– – –

Since the changeover in October 2008 to full allotment in its main refinancing operations (i.e. banks started receiving all the liquidity they required from the central bank instead of being subject to either rationing or competitive bidding, as was formerly the case), the ECB has been acting as the lender of last resort vis-à-vis the euro area banking system (Chapter 7), without having access to all available information on banks (Gros, 2012). Since its establishment in June 1998, the ECB has demonstrated its independence, which limits the risk of capture (10.1.2) (Beck and Gros, 2012). In a majority of both euro area and EU countries, banking supervision is entrusted to or backed by the central bank. The Treaty on European Union provided, in Article 127(6), a legal basis for strengthening the ECB’s powers without revising the Treaty, which made the procedure rather simple.

However, in view of the difficulty for the ECB to directly supervise some 6,000 European institutions, a distinction has been introduced between the so- called significant – i.e. systemic – banks, which are directly supervised by the ECB, and the banks that are not considered significant, known as “less significant” institutions. They continue to be supervised by their national supervisors, in

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close cooperation with the ECB. At any time, the ECB can decide to directly supervise any one of these banks to ensure that high supervisory standards are applied consistently. In 2020, there were 117 significant banks, holding almost 82% of total banking assets in the euro area. All euro area countries participate automatically in the SSM. As the European banking supervisor, the ECB can take a number of supervisory decisions, which are legally binding on banks under the Single Supervisory Mechanism. These include: – – – – –

Setting micro- and macroprudential capital requirements (“buffers”). Deciding on the significance status of supervised bank. Granting or withdrawing banking licences. Assessing banks’ acquisition and disposal of qualifying holdings. Imposing enforcement measures and sanctions on significant banks.

The Supervisory Board of the SSM, as an internal body of the ECB, prepares the draft decisions, which are adopted by the ECB Governing Council under  the non-objection procedure: if the Governing Council does not object within a defined period of time, the decision is deemed adopted. The Supervisory Board is composed of the Chair (appointed for a non-renewable term of five years), the Vice- Chair (chosen from among the members of the ECB’s Executive Board), four ECB representative and representatives of national supervisors. ECB Governing Council is composed of the members of the Board of the ECB and the Governors of the national central banks. To prevent conflicts of interest between monetary policy and supervisory responsibilities, the ECB ensures a separation of objectives, decision-making processes and tasks. This includes strict separation of the meetings of the ECB Governing Council and the Supervisory Board of the SSM. The ECB covers the costs of its supervisory tasks and responsibilities by levying an annual fee on all supervised banks. The fee is calculated according to the bank’s importance and risk profile. In principle, bigger banks with a higher risk profile pay higher fees. Effective SSM supervision started in November 2014 after an “Asset Quality Review” was completed. However, four years later and ten years after the start of the GFC, the ratio of bank non-performing loans to total gross loans was still, according to World Bank statistics, standing in 2018 at 19.5% for Cyprus, 42% for Greece, 5.4% for Ireland, 8.4% for Italy and 9.4% for Greece (the ratios stood respectively at 45.0%, 33.8%, 20.6%, 18%, and 11.9% in 2014). The comparable ratio for the US stood at 0.9% in 2018 and 1.9% in 2014. 10.3.2.2.2 The single resolution mechanism The SRM was created in August 2014 and has been operational since January 2016. It applies to banks covered by the SSM. The main purpose of the SRM is

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to ensure the efficient resolution of failing banks with minimal costs for taxpayers and to the real economy. The SRM is also in charge of the winding down of non-viable banks. It consists of: –

–

The Single Resolution Board (SRB) with, when discussing a specific bank, the Chairperson, the other four Board members, representatives from the national resolution authorities (NRAs) where the bank has its headquarters, branches and subsidiaries, as members and the representatives of SSM, the EBA, the EC and when relevant, of the NRAs of non-participating Member States, as observers. The SRB is directly responsible for the resolution of significant banks under ECB supervision as well as other crossborder groups, while national authorities are responsible for other entities. Upon notification from the ECB that a bank is failing or likely to fail, the Board will adopt a resolution scheme including relevant resolution tools and any use of the Single Resolution Fund (SRF). However, the Board remains ultimately responsible in determining whether no alternative solution is available and whether the resolution action is necessary in the public interest. The SRF and national funds, funded by banks’ contributions. The SRF will be built over a period of eight years (2016–2023) and should eventually have at least 1% of insured deposits (i.e. around €55 billion in 2024) at its disposal. Before it is sufficiently capitalized, the Fund could, if necessary, levy additional funds from the banking sector. It could also borrow funds on the market. A public backstop could also lend money to the Fund. This loan would be recovered from banks in the medium term to ensure that the mechanism was fiscally neutral.

Although Banking Union members have in principle surrendered the decisionmaking on bank resolution to the SRB level, at least for significant banks, Busch et al. (2019) find that Member States have difficulties accepting this transfer of power, as illustrated in several occasions (Monte di Paschi di Sienna, Banca Popolare di Vicenza, Veneto Banca) for Italy (Chapter 7). Furthermore, they note that Member State influence in bank resolution decisions remains present through the involvement of the NRAs, although national representatives are expected to act in the common European interest. 10.3.2.2.3 A European deposit insurance scheme In November 2015, the EC made proposals for a European Deposit Insurance Scheme (EDIS), which would be managed by the SRB. Banks would fund a DIF, separate from the SRF. Banks’ premiums would be risk-based and would target a level of the DIF of 0.8% of all covered deposits (i.e. around €45 billion in 2017) once the scheme is fully operational. In that proposal, the EDIS would have built

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on existing deposit guarantee schemes (DGSs), which already insure deposits up to €100,000 all over the EU, and to be introduced in three steps: –

–

–

In Step 1, proposed to last three years from July 2017 to July 2020, the EDIS would have played the role of a reinsurance scheme. DGSs would be able to access the EDIS, up to given limits, once they have exhausted their resources. In Step 2, which would have taken place in the next four years, a coinsurance scheme would have been set up. The DIF would have contributed to the first euro of loss and the share it would have contributed progressively, from 20% in year one to 80% in year four. In Step 3 (i.e. seven years after the inception of the scheme), the EDIS would have fully insured all DGSs.

Since the Commission’s proposal, no action has been taken, and the “third pillar” of the European Banking Union is not yet in place. Jokivuolle and Pennachi (2019) note that setting premiums to target a DIF fund to covered deposits ratio is a common practice amongst deposit insurance systems (Chapter 5), but that it conflicts with setting premiums that are really risk-based and in fact makes premiums countercyclical. In particular, premiums would have to be raised in recessions when banks are more fragile. Schoenmaker (2018) objects to the idea of maintaining national DGSs on the same grounds, since business cycles can vary from a euro area country to the other. In order to mitigate moral hazard concerns, inherent to any deposit insurance scheme (Chapter 5), he suggests introducing instead a country component in the risk-based premium, as proposed by Bénassy-Quéré et al. (2018) and Schnabel and Véron (2018).

Notes 1 In the remainder of this chapter, it is assumed that the same institution is responsible for the regulation and supervision of a sector, and reference is therefore most often made only to supervision. 2 The literature generally refers to the notion of a regulator rather than a supervisor as a captive. 3 Figures in US Dollars. Using PPA weights, G7 countries account for 30.1% of world GDP and G20 countries for 80.4%. 4 Such a premium may arise if investors anticipate that the country plans to exit the euro area by converting residents’ debts into the new currency (the reverse of the operation carried out when it entered the euro area) and depreciating the latter massively, so as to expropriate its creditors. While this tactic may seem advantageous to solve an unsustainable debt problem, it would nevertheless have the disadvantage of cutting the country off from external financing, imposing a drastic austerity cure on it. Kriwoluzky et al. (2019) find, in the case of Greece, that redenomination risk premia, rather than outright default premia accounted for a significant fraction of sovereign debt yields and for the bulk of the rise in yields in the private sector during the crisis period 2009–2012.

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11 EMERGING RISKS AND NEW CHALLENGES

The previous chapters identified the main risks threatening financial stability and the reforms that have been introduced since the GFC, in order to make the financial system safer. However, the financial system is constantly evolving. Most economists would agree that the reforms have, to some extent, ensured that the system would be able to cope with a crisis of the same type, which may be less likely to occur in the first place. However, the response would be less positive in the case of a crisis of a “new” type. The global crisis triggered by Covid-19 in 2020 is likely to be such a crisis. However, given the lack of hindsight, it is difficult to draw final conclusions. At the time of writing, it appears like a case study where public intervention relied on a large sample of the instruments analysed in the book as well as variants of them (11.1). We also identify in this chapter three new factors that are developing and have the potential to become major sources of risks in the coming years (11.2) as well as new challenges that originate inside or outside the financial system and may, at some point, also generate new risks to financial stability (11.3). However, these emerging risks and challenges are not independent. For instance, the new risks coming from climate change may interact with the risks of a new pandemic, as the melting of permafrost will release ancient viruses and bacteria (Tirole, 2020a).

11.1 The global Covid-19 crisis of 2020 Economists and policymakers hardly anticipated the severity of the Global Covid-19 Crisis (GCC). Arguably, the issue of health epidemics was not new and had been identified by the Eminent Person Group (EPG) (2018) report, which noted that “Pandemics and public health emergencies are high-probability, highrisk events”. But the EPG’s assessment of the annual global cost of pandemics at $570 billion or 0.7% of the global GDP is small in comparison to the expected

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impact of the GCC. In addition, pandemics are likely to occur more frequently in the future, given the trend in deforestation that destroys ecosystems within which unknown viruses were previously enclosed. In contrast to the GFC which was from the start a financial crisis, the GCC started in the real economy, with lockdowns generating output losses, hence a recession. The GCC was thus an exogenous supply shock in the first place. Metrick (2020) distinguishes between the four phases of the crisis and the policy responses associated with each phase: the Run (the initial liquidity shock), the Rescue (the response of public authorities), the Recession (with additional policy responses), and the Recovery. It is useful to refer to these different phases to understand the relevance of the policy responses. The succession of events is described (11.1.1) as well as the policy responses (11.1.2).

11.1.1 The second global crisis of the twenty-first century? The Covid-19 crisis took a different pattern from the GFC, as the crisis of 2020 originated outside the financial system. The likely phases of the crisis and their financial consequences, as of the time of writing, are reviewed: the sanitary crisis (11.1.1.1), the liquidity crisis (11.1.1.2), the impact on financial institutions (11.1.1.3), and the potential long-term financial stability consequences of the crisis (11.1.1.4).

11.1.1.1 The sanitary crisis Most of the events have been conditioned by the sanitary crisis, which makes the GCC special in comparison to previous crises, notably the GFC. After its original breakout in China in late December 2019, Covid-19 spread to the whole country in January 2020, then to the rest of the world, and triggered a severe shock to economic activity. It hit both supply and demand, triggering a temporary shutdown of plants and a lockdown of the population in many developed and emerging economies (China, EU, UK, US, etc.) which weighed on investment and consumption. It transmitted to the global value chain and world demand, with a particularly severe impact on some services sectors, notably tourism. At the time of writing, the impact on world GDP is expected to be of higher magnitude than the GFC, but lower than the annual GDP loss during the 1929 crisis, or World Wars I and II (Gollier and Straub, 2020). According to the Bank of England’s (BoE) Monetary Report (2020), an “illustrative scenario” of the Covid-19 pandemic is a GDP drop by 13% in 2020 for the UK, the most severe fall since 1706, according to the BoE’s historical statistics at constant geographical perimeter, with a recovery in 2021. The initial shock adversely affected the real sector, but in contrast to wars or natural catastrophes, there was no direct capital stock destruction or massive loss of human lives. Another potentially important dimension is the risk of “second waves of virus incidence”

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(which require imposing new restrictions) causing a protracted recession, which occurs in case of a too early return to free migration flows.

11.1.1.2 The liquidity crisis (March/April 2020) The expectation that lockdowns would cause major falls in the levels of output was a factor of turbulence on financial markets, with a sharp fall in stock prices in March 2020, especially those of banks, and a sharp rise in risk aversion and search for liquidity (Chapter 1). In addition, non-financial firms’ cash flows were expected to collapse, also generating a wave of business failures. The IMF’s Global Financial Stability Report (GFSR) (2020), describes this phase of the crisis, which pressed central banks to intervene on a massive scale, easing tensions (see 11.1.2.1). Both Standard & Poor’s (S&P) index for US stocks and Euro stocks declined by 30% in March 2020. A salient feature of the crisis was the abruptness of the shock: during the month, S&P 500 fell 20% from its peak in just 16 trading sessions. The asset price declines reached then about half the magnitude seen over the whole 2008–2009 period. Stock prices partially recovered in April following extraordinary measures put in place (see 11.1.2.1). Signs of strain also materialized in major funding markets, including the global US dollar funding market. Sengupta and Xue (2020) describe the flight for safety and the run on Money Market Funds: in March 2020, investors moved over $100 billion from prime funds into government funds. The US commercial paper market used for short-term funding of large corporates as well as the municipal bond market experienced tensions. As a result, interest spreads in these markets widened dramatically, and the market temporarily froze. In addition, investors rushed at some point out of US Treasuries and into cash. In some cases, this reflected their investment objectives  –  selling Treasuries to buy depressed equities (Cheng et al., 2020). These events raised the question of the ability of the US Treasury market to process large order flows (Duffie, 2020). Strains also took place in the risky credit market segments – high-yield bonds, leveraged loans, and private debt. Haddad et  al. (2020) provide details on the temporary disruption of the market for investment-grade and high-yield bonds. They look at two large corporate bond exchange traded funds, capturing the universe of investment-grade and high-yield corporate bonds. Both indices exhibit a similar pattern as stocks. While their declines started almost two weeks after stocks, they dropped by about 20% from peak to through. Notably, the drop for the three weeks from 1 to 20 March is about the same for investment-grade, high-yield, and the overall stock market, with investment grade actually suffering slightly larger losses. After that, the two corporate bond indices recovered. By the end of April 2020, investment-grade bonds were virtually back to their early 2020 level and the loss in high-yield debt, often considered as overpriced before the GCC, was of ‒10%. The explanation is that investors tried to sell safer, more liquid securities to raise cash.

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Avdjiev et al. (2020) describe how turbulence in the dollar funding market have led to a flight into safe haven currencies, in particular US dollar- denominated assets, and to an appreciation of the US dollar, especially during the second week of March 2020. Simultaneously, US dollar funding costs increased. Such increases in direct funding costs, for example, shown in the rise of the LIBOR- OIS spread, are usually accompanied by a widening of the cross- currency basis (the difference in the interest rate in US dollar money markets and the implied US dollar interest rate from FX swap markets). Such deviations from covered interest parity, measured by the cross- currency basis, reached for the three-month basis – 144 bp for the Japanese yen and 85 bp for the euro – then narrowed after the introduction of central bank swap lines (11.1.2.1). They provide evidence of the inability, at least for some borrowers, to fund directly in US dollar, forcing banks to rely on much more expensive “synthetic” US dollar funding.

11.1.1.3 Consequences for financial institutions The likely effect of the GCC is an increase in business bankruptcies as a consequence of administrative lockdowns imposed in many countries on business. The main mechanism of the crisis is the absence of revenues while fixed expenditures are still due, leading to losses that cannot be covered by liquid assets. However, it is important to note that all sectors are not hit in the same way, with energy, tourism, transportation, hotels and restaurants as well as non-food retail trades suffering the most. In addition, the companies that were the most fragile before the crisis are likely to be the hardest hit by the GCC. GFSR (2020) stresses that one scenario is that, as a consequence of losses incurred on loans to defaulting companies, banks could act as an amplifier in case the crisis deepens further, with a sharp cutback in bank lending as in 2007–2008, due to liquidity strains and losses at banks following massive companies’ bankruptcies, exacerbating the impact of the GCC on the economy. However, the higher levels of capital buffers built since the global financial crisis will help banks absorb losses. Indeed, average Tier 1 capital ratios across economies with large financial systems are more than 400 basis points higher than they were at the end of 2007. Ari et al. (2020) compare the GCC and past crises and conclude that some forces are enabling Non-Performing Loan (NPL) resolution, compared to the GFC: banks have higher capital, the forward-looking IFRS 9 accounting standards can help NPL recognition and the COVID-19 crisis was not preceded by a credit boom. However, other forces could make NPL resolution more difficult: government debt is substantially higher, banks are less profitable and corporate balance sheets are often weak. Such a view is shared by the European Banking Authority (EBA) (2020) for EU banks. However, the EBA notes that the GCC could have very severe consequences on asset quality. Indeed, EU banks have on average increased their exposures towards potentially riskier portfolios, such as small and medium- sized enterprises (SMEs), which were adversely affected by the crisis. Banks are likely

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to face higher NPL volumes and rising cost of risk in a context of prospective macroeconomic deterioration. The decline in asset quality might be accompanied by rising risk-weighted assets (RWAs). Higher volatility on financial markets is also a concern and could further increase RWAs.

11.1.1.4 Potential long-term financial stability consequences of the crisis One direct consequence of the GCC is the overall accumulation of debt by businesses as well as by fiscal authorities that deployed massive support programmes (11.1.2.2). The accumulation of public debt may create two causes of concern. First, as argued by Tirole (2020a), additional public debt in Southern European countries may increase the risk of subsequent speculative attacks (Tirole, 2020a, b). It could also generate tensions within the euro area which would have financial stability consequences. Second, if there is a risk on the sustainability of public debt, central banks may see fit to pursue the objective of facilitating the financing of public deficits, leading to indetermination of the price level and putting it under “fiscal dominance” (Chapter 9). In the case of the US, according to Blanchard (2020), “While today’s Fed would not yield to such pressure, a future Fed, with a chair appointed by a populist president, might be more willing to bend and keep rates low for too long, leading to overheating and inflation”, hence endangering financial stability. However, it is not necessarily under pressure that a central bank could fall under fiscal dominance: high levels of public debt causing increased term premia could prompt it to buy ever increasing levels of public debt in order to protect the private sector, putting itself under the threat of a sovereign default and endangering its reputation.

11.1.2 Policy responses In order to preserve financial stability, the policy response was to use fiscal policy to offset income losses by workers affected by lockdowns and extend bank loan guarantees as well as to loosen monetary policy (Chapter 9) together with a softening of prudential requirements (Chapters 6 and 8).

11.1.2.1 Fiscal and monetary policies Fiscal authorities reacted by implementing very large expansionary plans: amounting to 10.5% of GDP in the US CARES Act (plus 2.1% of GDP in public guarantees on loans) and 12.3 % of GDP in Japan (plus 18.5% of GDP in public guarantees on loans and 9.3% in direct public loans). In the US, the plans were designed to introduce additional social safety nets, by directly subsidising companies that were hoarding labour during the lockdown period. As governments were already much indebted after the GFC, public guarantees on loans allowed public interventions to be more targeted than direct subsidies granted to all companies and are expected to be reimbursed after the crisis.

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Regarding monetary policy, the responses of the large central banks, namely the US Federal Reserve (Fed), the European Central Bank (ECB), the Bank of Japan (BoJ) and the BoE, were overall similar in terms of channels and in their purpose to ease liquidity constraints and support the distribution of credit. Central banks introduced within a month a variety of large- scale measures at a pace much quicker than during the GFC. The Fed lowered the fed fund target rate in two steps in March 2020 by 150bps, bringing it back to the 0%–0.25% range, and the discount window rate by 200 bps to 0.25%. The BoE lowered its policy rates in two steps by 65 bps to 0.1%. Some central banks’ asset purchase programmes went markedly beyond measures taken during previous crises by being open- ended and/or having a stronger focus on the non-financial sector. With the same aim, the Fed also designed new instruments to provide direct lending to non-financial corporations. The experience from the GFC and the follow-up of the sovereign debt crisis for the euro area allowed all four central banks to reactivate unconventional tools in a quick and smooth manner (e.g. see Odendahl et al., 2020): –

–

The ECB adopted the Pandemic Emergency Purchase Programme (PEPP), giving itself higher flexibility in purchases compared to its previous asset purchase programmes. The Fed reactivated within two weeks the emergency liquidity measures that had been implemented over several months in 2008/2009, while also introducing some new measures (Martin, 2020). The Fed opened a Money Market Mutual Fund Liquidity Facility, a Primary Dealer Credit Facility and a Commercial Paper Funding Facility, all three being facilities already used during the GFC. On March 23, the Fed greatly expanded the classes of assets it was willing to purchase (including corporates for the first time for the Fed): Primary and Secondary Market Corporate Credit Facility (PMCCF and SMCCF), as well as direct lending to SMEs, with the Main Street Business Lending Programme. The latter matched equivalent facilities to SMEs by the ECB and the BoE.

Overall, as the Covid-19 shock directly affected non-financial companies, whereas the GFC hit them more indirectly, through less financing and less demand, central banks’ new measures aimed to a bigger extent at financing the real sector directly. However, the measures implemented also varied according to the financial structure of each economy: the ECB, BoE, BoJ that operate within bank-based financing models provided funding mainly via targeted bank lending, whereas the Fed that operates within a market-based financing of firms had to bypass dysfunctional financial markets while aiming at reactivating them. In addition, the Fed introduced liquidity measures to respond to the sharp demand for dollars during the crisis (flight-to-safety), as studied by Avdjiev et  al. (2020). To that aim, the Fed signed swap agreements in March 2020 with 14 more

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central banks, where the latter can exchange their currency for US dollars (Chapter 10). The Fed also introduced a Repo Facility allowing other central banks to exchange on a temporary basis their US Treasury bonds for US dollars through repo transactions. On top of providing liquidity, the objective of the new facility was also to smooth the functioning of the US Treasury bond market and alleviate tensions. Regarding the effectiveness of these policies, one can mention two types of criticisms: –

–

The cost for public finances of these measures was very high as they were in many instances “nationalising the wage bill”. Elenev et al. (2020) argue that the objective of interventions was to prevent a much deeper crisis by reducing corporate bankruptcies by about half and short- circuiting the doom loop between corporate and financial sector fragility. However, the gains from more targeted aids would have been significant, with more bankruptcy prevention at a lower cost. A much stronger criticism by Barrero et al. (2020) is that fiscal and monetary policies that soften the shocks and protect incumbent firms prevent sectoral reallocation, i.e. the move away from activities and firms that are unable to implement social distancing, and keep zombie firms alive.

11.1.2.2 Prudential regulation The threat of large- scale failures in the non-financial sector transmitting to the financial sector triggered several regulatory changes: –

– – – –

In the euro area, the Single Supervisory Mechanism (Chapter 10) softened capital and liquidity standards (Chapter 6), namely the Capital Conservation Buffer, the Pillar 2 buffer and the Liquidity Coverage Ratio. Banks were asked to reduce dividend payments in order to keep sufficient capital available in order to offset expected corporate defaults, given the high level of uncertainty. The Fed lowered, among other measures, reserve requirements to zero. The BoE lowered the countercyclical buffer (Chapter 8) by 100 bps to 0% (France and Germany also adopted the same measure). The Basel Committee announced in March 2020 that the implementation of Basel III (Chapter 6) would be delayed by one year to 2023. Several authorities, in the US, the UK, Italy, and other countries, allowed a temporary suspension of mortgage payments. In the US, regulators “encouraged financial institutions to assist borrowers in times of natural disaster and other extreme events”.1 In agreement with the US Accounting authority (the Financial Accounting Standard Board), it was decided that changes in loan contracts in the US would not trigger the move of the loans to the “Troubled Debt Restructuring” category.

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11.1.2.3 Responses by market authorities Several elements are worth noting on the part of authorities in charge of financial markets and accounting standards: South Korea, France, Italy, Spain, Austria, and Belgium introduced measures to limit short selling of some equities, although the literature provides evidence that such measures are inefficient and may even increase share price volatility (Chapter 5). These measures were lifted in May 2020 in most countries. Several accounting standard setters announced additional delays in the implementation of IFRS9 (Expected Credit Loss instead of Incurred Credit Loss) or the equivalent US GAAP measure, the Current Expected Credit Loss (Chapter 4).

11.1.2.4 Responses by international and European institutions Multilateral institutions and fora (Chapter 10) have been highly responsive to the consequences of the GCC in emerging and developing economies: –

–

A G20 Action Plan has outlined an unprecedented coordinated effort to help emerging and developing countries cope with the GCC (Cabrillac, 2020). The IMF (Chapter 10) pledged to set up credit lines and provide liquidity to both fragile and emerging economies, creating a short-term instrument better suited to large and urgent external resource needs. These measures should enable the IMF to mobilize its $1 trillion lending capacity for countries in need of external resources. Multilateral banks have dedicated $200 billion to emergency financing. Finally, the G20 and the Paris Club agreed on a Debt Service Suspension Initiative (DSSI), by suspending official bilateral debt service payments for the poorest countries to year- end 2020 and possibly longer, providing those countries fiscal space to fund social, health, and other measures to respond to the pandemic. In addition, the US agreed to increase the funding of the IMF, and hence to contribute to strengthening the global financial safety net (Chapter10). In Europe, proposals to mutualize public debt (Chapter 10) have resumed under the label of “coronabonds”. The Commission has created a fund providing loans to national governments in order to support the creation or extension of partial unemployment schemes (Support to Mitigate Unemployment risks in an Emergency, SURE). The fund amounts to a total of €100 billion, financed by direct borrowing by the Commission in international capital markets, with voluntary guarantees by national member states. Furthermore, the European Investment Bank (EIB) has created a pan-European guarantee fund for bank loans up to €200 billion and the European Stability Mechanism (ESM) has committed to grant loans to Member States up to 2% of the beneficiary’s GDP. Finally, on 20 July 2020, the 27 European states reached an agreement on a €750 billion recovery plan financed by Commission debt, in a move reminiscent of the eurobonds proposal (Chapter 10).

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Of the total amount, €672.5 billion is divided into two main categories: loans (€360 billion) and grants (€312.5 billion). In addition, there are various lines of the Commission’s multiannual budget for an amount of €77.5 billion, giving a total of €390 billion in grants. Yet, such borrowing will have to be reimbursed through an increase in the contributions of Member States. This could sow the seeds of a future European debt crisis. Moreover, the distribution of grants instead of loans creates a strong moral hazard: as each Member State contributes to a limited extent to the EU Commission budget, it is incentivized to spend inefficiently. In response, the so- called “frugal” Member States (Austria, Denmark, Netherlands, and Sweden) have suggested that European support should instead take the form of loans and be made conditional on reform commitments by the beneficiaries.

11.2 New risks Three new factors that are developing or have the potential to become major sources of risks in the coming years are described: cyber risk (11.2.1), crypto assets (CAs) (11.2.2), and climate change (11.2.3).

11.2.1 Cyber risk We first define cyber risk and explain why it is important for financial stability (11.1.1.1), and then we provide assessments of its costs (11.2.1.2), and indicate why and how policies can help reduce cyber risk (11.2.1.3).

11.2.1.1 Definition Cyber risk can be defined as “operational risks to information and technology assets that have consequences affecting the confidentiality, availability or integrity of information systems” (Cebula and Young, 2010). As such, cyber risk is a subset of operational risk, which itself is a pillar of the regulatory framework (Chapter 6), established by standard- setting bodies (SSBs) and applied on a sectoral basis (Chapter 10). However, cyber risk differs from traditional operational risks in two ways (Kashyap and Wetherilt, 2019): –

–

The form it takes: Cyber risk is malicious; it is a quasi- certainty, at least in the medium to long term; its timing is highly uncertain, with the possibility of a hidden phase; and it evolves rapidly. Its possible impact on the financial sector: This sector is particularly exposed to cyber risk because of the potential for direct financial gain and because it holds valuable confidential data (Le Maire, 2019). Furthermore, the financial sector is global in nature, highly interconnected, and shares common exposures to cyber risk using common software.

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11.2.1.2 Costs There are direct and indirect costs related to cyber events (Kopp et al., 2017). Direct costs are relatively well understood and include costs of forensic investigation, legal assistance, customer notification, post-breach customer security and credit protection as well as past-event measures to strengthen cybersecurity. Indirect costs are harder to quantify and show up in the long run. They include reputation risk, depreciation of intellectual property value, higher ongoing operational costs to prevent future incidents and higher future insurance premiums. Overall, costs are difficult to ascertain and probably underestimated for two reasons: –

–

At the individual level of firms, costs of cyber-attacks could appear only in the longer run, as indicated above, in a context of most likely more frequent attacks. Furthermore, Kopp et al. (2017) indicate that more than 90% of total costs would be attributable to indirect costs. At the aggregate level, data collected is probably very partial, as firms often refrain from publicizing information on attacks they have experienced, for fear of losing reputation, hence customers. However, in the EU, since May 2018, the General Data Protection Regulation (GDPR) has required firms to report breaches to the competent authorities within 72 hours.

Consequently, estimates of cyber losses show a wide range, from $250 billion to $1 trillion according to Kopp et al. (2017). Bouveret (2018) also mentions the following information: –

–

–

Over 2009–2017, financial institutions in the advanced economies were the main targets of cyber-attacks but emerging markets (especially Russia, China, and India) were also exposed to cyber risk.2 Among financial institutions, banks account for the bulk of the attacks (91%). One of the most known attacks was that against the central bank of Bangladesh in February 2016, in which criminals managed to steal $81 million. Among cyber-attacks, fraud accounts for 43% of the events, data breaches 34% and disruption 23%.

11.2.1.3 Policies Regulatory intervention to limit cyber risk can be justified by market failures: –

Negative externalities may not be taken into account by firms while society may wish to reap positive externalities. As negative externalities, Kashyap and Wetherilt (2019) mention three sources. First, firms may not fully account for system-wide effects of a successful attack. Second, firms’ exposure to common risks (i.e. the use of shared services or software) may not be fully priced.

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–

Third, if multiple firms are simultaneously attacked, each individual firm’s assumptions about the availability of external resources may prove incorrect. As possibilities of reaping positive externalities, they cite the sharing of information on attacks and the access of regulators to firms’ cyber resilience assessment reports. Cyber insurance has limits. As pointed by Kopp et al. (2017), cyber insurance policies typically include conservative coverage limits and impose relatively restrictive exclusions and conditions, reflecting the paucity of data and the fast-changing nature of cyber risk. In particular, policies typically do not cover indirect losses that manifest over the medium-to-long run.

To be effective in the face of a global threat, policy responses should be coordinated at the international level. However, there are challenges for international cooperation (Domanski, 2019): –

–

There are issues around the sharing of information, such as confidentiality and commercial sensitivity of information, some of which may touch on national security concerns. Furthermore, trust may take time to build, whereas cyber threats evolve very rapidly, creating the risk that regulators and supervisors are constantly “behind the curve”.

To this end, the G7 developed in 2016 a set of high-level fundamental elements, intended as the building blocks upon which an entity can design and implement its cybersecurity strategy and operating framework. The elements include cybersecurity strategy and framework, governance, risk and control assessment, monitoring, response, recovery, and information sharing (Group of Seven, 2016). Furthermore, the Financial Stability Board (FSB; Chapter 10) agenda on cyber security has evolved along three lines (Domanski, 2019): – –

–

Enhancing mutual understanding: In 2017, the FSB took stock of financial sector cyber security regulation, guidance, and supervisory practices. Helping to build a common language: In 2018, the FSB published a cyber lexicon to support the work of the FSB, SSBs, authorities, and private sector participants to address financial sector cyber resilience. Finding solutions: Since 2019, the FSB has been developing effective practices for cyber incident response and recovery.

Looking ahead, there are three concrete areas to improve coordination (Villeroy de Galhau, 2019a): –

Regarding regulation and supervision: The proliferation of texts by standard- setters for banking, payments, securities services, insurance and/or financial markets should be avoided, by adopting a “principle-based” regulation while paying attention to the risk of regulatory arbitrage.

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–

–

Regarding information sharing: A common categorization of cyber incidents would help better measuring of the impacts of attacks and better understanding of their evolution. Furthermore, financial authorities could engage bilaterally in Memoranda of Understanding (MOUs) with authorities with whom they share mutual trust. Regarding cyber crisis management: Large- scale exercises should be conducted regularly, some guiding key principles drawn from them, while enlarging their conduct beyond the G7 remit.

11.2.2 Crypto assets Whereas Bitcoin was launched only in September 2008, at the end of May 2019 there were globally more than 2,000 types of CAs, for a total market capitalization of around €230 billion, or 19% of euro banknotes and notes in circulation, and Bitcoin then still represented alone close to 55% of that capitalization (ECB, 2019). We first define CAs and present the main categories of them (11.2.2.1), and then the risks they raise and the policies to address these risks (11.2.2.2).

11.2.2.1 Definition CAs are different from physical currencies, such as notes, coins, or local currencies, but also from deposits in banks or electronic money, encoded on cards or other devices, which are, like CAs, assets kept in digital form. The difference between CAs and bank deposits or electronic money is twofold (Pfister, 2017): –

–

CAs do not correspond to any acknowledgement of debt, any commitment on the part of the issuer. This commitment is replaced by the execution of a protocol in which the holders place their trust rather than a third party such as a bank. This allows CAs to carry out exchanges in a decentralized manner. CAs have an exchange mechanism that allows payment and settlement using distributed ledger technology (DLT). A distributed ledger (DL) is an account book that can be shared (“distributed”) and updated in real time in a secure manner via a network of “nodes”, i.e. computers. The best-known DL is the blockchain, which all CAs use and is so called because the data is organized in blocks, linked by cryptographic techniques. Block chaining is typically achieved through a process of validation of transaction blocks (also called “consensus”). This process, known as “mining”, is competitive in the case of Bitcoin. Indeed, Bitcoin miners (computer scientists) incur a cost in the form of energy used to solve by “brute force” a problem requiring high computing power; the first one to succeed is rewarded by the allocation of units created for this purpose, allowing increasing the stock of bitcoins in circulation as well as by a transaction fee.

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CAs operate in two main modes of organization (He et al., 2016): –

–

Some schemes, such as Bitcoin, are referred to as “public” (or “open” or “non-permissioned”) and correspond best to the mode of operation described above. In these schemes, all nodes have both read permissions to the entire ledger, and write permissions, in the sense that each node can participate in the validation of transactions. The number of units is usually fixed ex ante (21 million in the case of Bitcoin), and the organized scarcity of the asset supports its value and encourages the public to become users and miners to validate transactions. A “speculative bubble” phenomenon is thus inherent in such schemes. Other schemes are said to be “private” (or “closed” or “permissioned”) because not all nodes have the same read permissions, in order, for instance, to preserve the confidentiality of certain information, and/or the same write permissions. This last restriction makes it possible to speed up the validation of transactions and reduce the energy expenditure inherent in competition between “miners”, but introduces a hierarchy, and therefore a relationship of trust, into the operation of the DL.

CAs issued within public schemes have met with little success because they are not capable of fulfilling the functions assigned to a currency: unit of account, medium of exchange and store of value (Yermack, 2013). Since very few prices and revenues are expressed in CAs, they do not serve as a unit of account. Hardly any merchant accepts them as a medium of exchange. Since their supply does not adapt to final demand but follows a dynamic predetermined by a protocol, their prices in legal tender are much more volatile than those between legal currencies, making them poor stores of value. On the other hand, the use of DLT within private blockchains, based on the representation of financial assets in the form of tokens (so- called “tokenization” of assets), would seem more promising (He et al., 2016). This approach would be supported by the inclusion in CAs of smart contracts (i.e. contracts that execute themselves when predefined events occur, such as the payment of interest). To date, two paths in this direction have been followed (Yermack, 2019): –

The first path consists of Initial Coin Offerings (ICOs), where tokens issued on blockchains against contribution of CAs make it possible to finance a project, giving their holders access either to services offered on the issuing blockchain (utility tokens) or to a remuneration that makes them assets similar to securities (security tokens). In 2018, more than 1,000 ICOs took place, raising more than €21 billion (Fatás and Weder di Mauro, 2019). However, the number of ICOs has fallen sharply since the second quarter of 2018, as Bitcoin prices fell.

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–

The second path is the issuance of stablecoins (SCs) backed by bank deposits or well-rated securities, whose price is kept fixed vis-à-vis a legal currency or a basket of currencies (Melachrinos and Pfister, 2021). Although SCs were introduced in 2014, just over 200 projects had been announced by July 2019, and only 66 of them had actually been implemented by then, with a total capitalization of just $4.3 billion. Furthermore, their market is highly concentrated, with Tether representing, in July 2019, 95% of transactions and 81% of capitalization (Bullman et  al., 2019). Overall, the success of SCs seems to be very mixed, and their market has so far appeared as an appendix to that of the other CAs. However, the arrival of very large players issuing SCs with the potential to reach a wide audience could provide an additional level of confidence to SC users and give their projects a potentially systemic reach. This is the case of the Libra project launched by Facebook, which is aimed at the public, especially in developing or emerging economies. This is also the case of projects promoted by large banks, which are aimed at large corporations and financial intermediaries, such as the Utility Settlement Coin project supported by a consortium of banks, including UBS and the JPM Coin project of the JP Morgan bank. In both cases, SCs would become global (Group of Seven, 2019).

11.2.2.2 Risks and responses CAs can represent a macroeconomic danger for legal currencies that have lost their credibility (Pfister, 2017) and CAs are in that sense comparable to dollarization. From a financial stability point of view, their outstanding amounts remain too small to represent a systemic risk. However, as indicated above, this could change with the arrival of global stablecoins (GSCs; Melachrinos and Pfister, 2021): –

–

Wholesale GSCs such as JPM Coin that are not backed by central bank deposits present a residual credit risk. Moreover, the concentration of financial transactions in a blockchain would strengthen the connections between large financial institutions and large firms at the global level, creating a single point of failure and a “too big to fail” moral hazard issue (Chapter 1) in the case of systemic SCs. In the case of retail GSCs such as Libra, from the issuer’s perspective, the viability of the business model of retail SCs depends largely on the level of interest rates on the assets held (the “reserve”). If the SC is 100% backed and the reserve invested in assets denominated in currencies such as the dollar, euro or yen, the historically low levels of interest rates nowadays considerably limits the return on the reserve. In order to preserve its profitability, the issuer may thus be tempted to invest in securities that are riskier, in terms of credit, liquidity and duration or even exchange rates, even if the latter strategy would not replicate the composition of the basket. In the case of a basket SC, it could even in principle change the composition of the basket (such a provision is provided for

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Libra; Libra, 2019), in order possibly to appropriate capital gains on reserves, but, unless it did so surreptitiously, it would expose itself to a risk of loss of credibility that could trigger a run. From a holder’s perspective, two conditions have to be met for the units to be redeemable at any time. The first condition is that the issuer does not hold a position such that the liquidation of its positions would cause a collapse of the financial markets in which it has invested or a liquidity crisis in the banks with which it has made deposits. The second condition is that it has prudently managed the reserve, as indicated above. “Same business, same risks, same rules” and a consistent regulatory approach among potential SC user countries are the regulatory guidelines proposed by the G7 working group on GSCs (Group of Seven, 2019). Following the work of the latter, a FSB (Chapter 10) working group was set up to indicate the various regulations to be applied accordingly to each aspect of GSC activity. The first response of regulators is therefore to coordinate in order to avoid regulatory arbitrage. However, since regulations differ according to the nature of the assets concerned (e.g. money or securities), regulators must also consider the legal classification of the SCs. In particular, there are three options for off- chain guaranteed SCs, which are the most common ones. The first is to consider them as money market funds, in that they invest in principle in low-risk, short-term assets denominated in the currency to which they are backed, with the aim of maintaining a constant value, since each unit issued can be assimilated to a money market fund unit, even in the case of basket SCs. The second option would be to consider SCs as electronic money, because SC units are intended to be used as a payment instrument and that their issuer undertakes to redeem them at par. This second qualification would entail much stricter regulatory constraints for issuers than the first, for example, in Europe with the 2009 European directive on electronic money, which includes capital requirements and the obligation for the issuer to be able to redeem holders at par at any time. The third option, which FINMA (the Swiss Financial Market Supervisory Authority) has chosen for Libra and which does not exclude the first or the second, is to treat SCs as payment systems since they circulate units on a blockchain for this purpose. In addition, prudential measures comparable to those taken in the case of dollarization (Gulde et al., 2004) could be adopted. For instance, liquidity requirements (Chapter 6) could be strengthened to cope with potentially more frequent runs in countries that do not issue the reference currency (or currencies) of the GSC. Obtaining credit lines in foreign currencies and setting up foreign exchange swaps by resident banks with foreign institutions would be part of the same approach (Chapter 10). The central bank could also strengthen its capacity to support its banking system by increasing the level of its foreign exchange reserves and by participating in foreign exchange swap networks between central banks (Chapter 10). Finally, credit distribution in GSCs should be subject to close supervision, or even to a specific regulatory framework, to prevent a sudden depreciation of the exchange rate from causing financial instability.

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Central banks could also issue Central Bank Digital Currencies (CBDCs) to counter SCs (Pfister, 2019). However, this could cause difficulties for their banking sector, whose resources would be affected by the substitution of CBDCs for deposits. Furthermore, it is not certain that this would be an adequate response to the risk of substitution of the domestic currency by retail GSCs resulting from a lack of confidence in the legal tender or in the national financial system or from the inefficient functioning of domestic payments systems. Finally, it remains to be seen what would make a retail GSC successful. If, as Adrian and ManciniGriffoli (2019) argue, it is the way it fits into an integrated ecosystem providing messaging, search engine, e- commerce, financial, and payment services and constituting a “digital currency zone” (Brunnermeier et al., 2019), then the issuance of a retail CBDC would not necessarily be successful.

11.2.3 Climate change related risks From a very different perspective, there is a rather broad consensus among scientists that surface temperature and precipitations are increasing on the earth, under the influence of human activity (the so- called “anthropogenic climate change”) and that more is to come, with potentially very severe consequences on ecosystems. While economists belatedly recognized the relevance of the issue, it is now widely acknowledged that such an evolution has negative economic consequences as well as a direct impact on financial stability. We first define the risks associated to climate change, as well as their impact, and transmission channels (11.2.3.1), then the policies to address these risks (11.2.3.2).

11.2.3.1 Definition The Intergovernmental Panel on Climate Change (IPCC; 2018), which assesses current knowledge of the climate-induced impacts and risks for natural and human systems, stated unambiguously that “warming of the climate system is unequivocal, and since the 1950s, many of the observed changes are unprecedented over decades to millennia. The atmosphere and ocean have warmed, the amounts of snow and ice have diminished, and the sea level has risen”.3 This was confirmed by subsequent reports (notably IPCC, 2018). MassonDelmotte and MoufoumaOkia (2019) highlight that “global warming is currently increasing at a rate of 0.2°C (± 0.1%) per decade. If it continues to rise at this rate, it is likely to reach 1.5°C between around 2030 and 2050”, with much more severe biophysical effects above 1.5°C. While the higher number and severity of heat waves and droughts is well documented as well as higher precipitations, floods, landslides, etc., the jury is still out regarding the higher frequency versus increased severity of some natural catastrophes, like hurricanes and tornadoes, etc. In addition, experts monitor the evolution of some sensitive areas where climate change is likely to have irreversible effects with the breach of biophysical thresholds (“tipping points”), such as, for

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example, the loss of Greenland ice sheets, with more severe consequence at the global level. Bolton et al. (2020) provide a list of these sensitive areas around the globe and possible cascading effects between them. Another dimension is that, in the short and medium run, some countries (notably in Southeast Asia and Africa as well as some regions in advanced economies, like the West Coast in the US) will be more affected by climate change than others (Kahn et al., 2019), creating a source of inequality among and within nations (11.2.3). The direct economic effects of climate change, as reviewed by Batten (2018), are lower economic growth,4 increase in the volatility of GDP and depreciation in the value of business and household assets and property. They may also have a negative impact on interest rates, if investment demand decreases (Hale et al., 2019). The slowdown in economic growth has an indirect impact on the financial system, hence financial stability, as it implies lower demand for financial services (lower demand for loans or insurance coverage). But climate change also has a direct impact on financial stability, creating new risks for financial institutions and markets. Since Carney (2015) and BoE (2015), it is common to distinguish between physical and transition risk. Physical risks, on the one hand, are “the economic costs and financial losses due to increasing frequency and severity of climate-related weather events (e.g. storms, floods or heat waves) and the effects of long-term changes in climate patterns (e.g. ocean acidification, rising sea levels or changes in precipitation)” (Bolton et al., 2020). While insurance traditionally offers catastrophe or weatherrelated insurance, and banks factor some physical risk in loan contracts, the nature and the dimension of climate change as well as further unexpected climate change related shocks imply a dramatic change in the way financial institutions conduct their business, with short and medium run adverse consequences on financial institutions’ profitability. This includes, as discussed in Bolton et  al. (2020) and DG Treasury et al. (2017): –

–

The losses incurred by firms across different financial portfolios (e.g. loans, equities, bonds) following climate change related events, which can make them more fragile. The impact on real estate exposures, in particular for long-term mortgage loans in coastal areas following rising sea levels (Bernstein et al., 2019; or in more regularly flooded areas along rivers, DNB, 2017). This could lead to an abrupt repricing of real estate (Bunten and Kahn, 2014) in some exposed regions, causing large negative household wealth effects that may weigh on demand and prices through second-round effects.

As natural catastrophes become more frequent worldwide (Munich Re, 2018), non-insured losses (which represent 70% of weather-related losses; IAIS, 2018) can threaten the solvency of households, businesses and governments, and therefore financial institutions. In particular, spillover effects from business interruption of

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a few single firms in a flooded area to suppliers and customers are likely to have a more significant negative effect: –

– –

As insurance contracts are liabilities of insurers to their customers, changes in insured losses may place insurers and reinsurers in a situation of fragility as claims for damage increase. The increasing number on climate related shocks imply that a higher share of insurers may be unable to meet their commitment, resulting in a risk of failure. Research by de Bandt and Overton (2020) reports that several insurers went bankrupt in the US in the early 1990s following Hurricane Andrew. Other insurers may feel more pressure for a continuous adjustment of contracts, forcing some of them to exit the market. On the demand side, customers may no longer be able afford to buy the new contracts, leading to a higher proportion of uninsured households and businesses. More broadly, damages to assets affect the longevity of physical capital through capital depreciation (Fankhauser and Tol, 2005). Moreover, the fat-tailed probability distributions of many climate parameters are such that extreme values may occur (Weitzman, 2011).

Transition risks, on the other hand, are the policy-induced risks that are associated with the impact that could result from a rapid low carbon transition, but they include also reputational impacts, technological breakthroughs or limitations and shifts in market preferences. In particular, a rapid and ambitious transition to lower emissions means that a large fraction of proven reserves of fossil fuel will not be extracted, becoming “stranded assets”. One possible scenario is a fire sale where these stranded assets suddenly lose value, with potential non-linear and second-round effects (Battiston et  al., 2017). As these assets appear in the portfolio of banks, insurers, or asset managers, these institutions will face asset depreciation and possibly losses, eventually transmitted to their customers, hence possibly triggering a financial crisis. As Mark Carney puts it: “too rapid a movement towards a low-carbon economy could […] spark a pro-cyclical crystallisation of losses and lead to a persistent tightening of financial conditions: a climate Minsky moment” (Carney, 2016). Another channel is the transmission to many other economic sectors dependent on fossil fuel companies, which may differ across sectors depending on competition, hence the ability to pass-through the constraints on customers. For instance, the automobile industry may be strongly impacted as technologies, prices, and individual preferences evolve. Physical and transition risks are actually interrelated: a swift policy action to mitigate climate change would increase transition risks and limit physical risks, but those would remain existent. In contrast, delayed and weak action to mitigate climate change would lead to more severe physical risks. Liability risk (increased litigation following climate change) is often considered as a third additional risk. Such a risk already materialized, as highlighted by the bankruptcy of California’s largest utility, Pacific Gas and Electric, which accumulated liabilities (Gold 2019).

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From a prudential perspective, physical, transition and liability risks are illustrations of standard financial risks: credit, market, liquidity, operational (DG Treasury et al., 2017). In addition, Bolton et  al. (2020) argue that climate change might trigger “green swan” events, i.e. potentially extremely disruptive events, with systemic consequences on the financial system, due to complex, far-reaching, nonlinear, chain reaction effects when exceeding climate tipping points, leading to catastrophic and irreversible impacts. They are actually much more sizeable and likely to occur than Taleb’s (2008) “black swan”, as also argued by NGFS (2019).

11.2.3.2 Policy responses While there is certainty that some combination of physical and transition risks will materialize in the future, the exact outcomes, time horizon and future pathway are uncertain (NGFS, 2019). There is therefore a need to improve the understanding of interactions between climate change and macroeconomics, as “we are still somewhat in the dark on some issues, particularly those of direct interest to central banks” (Villeroy de Galhau, 2019b). In particular, most of the available projections are based on integrated assessment models (IAMs) that aim to combine the biophysical impacts of climate change and their consequential impacts on economic systems. These models have strong limitations, in particular regarding the measurement of the damage of climate changes (Curran et al., 2019). In addition, policymakers need to provide incentives to economic agents who, more than for other structural reforms, face the “Tragedy of the horizon”, where “catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors – imposing a cost on future generations that the current generation has no direct incentive to fix” (Carney, 2015). A variety of responses is possible that are variants of the ones studied before: –

–

–

Tax policy (Chapter 9): A carbon tax is, in theory, the best policy action over banning carbon dioxide (CO2) emitting activities, as it takes advantage of price signals. One frequently raised objection is that it may hurt low-income households relatively more (11.2.1). However, a carbon tax implies no more than a change in relative prices and its impact on public revenues can be neutralized by a fall in other taxes on consumption. There are discussions on how monetary policy (Chapter 9) could take into account of climate changes. As indicated by Villeroy de Galhau (2019b), rather than introducing a “green QE”, the ECB collateral framework could be reviewed. What matters first is therefore a proper “taxonomy” of sustainable activities, i.e. low CO2 emission activities, starting with the European level. Financial regulation and supervision (Chapters 6 and 8) are additional tools. The first level is “Pillar III” requirements, in terms of transparency on financial institutions’ exposures to high CO2 emission activities. However, as

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shown by Mesonnier (2019), in order to have an effect on credit allocation towards “greener” firms, this would also require that final borrowers themselves report their CO2 emissions, which is not yet the case for SMEs. In addition, Pillar I requirements might be used, penalizing high CO2 emission assets, or softening solvency requirements for exposures to low CO2 emission activities (a “green supporting factor”, advocated by the banking industry). Note however that the latter contradicts the risk-based nature of financial regulation. In addition, research is active for defining proper scenarios for stress testing climate change (DG Treasury et al., 2017; NGFS, 2019). Two broad categories of scenarios may be distinguished, either related to transition risk, where the later the transition, the more adverse the shock is, or physical risk, with a distinction between a progressive increase in temperature, weighing inter alia on productivity, or an increase in the size or frequency of natural catastrophes.

11.3 New challenges We identify three new challenges to financial stability and macroprudential policy. They share common features: they are part of broader trends coming from outside the financial system, they are likely to take more importance over time, with adverse effects on the financial system, although their impact is somewhat ambiguous, and a proper analytical framework has not yet been developed. We highlight three challenges: the feedback loop between inequality, financial stability, and populism (11.3.1), population ageing, implicit liabilities, and sovereign debt (11.3.2), and complexity in banking and finance (11.3.3).

11.3.1 The feedback loop between inequality, financial stability, and populism Funke et al. (2016), who analyse the political history of 20 advanced democracies back to the 1870s complemented with data on over 100 financial crises, observe that financial crises are more politically disruptive than other types of economic downturns. Indeed, populist parties have emerged in a number of advanced economies in the aftermath of the GFC. Rodrik (2017) characterizes populist parties as emphasizing “a cultural cleavage, the national, ethnic, religious or cultural identity of the ‘people’ against outside groups who allegedly pose a threat to the popular will”. Funke et al. (2016) provide three explanations about the breakthrough of populist parties after a financial crisis: – – –

First, financial crises are perceived as resulting from the failure of regulation and policies. They lead to distrust in government and mainstream politics. Second, financial crises trigger creditor- debtor conflicts and increase income and wealth inequality. Third, large- scale bank bailouts, which frequently occur after a financial crisis, are not popular.

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One aspect of the rise of populism is that central bank independence has been questioned in the aftermath of the GFC, notably in countries where the value of an open multilateral order has come under attack (Borio, 2019). In particular, the distributional effects of quantitative easing and unconventional monetary policies in terms of wealth and income, creditors and debtors or the young and old are seen in the context of the winners and the losers of globalization (Goodhart and Lastra, 2018). Opponents claim that the persistence of such policies, designed by central banks, which are non-elected technocratic bodies, has worsened wealth inequality. Moreover, non- conventional monetary policies have blurred the line between monetary and fiscal policies and resulted in central banks playing a bigger role in supervision and macroprudential policies (Chapter 10) that also have distributional consequences. Indeed, inequality and financial stability are intertwined. Consequently, we address two issues: inequality and financial stability (11.2.1.1) and macroprudential policies and inequality (11.2.1.2).

11.3.1.1 Inequality and financial stability Is rising inequality conducive to a financial crisis? Empirical evidence seems to point to feedback effects between inequality and financial stability. Kumhof et al. (2015) document five stylized facts that characterize, for the US economy, the Great Depression starting in 1929 and the GFC. In the period prior to both major crises, rapidly growing income inequality was accompanied by: – – – – –

A sharp increase in aggregate household debt. Increasing heterogeneity in debt-to-income ratios between high-income households and all remaining households. An increase in the share of wealth held by high-income households. A sizeable increase in crisis probabilities, according to Schularick and Taylor’s (2012) methodology. High rates of default on household loans.

Why do poorer households’ debt-to-income ratios increase before a crisis? According to Rajan (2010), rising inequality in the US led to political pressure for subsidized mortgage finance to low-income households (Chapter 9), resulting in a lending boom and a run-up in housing prices which led ultimately to the GFC. More generally, the demand for credit by poor households may rise as they try to keep up with social consumption norms (Monnin, 2018) or, more simply, to maintain relative living standards, despite stagnating or falling income. According to this view, income inequality is a long-term determinant of debt leverage and financial vulnerability. Bazillier and Héricourt (2014), who review the existing literature, find strong evidence that inequality does play a role in the dynamics of credit, finance, and possibly financial crises, even though accommodative monetary policies and financial liberalization may also have contributed

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to an increase in credit supply. Consequently, Kumhof et  al. (2015) propose a general equilibrium model calibrated on US data, in which increases in the income share of high-income households and higher debt leverage among poor and middle-income households increase the probability of a crisis accompanied by a contraction in the real economy. According to Cihak and Sahay (2020), during the onset and early part of the crisis, inequality tends to dip, reflecting primarily that richer households are more exposed to fluctuations on financial markets. However, the post- crisis years are associated with increased inequality, as lowerincome households tend to experience disproportionately a loss in income due to the contraction of activity, constraints on consumption smoothing due to deleveraging by banks, etc. If income inequality is a systematic driver of financial crises, changes in income inequality should precede and predict crises. According to Kirschenmann et al. (2016), income inequality does have a high predictive power of financial crises in 14 advanced economies over the period 1870–2008, especially when it is at elevated levels. Paul (2017), who considers 17 advanced economies from 1870 to 2013, finds that changes in the top income shares and productivity growth are strong predictors of financial crises. Slowly rising income inequality and years of low productivity growth typically precede financial crises. Recessions that are preceded by unusually strong increases in inequality or low productivity growth are characterized by stronger declines in output compared with normal recessions.

11.3.1.2 Inequality and macroprudential policies In the aftermath of the GFC, several central banks have endorsed a more pro-active role in strengthening financial stability at the macroeconomic level, implementing new macroprudential measures to pursue this goal (Chapter 10). However: –

Macroprudential measures are not neutral in terms of income and wealth inequality (Koedijk et al., 2018). For example, Carpantier et al. (2018) show theoretically how caps on loan-to-value (LTV) ratios (Chapter 8) can increase or decrease wealth inequality depending on the underlying structure of the economy (i.e. the size of LTV ratios, housing prices, credit costs, the intensity of intergenerational transfers). Therefore, whether LTV ratios increase or decrease inequality is an empirical question. Using data on household balance sheets for 12 euro area countries, they find that wealth inequality among households with a mortgage increases when caps on LTV ratios become more stringent and decreases when house prices increase. However, due to the limitations of the data, these results do not reflect causality. Frost and van Stralen (2018) study the link between macroprudential measures and income inequality in a panel of 69 countries over the period 2000–2013. Countries with countercyclical capital buffers, concentration limits or limits on growth of direct credit (Chapter 8) tend to experience higher-income inequality while countries with special requirements for

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–

systemically important financial institutions have lower levels of income inequality. However, in this case too, results cannot be interpreted as proving causality. More research is needed on how macroprudential policies affect the distribution of income and wealth. In turn, income and wealth distributions may affect the effectiveness of macroprudential policies. Punzi and Rabitsch (2018) show that policies that tighten lending more for highly leveraged households than for others are more welfare-improving than policies that affect everyone equally. However, the highest-leveraged households are often the poorest and restricting their access to home ownership could increase inequality (Monnin, 2018).

How can regulatory and supervisory policies loosen the loop between inequality and financial stability? Since benefits of finance for economic growth start declining when aggregate leverage is high (Chapter 2), they could have a role to play in reining in excessive growth of the financial sector (Chapter 4).

11.3.2 Population ageing, sovereign debt and financial stability G-20 countries are in the midst of stark demographic change (Group of Twenty, 2019). The rate of population growth has been falling since the 1970s and the rate of growth of the working age population (15–64 years old) has been declining since the 1980s. Most advanced countries (Australia, Canada, France, Germany, Italy, Japan, Spain, the UK, and the US) and some emerging countries (Korea, Russia) are in the later stage of demographic transition with their working age population about to decline or already declining. Moreover, their dependency ratio, defined as the ratio of people aged 65 and older to those between 15 and 64, is increasing. Projections point to rapidly rising old-age dependency ratios. While today Japan is the only G-20 country with an old age dependency ratio over 40%, by 2050 nine G-20 countries will exceed this ratio. The process of population ageing has several macroeconomic and fiscal implications (Nerlich and Schroth, 2018; Group of Twenty, 2019). Ageing is likely to have adverse effects on potential growth and may be expected to increase precautionary savings. Consequently, ageing could contribute to a low level of real interest rates over an extended period. In addition, population ageing will place a burden on fiscal sustainability. It will exert upward pressure on the already elevated levels of age-related public spending (health care, which in some regions such as Europe is predominantly provided by the public sector, long-term care, and pensions). Pay-as-you-go pension schemes, the most common public pension arrangement worldwide, will be particularly affected: as populations age, the number of beneficiaries of public pension schemes will increase, while the number of contributors is expected to decline, resulting in increasing deficits, unless parameters are adjusted. Moreover, to the extent that ageing has an unfavourable impact on real GDP growth, public debt levels will become harder to sustain, particularly for countries where debt levels are already elevated, even if declining

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real interest rates could mitigate in part this effect. Unfavourable debt dynamics combined with significant and rising implicit public pension liabilities would leave little room for fiscal policy to address adverse business cycle developments. Moreover, a very unfavourable fiscal position is likely to affect financial stability through a decrease in the government’s ability to bail out or provide guarantees to the banking sector or through losses on banks’ sovereign portfolios, weakening their balance sheets (Chapter 9). What can be done? Raising labour force participation and productivity and strengthening investment and innovation may help to mitigate the macroeconomic effects of ageing. Reforms to public pension systems, in particular lifting the statutory and effective retirement ages (Nerlich and Schroth, 2018), should contribute, where needed, to address ageing-related challenges.

11.3.3 Complexity in banking and finance Complexity is a new challenge associated with development in mature economies. It affects society as well as the financial system. It is also difficult to define, its implications in terms of risk are ambiguous, but the principle of prudence calls for attention. We first define the challenges of complexity and explain why it is important for financial stability (11.3.3.1), and then we provide assessments of its costs (11.3.3.2) and indicate why and how policies can help reduce complexity (11.3.3.3).

11.3.3.1 Definition Complexity is usually defined by its negative impact on resilience. Three dimensions are found in the literature: external, internal, in terms of products. The first dimension is the nature of external exposures, with a multiplicity of links between institutions. It is the definition introduced by Gai et al. (2011) by reference to Simon (1962). This author stressed the lower resilience of complex networks that are non-hierarchical, with possibly multiple links between all the institutions. Gai et al. (2011) note that “In Simon’s words, the financial system has become less modular, less hierarchical and thus less decomposable. In consequence, it became markedly more susceptible to systemic collapse. This sowed the seeds of the global financial crisis of 2007/2008”. The second dimension is linked to the internal organisation of large financial institutions, on the basis of the observation that their internal structure has become more complex. In this literature (Cetorelli and Goldberg, 2014, 2016; Carmassi and Herring, 2019), the basic distinction is between: –

Organizational complexity, which measures the scope and breadth of activities, by the number of separate legal entities in a banking group, arguing that larger numbers contribute to higher resolution (Chapter 7) and systemic costs (Chapters1 and 8) in case of failure of the group.

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– –

Business complexity, which measures the (lack of ) concentration of businesses and industries across these legal entities. Geographic complexity, which captures the domestic versus international locations of these entities, depending on their span and dispersion across countries.

The third dimension of complexity deals with the nature of assets in which the institution is invested, or product supplied, where complexity implies the lack of transparency on the risks involved, with potential systemic consequences. Such a dimension is in particular chosen for the identification of GSIBs (Chapter 8), where complexity is defined by the amount of exposures to OTC derivatives, level 3 assets and the size of the trading book.

11.3.3.2 Implication of complexity for financial stability As discussed by Bussière et al. (2020), the relationship between bank complexity and bank risk is ambiguous or mixed, including either positive or negative impact of complexity on risk, although the overall conclusion is that one should remain cautious, given the existence of a non-monotonic relationship. On the one hand, complexity introduces diversification benefits and economies of scope. Focusing on bank credit risk, Fang and Van Lelyveld (2014) show that geographical diversification reduces bank risk. The benefits of international diversification are also supported by Meslier et al. (2016). On the other hand, complexity may imply additional risks or new costs, including monitoring costs, which might outweigh gains. In theoretical work, Wagner (2010) shows that diversification may reduce the failure risk of individual institutions while simultaneously increasing systemic risk. As a result, full diversification is no longer desirable and the optimal degree of diversification may be arbitrarily low. Battiston et al. (2012) argue that the diversification of credit risk across many borrowers has ambiguous effects on systemic risk in the presence of mechanisms of loss amplifications, such as in the presence of potential runs among the short-term lenders of the agents in the network. The greater impact of monitoring costs is supported in Buch et al. (2013). De Jonghe (2010) also concludes that complexity increases with the diversification of activities, in particular in case of shift to non-traditional banking activities. In addition to the diversification channel, complexity also introduces agency problems. These agency problems are related to the opacity of the conglomerates’ balance sheets, the “Too Big to Fail” (Chapter 1) dimension of banks and the implicit bailout guarantee. In addition to size, Farhi and Tirole (2012) show that complexity is also a determinant of TBTF. Cetorelli and Traina (2018) find that “living will” regulation which sheds light on banks’ organization, hence making bailout no longer the only solution possible in case of troubles, implies a negative impact of complexity, which increases a bank’s annual cost of capital by 22 basis points, or 10% of total funding costs. This effect is stronger for large banks, i.e. in banks that were measured as systemically important before the regulation’s announcement.

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Nevertheless, Liu et al. (2015) reconcile these two strands of the literature by exhibiting an inversely U-shaped relation between bank complexity and banks’ sensitivity to systemic shocks. Guerry and Wallmeier (2017) investigate the diversification discount on financial conglomerates. They show that complexity, on the basis of income- and asset-based diversification, lowers financial conglomerates market values. In the earlier literature, Laeven and Levine (2007) found evidence of a diversification discount, while Baele et al. (2007) conclude that a higher share of non-interest income in total income affects banks’ franchise values positively, but the diversification of revenue streams from distinct financial activities increases the systematic risk of banks. While Guerry and Wallmeier (2017) are consistent with Laeven and Levine (2007), with a significant diversification discount at the end of the 1990s (with a significant premium for investment banks), their main finding is that the diversification discount decreases over time and practically vanishes after the GFC.

11.3.3.3 Evolution over time and policy responses The evolution of complexity since the GFC, its main motivations, and policies to address it are reviewed successively. Regarding evolution over time, Carmassi and Herring (2019) show that the number of controlled subsidiaries of GSIBs, based on Bureau van Dijk data, as of October 2018, has not decreased since the GFC with large increases for subsidiaries reported by US banks, but maybe due to a revision of data sources. Outside US GSIBs, one can notice an average decrease by 7%, which hides considerable heterogeneity across banks. On average, Bank Holding Companies (BHCs) operate in 45 different countries as opposed to 41 in 2013. The average proportion of subsidiaries in Offshore Financial Centers (OFCs) has increased from 15% to 18%. Concentrating on the US, Goldberg and Meehl (2019), using Federal Reserve data, show that large US BHCs remain very complex across the organizational, business, and geographic dimensions. Nonetheless, the most organizationally complex ones have reduced the number of legal entities, and sometimes reduced the number of countries in which they have affiliates, in connection with the requirement to prepare living wills for resolution (Chapter 7). By contrast, the multiple industries spanned by legal entities within the US BHCs have shifted more than they have declined, especially within the financial sector. Non-financial entities within US BHCs still tilt heavily towards real estate-related businesses and span numerous other industries. Fewer large US BHCs have global affiliates and the geographic span of the most complex has declined. Locations with favourable tax treatment still attract a significant share of the foreign bank and non-bank entities while informationally opaque locations are losing their share of such entities. Regarding incentives to complexity that may explain its evolution, Carmassi and Herring (2019) distinguish: –

The effect of regulation, as host supervisors may request to form legally chartered subsidiaries;

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–

Tax, accounting, and financial regulation arbitrage that may, among others, induce GSIBs to locate some activities in OFCs through Special Purpose Vehicles.

Regarding policies to address complexity, they are of micro- and macroprudential nature: –

–

Complexity impedes effective oversight, creates obstacles to effective resolution (Chapter 7) and complicates crisis management. This is the reason why home and key host supervisors have been requested to maintain a Crisis Management Group (CMG). They include supervisory authorities, central banks and ministries of finance and review, at least annually, information sharing as well as recovery and resolution plans. Complexity provides additional incentives to banks to hoard liquidity in case of crisis. The solution is therefore to increase ex ante the amount of liquidity held by banks in order to reduce the effects of stress events (Gai et al., 2011; Chapter 6).

Notes 1 Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus, 22 March 2020, https:// www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200322a1.pdf 2 Additionally, Domanski (2019), citing IBM sources, indicates that 19% of all cyberattacks and incidents in 2018 were focused on financial services more than any other sector. 3 Quoted by Hale et al. (2019). 4 10% loss to global GDP in 2100 if no action is taken to reduce carbon emissions (OECD, 2016). The more sophisticated studies suggest average global incomes may be reduced by up to a quarter by the end of the century (NGFS, 2019).

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INDEX

accounting standards 12, 75–83, 164, 244, 336, 340; historical; fair value 78–81, 177; see also pricing adverse selection 6, 11–13, 17, 27–28, 48–49, 124–125 agency problems 41, 49, 357 allowance for corporate equity (ACE) 277 architecture of financial stability institutions 288–294 asset-backed commercial paper (ABCP) 38, 41–42, 45 asset-backed security (ABS) 37–38, 41, 42, 269 asset purchase program (APP) 62–64 asymmetric information 23, 26, 39, 247

banking panic 23, 48–49 Basel: gap 223; pillar 1 154–155, 164, 166, 213; pillar 2 117, 155, 159, 164, 172, 213, 339; pillar 3 155 Bear Stearns 23, 27, 41, 112, 191 Bitcoin 344–345 bonus compensation: 92, 94–95, insurance 179 book: banking book 117, 162, 180, 235; trading book 117, 135, 162, 180, 215, 357 broker-dealer 40, 45, 236 bubble 14–16, 22, 24, 26, 64, 76, 79, 90, 104, 156, 222–223, 246, 266, 268–269, 278, 345

bail in 189–190, 195–200, 203, 206–209, 211, 213–214 bail out 18, 21, 24, 62, 95, 200, 217, 272, 329 bank: global systemically important bank (GSIB) 32, 106–107, 163, 190, 211–216, 221, 226, 253, 273, 357–359; narrow banking 112, 140; run 23, 25, 42, 47, 50, 103–104, 194, 198, 313; systemic bank (ing) 53, 229–232, 247, 281; universal bank (ing) 97, 106, 108–112, 114–115, 135, 140–141, 182 Bank for International Settlements (BIS) 251, 305–307 Bank of England (BoE) 238, 240, 289, 291–292, 312, 334, 338–339, 349 Bank of Japan (BoJ) 264, 312, 338

capital: capital conservation buffer (CCB) 159, 339; capital controls 46, 65–66, 210; capital requirement directives (in Europe) 95–96, 117, 152, 157, 159, 242; capital requirement regulations (in Europe) 95, 135, 156–157, 180, 184, 240; tier 1 147, 150, 152, 154, 156, 158–159, 163, 194, 241–242, 274, 336; tier 2 152, 159, 200, 212; tier 3 252, 259 carbon tax 351 central bank digital currency (CBDC) 348 central counterparty (CCP) 130, 227 charter value 73, 280–281 circuit breaker 123, 126 climate change: physical risks 349–350, 352; transition risks 350–351

366 Index

collateral 2, 12, 27, 36, 38–39, 42–46, 73, 118, 131–133, 135; reuse and rehypothecation 128–129 collateralized debt obligation (CDO) 38, 44 collateralized loan obligation (CLO) 38 collective action clause (CAC) 310–311 common equity tier 1 (CET1) 150, 157–159, 194, 212, 214–215, 241 compensation 81–82, 91–96, 244, 297 competition: in the financial sector 7, 19, 21, 38, 40, 46, 77, 83, 110, 125, 135, 152, 170, 245; policy 279–282 concentration 19–20, 73, 88, 93, 110, 132, 167, 169, 227, 238, 240–241, 248, 281, 316, 346, 354, 357 conflict: between home and host supervisors 250; of incentives 295; of interest 76–77, 84–85, 109–113, 291–293, 324; of objectives 208, 248, 326 constraints: financial 7, 19, 25, 37, 46, 49–50, 82–83, 87, 90, 94, 250, 267, 303, 338, 354; on monetary policy 259–262, 308–309; regulatory 19, 25, 73–74, 82, 87, 103–141, 148, 167, 240, 244, 347, 350 contagion 14, 16–17, 22–24, 47, 49, 61, 82, 109, 114, 120, 124–125, 129, 133, 188, 190, 194, 198–200, 212, 222, 226–228, 232–233, 240, 260, 302, 307, 313, 317 contingent convertible bonds (CoCos) 193–194, 207–208, 212–215 contract: see financial contract covid-19 i, xiv, 1, 3, 318, 333–334, 336, 338, 359–364 credit default swap (CDS) 17, 122–123, 130–132, 194, 209, 226, 232, 317 credit rating agencies (CRAs) 75–77, 244, 321 credit risk 39, 41, 66, 77, 95, 130, 132, 153–158, 160–161, 219, 228, 311, 313, 317, 323, 346, 357 credit-to-GDP ratio see ratio crisis: banking 19, 46, 58, 66, 112, 189, 191, 209, 271–272, 281, 322; currency 16, 48–49, 65, 67; financial 2, 5, 11, 14, 35–36, 46–50, 59, 74, 78, 115, 143, 145, 199, 223, 225, 277, 291, 300, 302, 352– 354; liquidity 21, 46, 259–260, 305, 334, 335–336, 347; sanitary 334; sovereign debt 14, 46, 55, 58, 61, 62–63, 72, 122, 234, 262, 264, 272–273, 313, 317, 320, 338; subprime 16, 23, 27, 42, 49, 117, 192, 244, 278; systemic 23, 47, 104, 308

cycle: credit -, 50; financial (see financial cycle) cyber risk 341–344 data gap 251 deleveraging 24, 160, 220–221, 269, 272, 354 deposit insurance 8–9, 18, 23, 27, 72–75, 95, 103–106, 109, 118, 143–144, 173, 189–190, 192, 194, 196–198, 221, 243, 273, 279–280, 288, 290, 297, 316, 325–326 deregulation 23, 34, 38, 69, 110–111 discretion: 81, 99, 178, 204, 257, 292, 296–297, 303, 330; constrained discretion 248 Diamond and Dybvig model 8–12, 17, 23, 104, 199, 279 Dodd-Frank Act (DFA) 112–113, 190, 202, 206–207, 234–236, 243–245 eurobonds 313–318, 340; coronabonds 340 European Banking Authority (EBA) 92, 96, 146, 161, 205, 221, 227, 234, 236–237, 289, 321, 325, 336 European Central Bank (ECB) 62–64, 167, 169, 207, 218, 235, 250, 261, 264, 271, 289, 290, 300, 312–313, 316, 318, 321–325, 338, 351 European Financial Stability Fund (EFSF) 317 European Insurance and Occupational Pensions Authority (EIOPA) 176, 180, 184, 241, 255, 289, 321 European Investment Bank (EIB) 340 European Market Infrastructure Regulation (EMIR) 134 European Securities and Markets Authority (ESMA) 289, 321 European Systemic Risk Board (ESRB) 80–81, 128, 238, 241, 248–250, 290, 316, 321–322 European Stability Mechanism (ESM) 317–318 exchange-traded funds (ETFs) 126–127 exposures 22–24, 41, 44, 50, 70, 108–109, 129–135, 152, 154–157, 160–164, 192–193, 198, 298, 212, 219, 227, 229– 230, 234, 236, 238, 240–243, 250–251, 272–274, 281–282, 302, 304, 316, 336, 341–342, 349, 351–352, 356–357 externalities 16, 28, 44, 70, 84, 89–90, 93–94, 124, 129, 204, 219, 295, 312–313, 342–343

Index  367

fair value see pricing Fannie Mae 113, 191, 278 Federal Deposit Insurance Corporation (FDIC) 27, 72, 103, 190, 197, 202, 206–207, 214, 216, 243 Federal Deposit Insurance Corporation Improvement Act (FDICIA) 72, 105, 198 Federal Reserve (Fed) 74, 111–112, 172, 218, 235, 243–244, 288, 312, 337–339 financial accelerator 7, 50 financial activities tax 89–91 financial contract 180, 189–190 financial cycle 7, 33–45 financial development 5, 33–35, 84, 309–310 financial innovation 7, 14, 37, 88, 118, 152, 279 financial market infrastructures (FMIs) 63, 130–135, 322; principles for (PFMIs) 134, 306 financial repression 73, 87, 262–263, 272–273 financial stability 4–7 Financial Stability Board (FSB) 40, 77, 84, 95, 106, 117, 128–129, 190, 201, 204–206, 211–214, 226, 229, 231, 241, 306, 343, 347 Financial Stability Oversight Council (FSOC) 202, 243, 249, 290 financial transactions tax 85–89 fire sale 6, 24, 26, 42, 45, 82, 90, 121, 237, 259, 267, 269, 308, 350 firewall 130 fiscal dominance 262–263, 337 fiscal policy 239, 259, 262–264, 271–274 flash crash 126–127 fragility 6–7; competition-fragility hypothesis 279–280; systemic 226 fragmentation: financial fragmentation 58–64; of responsibilities 290 Freddie Mac 113, 191, 278 funding: funding liquidity 10–11, 29, 127, 129; market funding (see market) G7 300, 306, 343–344, 347 G20 80, 84, 87, 89? 95, 117, 130, 134, 190, 204, 211, 251, 300, 306, 340 Ginnie Mae 113, 191, 278 Glass-Steagall Act 73, 110–112 global Covid-19 crisis (GCC) see covid-19 global financial cycle 55–58 global financial safety net (GFSN) 66, 309, 340 global risk (VIX) 56–58, 147

governance: corporate 74, 83–85, 94, 135, 157, 171, 174, 176, 281; of financial stability institutions 65, 290, 294–299, 313–326, 343 government sponsored enterprises (GSEs) 244, 278 Gramm Leach Bliley Act 111 great financial crisis (GFC) 11–27, 33–37, 55–65, 103–133, 142–163, 189–209, 218–251, 259–282, 290–324, 333–358 growth-finance nexus 34 global systemically important bank (GSIB) see bank haircut 27, 42, 132, 165, 199, 242, 303 hedge funds 23–24, 40–41, 113, 127–128 high-frequency trading 115, 123–126 high quality liquid assets (HQLA) 156, 165, 270 home equity based borrowing 279 housing policy 278–279 herd: behaviour 6; rational herding 24 illiquidity 42, 260–261 inaction bias 248, 250 incentives 12, 24, 38, 46, 69–102, 118, 131, 143, 168, 180, 190, 193, 196–197, 199, 250, 267, 272, 275, 295, 304, 310, 332, 351 independence: of the board of directors 84; of the central bank 293–294, 323, 353; of the financial stability institutions 293, 296–299 information asymmetry 163, 304 inequality: and financial stability 352–354; and macroprudential policy 354–355 innovation: see financial innovation insolvency 27, 42, 158, 194, 196, 207, 223, 260–261 interconnection 24, 41, 109, 225, 227, 229–230, 238 internal model 154, 160–162, 165, 170, 174–175 International Financial Reporting Standard 9 (IFRS 9) 79–81, 239, 336 International Monetary Fund (IMF) 65–67, 89, 91, 226, 234–235, 246, 251, 276–278, 288, 300–305, 307–313, 317–318, 335, 340 International Organization of Securities Commissions (IOSCO) 117, 134, 306 large scale asset purchases (LSAP) 263, 269–270 lean against the wind (LAW) 268–270

368 Index

Lehman Brothers 21, 23, 27, 41, 45, 112, 188–189, 197, 209, 243, 251 lender of last resort 9, 18, 28, 48, 70–71, 259–261, 270–271, 291–293, 307, 312, 323; international 312 leverage 6–25, 37–40, 45–56, 57, 60, 65, 66, 75, 81–82, 87–91, 107, 121, 133, 144, 152, 157, 178, 212, 223, 226, 229, 235–237, 238–239, 243–244, 248, 266–270, 274–278, 279–281, 335, 353–355 leverage ratio 162–165 licensing 2, 20, 111, 119, 168, 298 limitations of the scope of financial activities 106–118 limited liability 15, 144 liquidity 6–12, 14, 19, 20–25, 39–46, 55, 63–65, 70–95, 103–105, 112, 120–134; liquidity coverage ratio (LCR) (see ratio); liquidity risk 103, 127, 129, 157, 162, 219, 235, 310 loop: doom 61, 271–274, 339; negative feedback 82–83, 126 living will 99, 202–203, 206, 216, 357–358 loss-given-default (LGD) 154, 156, 161, 180 macroprudential policy 218–258; relationship with monetary policy 267–268 marginal expected shortfall 226, 232–233 market: consistency 175; discipline 19, 69, 74, 75–78, 104–105, 155, 173, 193, 198–199, 244, 261, 296, 314; failure 70, 143, 145, 342, 363; funding 63, 272; making 24, 88–89, 113, 115, 138, 215; risk 22, 108, 119, 130, 152–154, 158, 162, 171, 300 maturity mismatch 8, 18, 44, 112, 238; transformation 5, 40, 42, 166–167 McFadden Act 73 Merrill Lynch 41, 112 minimum capital requirement: for bank 135, 153–155, 182–184; for insurance (MCR) 174–176, 241 minimum required eligible liabilities (MREL) 190, 211–213 Modigliani and Miller 7, 144–145, 150, 276 monetary policy: global financial cycle 58–64; financial fragmentation 58–64; financial globalization 64–67; financial stability 259–271 money market mutual fund (MMMF) 26–27, 261

moral hazard 17–20, 39, 48–49, 70, 73–75, 90–94, 103–104, 131–135, 160, 185, 189–214, 238, 244, 260–262, 292, 303–326, 341, 346 moral suasion 152, 273 mortgage-backed securities (MBS) 37–38, 60, 278 net stable funding ratio (NSFR) see ratio netting 62, 131, 164–165, 227 noise trading 86 non-performing loan (NPL) 147, 224, 264–265, 276, 280, 324, 336–337 normative approach 70–71, 118, 143, 245, 297 norms: accounting norms (see accounting standards) Northern Rock 21, 23, 47, 49, 112, 142, 191, 291 off-balance sheet 37–39, 41, 91, 152–153, 163, 165–166, 181 operational risk 154, 158, 341 Organisation of Economic Cooperation and Development (OECD) 84, 119, 146–147, 153, 160, 279, 281 originate- to- distribute 37, 117 over-the-counter (OTC) 27, 74, 89, 130, 132, 134, 231, 242, 248, 357 own funds: bank 9, 144, 150, 152, 155–156, 158–159, 162–163, 180, 251; insurance 174–175, 182 own risk and solvency assessment (ORSA) 174, 176 pandemic emergency purchase programme (PEPP) 338 Paris Club 340 payment systems 26–27, 62–63, 70, 196, 288, 291, 347 population ageing 355–356 populism 352–353 positive approach 71–72, 295 pricing: fair value 78–83, 100, 177, 180, 235; historical cost 12, 78–79, 81–83, 175; mark-to market 78–79, 82, 96, 99, 101, 162, 181, 273 primary dealer 122, 338 probability of default 24, 122, 136, 154, 156, 161–162, 180 procyclicality fiscal: 319; of accounting standards 12, 77–83, 164, 244, 336, 340; of Basle II 155–156; of capital inflows 66 prompt corrective action 173, 202, 216

Index  369

proprietary trading 94, 113, 115, 123–124, 139, 244 provision: best estimate of 175, 177–179, 182, 229; technical 119, 175–178, 181–182, 229 provisioning: 19, 80–81, 172, 239; dynamic 239, 246, 257 quantitative easing (QE) 263, 351, 353 rating: advanced internal rating (AIRB) 154, 160–161; credit rating (see credit rating agencies); foundation internal rating (FIRB) 154, 160–161 ratio: credit-to-GDP 223–224, 255, 258; liquidity coverage (LCR) 146, 156, 165–167, 181–182, 184, 339; loan to income 223; loan to value (LTV) 223, 240, 247, 251, 267–268, 354; net stable funding (NSFR) 146, 165–167, 184; solvency 156, 159, 164, 177–178, 194, 202, 214, 221, 225, 237, 239, 241 regulation: normative approach of 70–71; positive approach of 71, 295 regulatory: capture 292–299, 323; forbearance 19, 173, 295; requirements 76, 149–150, 156, 161, 221 regulatory arbitrage 12, 41, 45, 74, 106, 117, 126, 134, 153, 163, 170, 173, 177, 223, 240, 245, 250, 343, 347, 359 rents: agglomeration 88; of finance workers 93–94, 280–281; informational 35; monopoly 71, 73 repression: see financial repression repurchase market (repo) 26–27, 38, 42–49, 89, 128–129, 133, 164–167, 188, 236, 269, 339 resolution: authority 190, 195–197, 201, 203–205, 207, 213, 289, 309; bank recovery and resolution directive (BRRD) 116, 190, 197, 199, 203, 206, 208–209, 214, 273; cross-border 201, 209; key attributes of effective resolution 190, 201, 204, 206, 216; public interest 85, 199, 207, 214, 294–295, 325 revolving door 72, 294–296 risk: appetite 57; assessment 77, 127, 163, 171, 179, 321; aversion 55–58, 63, 120, 310, 335; premiums 14, 45, 66, 269, 311, 313, 318; risk weighted assets (RWA) 145, 150, 152, 154–156, 161, 163, 170, 182, 212, 241, 337; - shifting 15, 49, 94, 164, 247, 273; -taking channel 266–268; transfer of 155

safe asset 12, 14, 42, 59–60, 129, 269–270, 308 safety net 17–19, 44, 66, 70, 189, 198, 309, 317, 337, 340 savings glut 14, 59–60 search for yield 56, 60, 264–265, 267 securitization 11, 13, 27, 37–42, 44–45, 74, 76–77, 113, 117, 153–155, 158, 244, 271, 278–279 securities settlement system 130 seigniorage 263 shadow bank 39–42, 44–47, 116–118, 142, 153, 163, 220–221, 235, 242, 244, 247, 322 short selling 87, 118, 120–123, 340 short-termism 15, 81 Single Resolution Mechanism (SRM) 190, 207, 323–325 Single Supervision Mechanism (SSM) 169, 207, 273, 289, 317, 323–325, 339 solvency II (in Europe) 119, 143, 174–179, 181, 186, 241, 255 solvency capital requirement (SCR) 174–176, 178–179, 182, 186, 241 sovereign debt 14, 24, 46, 55, 58, 61–63, 72, 122–123, 156–157, 166, 221, 227, 234, 262, 264, 271–274, 302–304, 307–308, 311, 313, 315, 317–318, 320, 323 special purpose vehicle (SPV) 37–39, 41, 359 stranded assets 350 stress test 233–237 structural policies: competition policy in the financial sector 279–282; housing policy 278–279; tax policy 274–278 structured investment vehicle (SIV) 38, 41, 261 subprime mortgage 39, 44, 112 sudden stop 55, 65–67, 304, 310 supervision: accountability 296, 299, 330–331; home 169, 209–210, 249, 250, 359; host 111, 209, 250, 358–359; independence 294, 296–299; off-site 168–172; on-site 117, 168, 171–172, 186, 295; twin peak 288 supporting factor: green 352; SME 156 swap agreements 312, 338 systemic: systemic bank (see bank); systemic risk 16, 21–28, 39, 41–42, 47–48, 66, 70, 82, 84, 90–91, 109, 112, 130, 132, 134, 142, 160, 194, 209, 218–219, 222, 225–233, 249, 259–261, 282, 307–311, 322–323

370 Index

tax bias: towards homeownership 275–276; towards debt finance 276–278 taxation 12, 85–91, 94, 125, 157, 275–278 time consistency 18, 248, 296–297 too big to fail (TBTF) 20–21, 35, 77, 93, 95, 109, 112, 144, 189, 211, 282, 346, 357 total loss absorbing capacity (TLAC) 150, 190, 197, 200, 209–216 Trans-European Automated Real-Time Cross Settlement Express Transfer System (TARGET 2) 27, 62–64 transparency 74–76, 83, 85, 109, 117, 122–123, 127, 130–131, 157–158, 161,

176–178, 192, 243, 248–249, 296, 299, 351, 357 Troubled Assets Relief Program (TARP) 71, 75, 95, 121–122, 191–192 value-at-risk (VaR) 162, 170, 175, 181, 226, 232–233 Vickers rule 113–114 volatility 14–17, 25, 43, 56–57, 65–66, 81–82, 85–88, 108, 121–122, 125, 127, 132, 147, 160, 164, 177–178, 232, 249, 271, 274–275, 300, 337, 340, 349 Volcker rule 112–113, 244